James Grant on Bubbles, Bargains and Everything in Between
The Daily Reckoning Presents… Steve Forbe’s Intelligent Investing with Jim Grant, editor of Grant’s Interest Rate Observer
Steve Forbes: Jim, good to have you with us.
James Grant: Thank you, Steve. Good to be here.
Forbes: Tell us, what is going on? We’ve had the worst recovery from a sharp downturn in U.S. history. Yet the monetary base has exploded far in excess of what it did in the ’70s and yet we haven’t had an explosion, at least in the Consumer Price Index. Gold is down from its highs of three years ago. Stocks are at a record high. What you call the taper tantrum, now the markets are in seeming calm about that. So what in the world is happening?
Grant: Well, I think first and foremost the patient is overmedicated. That is, the economic patient. Stimulus, by the bottleful, by the prescription fill, gradually and by degree are (and I guess not so gradually) the Federal Reserve has moved to substitute price administration for price discovery. And it seems to me that the Fed’s kind of full-court pressed (to switch metaphors) on financial markets and pricing thereof has induced a deep complacency with respect to financial assets and has also introduced a sharp degree of optimism or what we might call even inflation in the financial markets.
It’s a fairly recent conceptual invention, this thing we call the economy.
I certainly can’t explain why, to date, no such inflation has been visible or very little has been visible in the consumer realm. But you know one would almost expect that in this day and age of miraculous digital enhancements to everything we do and the related improvements and the efficiency of production that prices would, in the absence of these monetary insertions, actually fall, or at least dwindle a little bit. So I suppose that a little bit of inflation is itself an anomaly one ought to have seen, kind of a dividend for the working guy in the shape of low and everyday lower prices.
Forbes: Just to put that in perspective. Somebody pointed out if you tried to create the iPhone in 1990, it would cost $3.5 million.
Grant: Right. It’s less today.
Forbes: Huge deflation.
Grant: We’ve seen this before, of course, in many different ages of American economic history. The late 19th century was a time of persistently dwindling prices. Some people resented it, of course. There was a progressive movement, so called, that mobilized itself in opposition. William Jennings Bryan was a figurehead of the movement for abundant, cheap, silver money. But on the whole, Americans rather enjoyed a great generation of progress. In the 1920s, prices were stable or dwindled. In the early 1960s, the same.
As recently as 1954, I guess, there were 12 consecutive months of falling prices, as registered by the CPI. And to go back and look at the newspapers you will search in vain for expressions of hysterical concern about that as we would certainly see today. So I think what has changed is not so much the behavior of prices but rather the attitude of our central bankers towards prices. They feel they must control them and they must raise them up.
Forbes: Has there ever been a time in terms of central bank history where a major one has not just manipulated short rates, which is almost a given, but suppressing long rates for such a period of time?
Grant: Well, sure in our own financial history, of course, during the 1940s the Fed was mobilized in service of the Treasury to finance the second World War. And indeed the Fed, not so many years after its founding in 1914, was conscripted into the national service in World War I. In World War II the Fed controlled and pegged, as they said, short, medium and long dated Treasury yields and thereby influenced all bond yields (and they were, as you might expect, rather low). That ended in 1951.
But I think what is different today is the Fed’s intrusion into the pricing of stocks. You know, Chairman Bernanke famously, or as you might say, infamously took credit for levitation of the small cap indices a couple of years ago. So the Fed has got its finger in almost every financial market pie. That’s a new thing.
Forbes: Before we get to various bubbles or mini-bubbles, the economy itself, as you know in the last five years, 1.8%, truly subpar.
Grant: As measured, right?
Forbes: As measured. Is it going to get better? Or is it just one of these walking pneumonia things that will just continue to…
Grant: The more birthday candles I blow out, the more agnostic I’ve become. In fact I’ve even come to doubt this thing, the economy, it seems to me ought to be a phrase we use in quotation marks. It is the aggregation of individual effort.
It’s a fairly recent conceptual invention, this thing we call the economy. It mostly came about through the attempts to measure and mobilize business activity during the second World War. And Paul Samuelson, I guess, was the preeminent voice for conceiving of things in the aggregate. And for most of our American financial and economic history, we didn’t even talk about the economy. It was farming or enterprise or textiles or trade or commerce. When you’re President, Steve, I want us to get back to that.
Forbes: This is not a machine. In terms of this thing on inflation which you mentioned. Why is the so-called Phillips Curve, which posits that there’s a trade-off between inflation and unemployment, still have a vice-like grip on so much of the economics profession when it’s been debunked time and time again?
Grant: Can’t explain it. But as they say in Brooklyn, “It don’t work.” Well, it’s not the only such anomaly and, as it were, the science, mind you, of economics. People do hang on. My contention is that macroeconomics, especially, is politics dressed up in algebra.
Forbes: Certainly that would seem to be the history of John Maynard Keynes.
Grant: Yes indeed.
Forbes: Federal Reserve’s behavior now. They’re doing what they call reverse repos. An effect which, as you pointed out, the Fed can conjure up all the cash it wants. But it’s, in effect, taking cash in and lending out its security portfolio as collateral.
Grant: Well, football fans would recognize this as the old Statue of Liberty play or the hidden ball trick. Now here’s the way it works. The Fed, lo these many years after so much of what they call “quantitative easing,” meaning the purchase of vast amounts of Treasuries and mortgage-backed securities with money that didn’t exist before the Fed created it. Four trillion or so of these securities the Fed accumulated.
So the Fed has kind of stripped Wall Street of what Wall Street calls collateral, securities. So what to do now? Well, the Fed has a plan. And the plan is to invite Wall Street to borrow, temporarily, these securities in exchange for Wall Street’s cash. Wall Street has acquired all this cash from selling these securities and now the Fed wants Wall Street to reacquire the collateral in exchange for Wall Street’s cash. And the Fed is proposing to pay five one-hundredths of one percent interest to borrow this money.
So it’s rather complex except the purpose is twofold. One is to control the short-term money market interest rate. The Federal Funds rate is kind of yesteryear’s money market rate. So the one object is to control that rate. And the Fed has, it says, set five basis points as its rate. And the second object is to sweep away redundant cash, come the time, when conventional inflation, that is not inflation of Wall Street, what we call a bull market, but inflation of the checkout counter, the bad old kind of inflation, when that inflation rears its head.
Interventions, as I see them, are rather like lies in that the first one begets a second, begets a third. So the first intervention begets a second, a third and enth. And the Fed is now concerned that this invitation to exchange cash for Treasuries constitutes an open invitation to a bank run. So the next time of trial the banks will say, “Well okay, we’ve got all this money. We’ll get Treasuries from the Fed.”
Well, to neutralize that effect, the Fed is weighing the creation of another kind of repurchase facility that will do the opposite of the reverse repo. Don’t get me started, Steve. I’m sure everyone by now is wondering why I started talking about this.
I think the takeaway is that there has been a succession of interventions since 2007. And they accumulate to immense, improbable, unimaginable amounts of digitized, immaterial money. And they also have given us immense kind of incentives to invest and speculate in new and arguably riskier ways.
Forbes: In terms of what they’re doing with so-called reverse repos. Is that a way, too, to help Freddie and Fannie and non-banks in effect to more participate even though they’re not bank banks?
Grants: I think that is the attempt to control the so-called shadow banking system.
Forbes: Now in terms of, instead of using the loaded word “bubbles,” distortions, that this has led to, what’s it done to money market funds?
Grant: Well, the money market funds are rather in the crosshairs of many federal weapons. The bank regulators want the banks to fund long. They want long-dated liabilities that are run-resistant, okay. Money market funds are under a different set of crosshairs under the SEC. The SEC wants the money market funds to invest short. So this is a little bit of a conundrum. The SEC also insists that the money market funds invest in the highest grade collateral with the shortest duration, of course, and that they have a certain amount of their assets available on call, day or night, 24/7.
So these are very, very demanding specifications. And it turns out the market is not exactly overflowing with assets that conform to the SEC’s dicta. So all this, by the way, gets us back to the question of price suppression and price manipulation. Money market interest rates, as every saver knows full well, all too well, are about zero before tax. Money funds yield about zero before tax.
…Gazprom is the most reviled company on the face of the Earth. It must be. It’s the biggest Russian stock.
So we take credit risk to how we price credit. Well, we don’t price credit risk. I mean, it’s a worry. For example, the Fidelity organization, I think, is the most assiduous and diligent and responsible analyst of credit risk in its money market mutual fund or funds. But what purpose is that worth when you get paid one or two basis points or three basis points or nothing? I mean, it’s absurd is what it is.
Forbes: The bond market. Is there a real risk of what you wrote about or quoted somebody as saying about a melt-up where people are forced, in effect, to rush into long-term Treasuries?
Grant: Well, that’s an interesting idea that was proposed at our recent conference by Jeffrey Gundlach, a very good bond manager and an imaginative one, which is an even better attribute of successful investing. And he proposed that the way the market is set up now, that there is a kind of embedded short interest in Treasuries. People have been selling Treasuries short to hedge against rising interest rates.
What happens if rising interest rates don’t happen? What happens if, instead, rates continue to fall and there is something that goes bump in the night in the world’s finances and people want safety? Well, on form people are going to demand long-dated Treasuries as their safe haven. Maybe not certainly but probably.
Well, in that case there could be a short covering rally superimposed on a flight to what people regard as safety. So it’s an interesting idea if one wanted to hedge what the analysts call “tail risk.” One might get long-dated options on 30-year Treasuries. That’s his idea, at least.
Forbes: It’s amazing even now as the Fed is tapering, it is still doing a disproportionate buying and long-dated securities, which means they’re still trying to play games with it. Amazing. Putting aside the temporary melt-up, let’s say blow-up in Ukraine or in the Baltic States, is this really a bubble? No sane person would buy a 30-year treasury at these yields.
Grant: Well, as you noted a moment ago, bubble is a term of art and probably one rather too frequently invoked. But there certainly is a great distortion, in my opinion, in the pricing of junk bonds, what we used to call high-yield..
Forbes: Give the yield, latest Merrill Lynch…
Grant: Well, it begins with a five.
Forbes: Not a 1-5.
Grant: But that is the best of it. The worst of it is the yield to call. Many of these securities, of course, have an option in part of the company to redeem them before the maturity date. So you’ll find securities, for example, of the Valeant Corporation, VRX, this roll-up of pharma companies that is now going to be out there and acquiring yet something else. There’s a Valeant issue that yield begins with a five number but the yield to first-call is a four number, a four handle, and you wonder what exactly is the upside?
I mean, the equity-holders conceivably could do, who knows? I think Valeant is not advertised as a great company. We have issues with its accounting. But say it works. Say it cures cancer. It cures ugliness or something. Okay, so stockholders do well. But what is in it for the debt-holders? These debt-holders are either the wiling or the inattentive victims or tools of the investment bankers as they have been at the top of every credit and M&A cycle.
Forbes: Is this example, putting aside the word “bubble,” of the huge distortions? I mean, no one in their right minds would take a jump on yielding 5.63% or whatever the average is.
Grant: To put ourselves in the shoes of savers trying to make ends meet in retirement, you have to do something. I’m in the business of deploring this stuff, as I guess is Forbes. But you know if you are given the choice of nothing or four and a half, it’s not the only choice, to be sure. But if that is your limited field of investment vision, I guess you take the four and a half to worst. But it is certainly distortion.
Forbes: You mentioned Valeant. Another one that has been mentioned in your newsletter, in the Interest Rate Observer, is Intelsat and other examples of strangely-priced…
Grant: There are many companies that would seem to be on the edge of or closer to credit difficulties than credit redemption, whose securities are yielding not very much, either to maturity or to-call. And this is a very good setup for the professionals who can sell bonds short. Way back when, when I was only like 50, junk bonds had…
Forbes: …Double-digit yields?
Grant: Yes. And it was very difficult to sell them short because you know the short-seller must of course…
Forbes: …Pay the interest.
Grant: Pay the interest on the securities. But if you’re only yielding 4.5% or 5.5%, it’s a much more attractive short sale. I dare say not everyone in our vast viewing audience is either preparing emotionally or financially to do this, or technically. But the pricing of these begs someone’s focus on the short sale possibilities.
Forbes: Stocks. How much of that is a distortion? People would say some sectors are kind of dicey. But PEs overall, not too out of line.
Grant: Yes. There is such a thing in analysis called the dividend discount model. And it says that the value of an equity is the value of its projected cash flows discounted by a suitable rate of interest. And there’s more to it than that, of course.
But if the rate of interest one uses to discount cash flows is itself unsuitable or if it’s suppressed, that means the cash flows are exaggerated or inflated. And the price is higher than it would otherwise be. And I think that’s the risk in the stock market generally. I understand that many areas of the stock market are not certainly in the neighborhood of valuation where they were in 1999. But that doesn’t mean that things are fairly valued. And also I think more broadly, more fundamentally, we are all doing business in a kind of valuation hall of mirrors on account of the suppression of interest rates and the general body English that our federal masters are giving the stock market. They want it higher for the so-called wealth effect. Wealth effect, mind you.
Forbes: Used to be called trickle-down economics.
Grant: Right. Rather disapprovingly, I think.
Forbes: Sectors of the market you feel are overvalued. You’ve written about biotech. You mentioned Valeant.
Grant: Biotech is our favorite, is our favorite specimen. If you go on the website of the ETF that tracks the basic biotech equity index and look at the valuation they’ll say the stocks are valued 45 times earnings or so. That is my latest recollection. If you read deeper into the explanation, you will see that in order to compute this, why they discard all P/Es over 60.
So as we do the numbers in our homemade way, we come up with a valuation 2,000 times earnings on this exchange-traded fund. These biotech equities certainly are regarded as lottery tickets on scientific progress. And I dare say that some of them will pay off. But the odds against success in pharmaceutical research are heavy against the investor. So I’d invite people to read deep into the fine print on the ETF.
Forbes: Other areas of the market you feel are frothy?
Grant: Well, there’s froth in reverse. One of my favorite sightings, and I’m talking about my book here because I actually own this, but Gazprom is the most reviled company on the face of the Earth. It must be. It’s the biggest Russian stock. It’s known to be Vladimir Putin’s economic instrument on foreign policy and not universally favorable foreign policy. It owns a great deal of gas, certainly most of Russia’s gas reserves. Not insignificant portions of the world supplies Europe with about a third of its gas. There’s $150 billion or so in revenues. It earns a lot of money. It pays a 5% dividend and like a 15% payout ratio. And it is priced at 2.5 times earnings.
Forbes: So anything at that price is worth buying.
Grant: This is like botulism with a ticker. And also Jay Carney, the President’s press secretary got up in the middle of March and said, “I would advise you, if you’re going to trade in Russian stocks, to be short.” Well, this is a new face of Jay Carney. We had to know that the President’s press secretary was also a famous speculator. So I don’t know about you, Steve, but…
Forbes: So that was a buy signal to you?
Grant: When I hear Jay Carney saying something, I’m constitutionally not able to be bearish. I must be bullish. Three proverbs might work in this. One is, good things happen to cheap stocks. Two is, this too will pass. And three is an epigram I credit to my friend, Joe Robillard, who says, “Successful investing is about having everyone agree with you later.” Isn’t that wonderful?
Forbes: Talking about stocks. You were in India. And you came away bullish in India, that they’ll somehow pull it together and huge opportunities.
Grant: Of course, this has been an age-old hope. The British left them in the late ’40s the poisoned chalice of Fabian socialism. And India has been a laboratory, certainly the world’s biggest laboratory in the, how should we call, the un-success of the socialist model of development. Indians are fed up. And there’s an election. And the frontrunner, Mr. Modi, is in favor of honesty and modernization and maybe even a little enterprise [shortly after this interview, Narendra Modi won the election with 282 of 543 parliamentary seats]. India has been in the funk economically and the stock market.
Forbes: He did deliver an estate as governor, right?
Grant: Yes he did. He’s not, alas, as much of an anti-state or libertarian as some of us would hope. We shouldn’t make him out to be a Friedrich Hayek of the Hindu persuasion. But he is, besides being for modernity, he is in favor of enterprise. And my goodness, there’s so many areas of India that would positively blossom not merely if there were a Friedrich Hayek running the country. But if things stopped being so awful. There’s a saying that a rally from awful to bad is much more lucrative for an investor than from good to great.
Forbes: Right, right.
Grant: So expectations are set low. The market has come back since last summer when it was in its doldrums. But I think there’s a lot of cheap financial stocks in India. And I think there’s also the prospect, the possibility, that this time, what’s the phrase, might be different.
Forbes: Talking about distortions or bubbles. Discuss the art market.
Grant: Oh yes. Not willing to settle for its mastery, mind you, of finance and economics, has branched out in fine arts. And we have been following the valuation of certain artists. And we observe that there is an artist called Oscar Murillo, a contemporary, born in 1986 who painted something called The Untitled Burrito, which to the lay eye would seem to be a bunch of yellow squiggles over which has written the word freehand, “Burrito.” We noticed that traded for about $325,000 recently. We notice that there is an artist called Esteban Murillo who was one of the greats of the Spanish counter-reformation whose works are now in a deep funk.
Inflation is too much money and credit. That’s the cause. The symptoms of that redundancy are variable.
And a pair of his works, the other Murillo’s, failed to sell at auction recently, at about, oddly enough, the same price as Oscar’s flew out of the sale room. So it’s a curious sighting. It tells us there are cycles and vagaries of taste in art as there are cycles and vagaries of taste in finance and investment and, I dare say, in hair styles and everything else.
And I think also to a degree, the valuation of modern art has to do with modern money. People are buying up the new, hot artists in expectation that here, at last, is an inflation hedge that will truly hedge. And it’ll hedge not just the inflation that has not yet materialized at the checkout counter at Wal-Mart, but also the inflation that has certainly materialized in the corner of Wall and Broad, at the corner of Main Street.
Forbes: You hit on something that should be underlined, is that inflation isn’t just the CPI.
Grant: Inflation is too much money and credit. That’s the cause. The symptoms of that redundancy are variable.
Forbes: So it can be commercial real estate. It can be financial assets. Stocks. Art. Farmland.
Grant: The things you just mentioned, Steve, the word for inflation is bull market.
Forbes: Bitcoin. Is that a symptom of the desire to try to find an alternative?
Grant: Yes. I think it’s a cry for help on the part of the Silicon Valley brainiacs. Hey, Silicon Valley. They’re not going to lose your Krugerrands in the hard drive. Gold is a universal currency that people recognize at sight. Wait, I’ve come prepared, Steve.
Forbes: Now tell us the source of sound money.
Grant: This is a double eagle. It’s a $20 gold piece that was produced in the heyday of the Coolidge administration.
Forbes: Which you spoke at an event.
Grant: Right, we were both present to inaugurate the Coolidge dollar, which is actually concocted of base metals. But here is a gold piece worth $20 in 1927. And the derivation of the term “sound money” is this. Now isn’t that a lovely tintinnabulation. You’re not going to get that with Bitcoin.
Forbes: So putting aside all of the myths and the motions, the gold standard simply means you have a fixed value for money, which is supposed to measure value just as you have a foot for length or a scale for weight or a clock for time.
Grant: It is a weight or a measure. And that is all it is. For those of the viewers who did not see Steve and I debate, it seems like a long time ago. Anyways, we were in a debate. And we were up against a couple of paper money guys. And God, we were so eloquent. And the only extenuating circumstances of the debate was held in hostile territory, in the Upper West Side of Manhattan. And we got thunked.
I mean, I think that, except for my cousin and wife, everyone in the audience would have voted against this idea that money ought to be a measure or a standard or a weight. He said it so well. But for now the world is happy. The world is truly complacent in the face of QE and 0% rates and the regime of Janet Yellen. So the world will have to do what the world wants to do. That’s my approach.
Forbes: On that, we had a severe crisis in the ’70s. And yet Reagan couldn’t get a restoration of a gold standard. Milton Friedman and others were adamantly opposed. We had a disaster in ’08 and ’09. And instead of punishing the Fed, it gets punished with more powers. So a crisis in and of itself doesn’t lead to the solution. Is it just the hard work of persuading people that there is a better way?
Grant: I think it is exactly that hard work which you, Steve, have taken the lead in doing.
Forbes: Following your good example.
Grant: To me it is inexplicable, the hold that the current regime of money and credit has on the intellectual, so-called thought leaders of finance. I guess many of them do benefit from 0% funding cost when the cost to borrow to undertake a leveraged buyout or going-private transaction is 4% or so with credit risk. That state of affairs is not going to strike everyone as objectionable.
People in Greenwich, Connecticut rather like it. And I think the banking community doesn’t object to it so much. That 2008 and 2009 was a crisis, not even so much of money as it was of credit, of course the promise to pay money. And it revealed, really, the scandalous weakness of our banking situation. My goodness, there was no depression. And yet these institutions came to the brink and over the brink, many of them, of failure.
What an indictment of analysis, of credit, of foresight, of stewardship. You know, in the day, Steve, there was something called the double liability rule. And it meant that stockholders in a nationally-chartered bank were held accountable in the event of the impairment or the insolvency of the institution in which they invested. They got a capital call from the court in the case of a crisis. And they had a capital call to the full extent of par value of the shares they owned. And it resulted in a great pile of money for the creditors, this legal requirement did. But it was outlawed about the time the FDIC came in.
But if you think about the evolution of credit from that time to this, it has been all about the creation of new incentives to lay off risk on who? On the American people, on the taxpayer, on the government, on the state and to remove the pain of failure from the shoulders of the capitalists.
And of course it’s inequitable. It’s iniquitous. There was a guy who was a banker of yesteryear, a guy named George Williams who ran the old Chemical Bank in the 19th century when it was called Old Bullion for its unfailing readiness to pay out gold in a time of crisis.
Forbes: Before it became Comical Bank.
Grant: Right. Before it became Comical Bank. And some reporter asked, “Mr. Williams, Mr. Williams, what is the secret of your success?” And George Williams replied, “The fear of God.”
Forbes: In closing, you’ve got a book coming out.
Grant: Yes. I was hoping we’d get around to this.
Forbes: Title? And what’s it about?
Grant: Oh the title. I’ve forgotten the title but it’s something like The Forgotten Depression: The Crash That Cured Itself, 1921. So the Depression actually was not forgotten which is why I’ve forgotten the title because I remembered it. The Depression has to do with the events of 1920 and 1921. The nation suffered a severe economic contraction and unemployment that, unmeasured, was almost certainly in the teens. Industrial production down 20%. Commodity prices chopped in half. Stock prices ditto. GNP, which was then really unmeasured and unconceived, I’d call it in nominal terms 15% or 20%. We don’t know, but a lot. You know, mass hysteria, right? What should the government do?
[The Great Depression] was great in how it cured itself and how it did not result in the massive increase in the public debt.
Forbes: Well, in that one year it was worse than the first year of the Great Depression.
Grant: Yes. Well, the collapse in prices was much steeper in 1920 through ’21 than anything the Depression saw. But yet the banking system held up. Next to no failures of consequence. But anyway, well, how did the government meet this? Well, the government met it in two ways. First of all the Treasury ran a surplus. And secondly, the Fed in its ignorance or inspired, I don’t know, whatever it caused to raise rates, the only time in the history of the Fed that interest rates were higher at the trough of a business cycle downturn than they had been at the preceding peak, Fed raised rates at punitive, constricting, real money market interest rates prevailing at the lows of this business cycle. There was a liquidation, of course. However, things got cheap. Money came into this country.
Forbes: Taxes were cut.
Grant: Taxes were cut, although rather late in the cycle. Andrew Mellon came in and said, “What’s all this? We pay the debt. Cut taxes. Encourage enterprise. And let the price mechanism work.” And lo and behold the Great Depression was a great depression. It was great in how it cured itself and how it did not result in the massive increase in the public debt. And it was great in the dynamism of the recovery that followed. It was a terrific episode in American history.
Forbes: Perhaps we’ll learn those lessons again.
Grant: Well, I hope so.
Forbes: Jim, thank you.
Grant: Thank you, Steve. What a pleasure.
This interview originally appeared here on Forbes.com.