2017 Fall Grant’s Conference

Hamilton & Company professionals regularly attend various investment conferences and symposia in furtherance of our continuous research into both individual managers and the investment environment at large. As has been our practice, we intend to share with you occasional summaries of these events.

On October 10, we attended the fall Grant’s Conference in New York City, hosted by Jim Grant, publisher of the influential newsletter Grant’s Interest Rate Observer. As we’ve noted in past dispatches, we consider this event of particular interest both for the intelligence and diversity of its presenters as well as the quality and influence of its audience.

Last year, we remarked that the atmosphere was generally bearish, with managers alluding to what they saw as overheated equity markets, as well as perils facing bond investors. This year, despite even higher equity market valuations and even greater certainty regarding rises in interest rates, the mood in the room was surprisingly bullish. To be sure, there were notes of caution in the air—especially as to the potential speed with which markets may unwind when they do, finally, correct.

A brief summary of some of the more interesting presentations follows.

Former Fed chairman Alan Greenspan spoke briefly, and sounded a cautionary note. While corporate profit margins are good, and a “sense of benevolence” hovers over the economy at present, Greenspan warned that that positive feeling may be “a false one,” at risk as, among other things, entitlement spending in the United States seems primed to grow, particularly in light of the aging of our population. “Unless we can curb entitlements, our productivity will be hampered,” Greenspan said. “And without productivity growth, economic growth can’t happen.” Greenspan showed a chart demonstrating that corporations were reluctant to invest in very long-term assets, those with a life of more than 20 years. As he described corporate spending, “Software? Yes. Warehouses? No.” This apparent lack of long-term corporate confidence was not a positive sign, Greenspan warned, and noted that, while conditions may look “quiescent” at present, “Fear is a far more formidable force than euphoria,” and “Markets go up slowly, but come down fast.”

On a more positive note, economist Ed Hyman of investment banking and asset management firm Evercore, shared a sunny forecast, punctuated by more charts than could possibly be summarized here. Our post-2008 economic expansion, he said, may be “chronologically old,” but it is “economically young.” Major positives Hyman highlighted were “synchronized global growth,” low inflation, and high corporate earnings. He does not foresee a recession within the next three years.

Similarly positive—and surprisingly so—was long-time bear Jeremy Grantham, co-founder of Boston-based asset manager Grantham, Mayo, Van Otterloo & Co. “When does dry powder become dead weight?” asked Grantham, alluding to more enduringly bearish managers who may prefer to hold cash in anticipation of future opportunities during a market correction. For Grantham the answer is now. His argument was that U.S. equity markets are not presently exhibiting the classic signs of a bubble. For one, there is no boom in IPOs, no coincident credit boom, and no irrational exuberance. “This has been an anti-euphoric market for eight years,” he said. “Nervous all the way—as it is now.” Grantham also cited a Shiller PE ratio still below its 20-year average [though, at 31, it is nearly double its long-term historical average], and noted that, unlike during the Internet Bubble, where one sector boomed beyond the others, the recent rising tide has lifted all boats roughly equally. “Bubbles want tulips, not flowers,” he said. “They specialize.” While he did not rule out a market correction, Grantham, unlike several earlier speakers, thought “regression is likely to be slower than normal this time around,” and not the product of an abruptly bursting bubble.

Short-seller James Chanos, perhaps best known for his epic short of Enron shares, which Barron’s called “the market call of the decade, if not the past 50 years,” addressed the healthcare arena, which he thinks is littered with companies riding for a fall as Americans, faced with rising premiums, copays and deductibles, become increasingly attuned to the true costs of healthcare. Per capita healthcare spending in the United States is currently $11,000, and is projected to grow at 5.6% per annum in years ahead. At that rate, by 2025, it will amount to 20% of GDP.

Many companies, Chanos noted, had benefitted from the ACA (Obamacare) and, in light of the potential unwinding of some of that law’s requirements and subsidies, a number of businesses within the sector boasted “unsustainable profit margins.” One group singled out by Chanos was independent so-called Pharmacy Benefit Managers (PBMs), such as ExpressScripts. PBMs ostensibly help insurance companies and consumers by negotiating discounts on drugs from their manufacturers. In practice, however, they help drive up prices because they are compensated based upon the size of the discount they are able to negotiate. The higher the notional list price of the drug, the larger the “discount” the PBM can achieve and the more money it pockets. This game, Chanos argues, is about to come to an end. Not only is Amazon preparing to enter the business, which will bring pricing transparency, Chanos said, ExpressScripts is currently being sued by its largest customer, health insurer Anthem, which accuses the company of overcharging by $3.5 billion. Other areas in the healthcare space destined for trouble Chanos identified were mental health facilities, which Obamacare anointed as “essential health benefits,” leading to a boom and myriad abuses, along with highly leveraged for-profit rural hospital chains.

Elliott Management founder Paul Singer expressed his considerable annoyance that activist investors, who take a large stake in a company and use that position as leverage to effect change and create shareholder value, such as his fund, were frequently the subject of “divisive” and “objectively false” claims that they were “short-termers,” who might produce some rapid and immediately profitable change at a targeted company at the expense of its long-term prospects. In Singer’s view, short-term fixes frequently lead to long-term benefits. Moreover, he pointed out that in a world where 30% of investible assets were committed to passive vehicles, active management, and especially activist investors, were more important than ever. “Who is going to create efficiency in the markets, when the people who actually do that work [i.e. fundamental research] are reduced to a small, beleaguered band?” Index funds, he noted, are not geared toward improving the companies in which they invest, only toward holding them because they happen to be part of an arbitrarily composed set of stocks. Activist investors do average investors a service, he said. Too many corporate boards, he said, are composed of “luminaries and academics,” with little understanding of the businesses they’re tasked with overseeing. Activist investors, meanwhile, “have skin in the game—typically more than boards or managements.” In short: “Shareholder activism creates better American companies.”

Finally, in a particularly thought-provoking presentation, Frank Brosens, co-founder of the hedge fund firm Taconic Capital Advisers, argued that while equity market volatility has been notably low in recent years, a number of currently vogueish investment strategies and vehicles may lead to “pro-cyclical” selling in a downturn, exacerbating the speed and severity of the market’s drop. As one past example, Brosens cited the role of “portfolio insurance,” a once-fashionable strategy employed by pension funds that called for selling index futures into a declining market, in enhancing market losses during 1987’s Black Monday plunge. Today, Brosens sees the potential for similar dynamics, in which selling begets more selling, stemming from the use of investment strategies including “targeted volatility” and “risk parity” approaches, which call for near-constant rebalancing between asset classes depending on the expected risk-adjusted returns of each; “trend-following CTAs”—commodity traders who rely upon a technical analysis approach that tends to reinforce directional market moves; various option-overlay strategies, along with the widespread adoption of daily levered index ETFs, which employ leverage to seek a return that is some multiple of the index’s daily result. Should volatility spike, and markets move to the downside, Brosens argued, some or all of these investment approaches could combine to produce a rapid and exaggerated drop.

Despite any optimism expressed by the day’s speakers, or reflected in recent market performance, we suggest that you continue to proceed with caution and remain ever-mindful of the risks that underlie heated markets.

Should you have questions or wish additional information, please contact your consultant.