October Lunch Club

Investors speak out on oil prices, the evils of indexing and lastly, death.


Elizabeth Tran, CIO, American Express Asset Management
Marc Faber, Marc Faber Ltd
William Kaye, senior managing director, The Pacific Group
Vincent Duhamel, principal and chief Executive, State Street Global Advisors
Gianpaolo Guarnieri, managing director, Phoenix

Q: First off, where do you all think the US stock market/Nasdaq will be 90 days after the presidential election?

Faber: I have no idea where it will be 90 days after the election, but I have an idea where it will go to. Nasdaq will go down 60% from where it is now.

Tran: You’re forcing fund managers to break our sacred rule. We either say where or when. But to get both right ... But being serious, we’re pretty cautious on technology stocks. We can’t see them going up at these levels.

Guanieri: I see the US market going down after the election. Maybe 20%.

Kaye: All the smart money seems to believe the Nasdaq has to go down anywhere between 50% to 60%. Then again, I would never have been able to estimate the heights to which Nasdaq went. The public is driving this, and they don’t care about valuations.

Faber: Where I disagree with the consensus is that I think the US economy will not have a soft landing. I think it will weaken much more than people think. Why are retail stocks all down more than 50% from their highs? Do you think that’s an accident? The market smells that consumption is not sustainable in the US at the current rate compared to income growth. So I think the market is telling us a big slowdown is coming and the biggest collapse will be in technology, where there has been massive over-investment. The Nasdaq is much more overvalued than Japan was in 1989. Much more.

Tran: One issue is that institutional investors often don’t have the courage of their convictions because they are benchmarked. So we have had a syndrome of fully-invested bears for some time now. You may not believe in the fundamentals, but you wouldn’t dare to underweight in a sector because it’s such a big part of your benchmark. I was just in Alaska on holiday and came across tourists on buses and even though 90% were retired they were all looking for opportunities to buy.

Q: Speaking of Alaska, what do people think about recent oil price rises?

Duhamel: The impression I have is that it is more of a bottleneck effect.

Faber: I think the price is very low. It should be around $300 a barrel … Maybe not quite that high. But the economics of oil are very simple. Non-OPEC countries produce 60% of oil supplies, but have only 20% of reserves. OPEC produces 40% of oil supplies but have 80% of reserves. Meanwhile the reserves of non-OPEC countries have been going down. They have been flat for the last 10 years and there is no exploration. Non-OPEC countries are producing at 100% of capacity and cannot increase production. OPEC is producing at 96% of capacity, and so can only increase 4% in the short term. So on the global supply of 76 million barrels a day, that would be 2% or less.

Anyway, are they so crazy as to increase production? They’d earn much more money by cutting production. Then there’s the bottleneck, which is with tankers. There are a shortage of these and that’s why tanker rates are at a 30 year high. There’s no tankers around to carry the oil even if they increase production.

In Asia the demand for oil has more than doubled since 1992. But Asia still consumes – including Japan – less than the US. That’s three billion people in Asia consuming less oil than 260 million in the US. Per capita consumption in Asia is two barrels. In the US it is 24 barrels. In the next 10 years, Asian per capita consumption could match Latin American levels, which is four barrels per head. The Asian demand will mean we will outstrip production capacity.

Tran: The probability of an upward spike in oil prices is high. We really need a mild winter in the northern hemisphere. Apart from Saudi Arabia, the rest of OPEC is producing at full capacity. So we’ve got ourselves into a dire situation. US refining capacity is at 95% at the moment. So it’s very hard to see the oil price fall back during the winter.

Q: Will oil prices cause a fresh crisis?

Kaye: I can’t see what would cause a crisis unless policymakers do something stupid such as printing money. Right now part of the glue in the financial markets is our confidence that central bankers will do intelligent things such as fight inflation. Once it’s perceived that Alan Greenspan and his comrades are mortal, that changes everything. If the price of oil goes up it has an effect on peoples’ discretionary incomes, but it’s really just a change in relative prices. But if that’s accomodated by the printing of money, that would have enormous consequences and we would see an enormous decline in the value of equities.

Q: Would anyone around this table put their assets into Euros? Do they feel it is very undervalued?

Faber: I keep some Euros and some US dollars. I personally feel the Euro is low versus the dollar. But the reason the dollar is so strong is because of this tremendous faith of foreigners in the US capital market. One day a reversal will happen – and you will have the kind of decline I anticipate in the Nasdaq. Foreigners will then withdraw. Then you’ll get a significant weakness in the dollar.

Q: What are the implications for Asia?

Faber: The recovery in Asia is very patchy. If  financial markets are the measure of economic health, most markets are down 70% from their highs. That tells you that all is not well in Asia. The Asian recovery happened because the US trade defecit has doubled since 1998. Without that doubling, exports would never have fully recovered. So a weak US economy would translate into weak consumption and weak imports, which is negative for Asian exports.

Tran: A higher oil price is very negative for Japan, which is negative for Asia.

Q: Are countries like Indonesia and the Philippines becoming an irrelevance for investors?

Tran: Yes. If  you’ve got a global portfolio why would you bother. The risks aren’t worth it. On top of that you’ve got Morgan Stanley [MSCI] probably instituting float-weighted benchmarks and that is not good news for them either.

Duhamel: We’ve spent the last 12 years banging on the table saying Asia will increase its weight in the MSCI, but in fact it has been shrinking. In the context of the Philippines, Malaysia, Indonesia, well, there’s some value down there but who cares?

Faber: I am quite interested in buying stocks in the Philippines, Thailand and Indonesia. I am glad the other fund managers are not there, because otherwise these stocks would not be as cheap as they are. I have a very negative view about fund managers that benchmark. It is the most ludicrous idea that fund management has ever endorsed. It means you buy what is expensive and you don’t buy when it is cheap. That is essentially the logic of benchmarking and indexing.

Tran: It’s about to get more ludicrous, because everyone is now talking about tracking error and trying to limit their tracking error.

Faber: Can you this explain to me – I am a simple peasant from Switzerland.

Tran: The clients, and their consultants, want to make sure that active fund managers stay much closer to the benchmark.

Duhamel: That is a strange concept. If you have active managers you should not even benchmark. You should specialise in certain areas.

Tran: But clients are putting constraints in the investment management agreement that your tracking error should be x as measured by Barra.

Kaye: When you think of the wealth of so many people being captive to this inane process it’s startling. I always felt Hitler had it wrong. Instead of going after the Jews he should have gone after the consultants. I mean this is really retarded. This process is doomed to failure. There is no active thought going into what the fund manager is doing. If a large deal from China like China Mobile comes along – which is an effort to get foreigners to pay for the rollout of a network with very little prospect of any money being returned to the people who are taking 100% of the risk – then you have to blame the consultants for creating a process that means all the serious money has got to benchmark itself against the market leaders like China Mobile. This results in companies like these having market caps in excess of $100 billion. It’s insanity. These guys should be taken out and shot.

Duhamel: We should distinguish between indexing and the benchmarking of an active manager, which is closet-indexing. The way the whole industry is moving is to force everyone to charge a high fee for the services of an active manager. But if all he is doing is benchmarking, the indexer could do the same thing for a small fee and give you the same results.

Kaye: I agree with what everyone is saying about indexing. But there is another point. Indexing may be big in the United States, but at least the vast majority of companies there have good corporate governance and are working hard for their shareholders. They may not always make the decisions you are happy with, but essentially their motivations are pure. In Asia, more often than not, there is a sinister side. There is a lack of corporate governance. There are a number of big cap companies out here that I don’t even consider to be investable. I don’t understand why fiduciaries would agree to invest in them. They ought to get sued because inevitably they will lose money.

The US has overvalued stocks, but at least there is a high return on equity. It’s the public’s fault these stocks are overvalued. But in Asia it’s the consultants’ fault for driving up, for example, China Mobile to these crazy levels simply because everyone is required to own it, because it’s the largest stock in the Hong Kong index – and they don’t even have any business in Hong Kong. The company itself says in the prospectus that they won’t pay a dividend or make a capital distribution for the forseeable future. In China the foreseeable future is a very long time. The health warnings in that prospectus are such that no prudent man would touch this with a barge pole, and yet everyone is required to own it because of the consultants and their benchmarks. It’s insanity.

Q: Why shouldn’t everyone be absolute-return oriented?

Tran: The chief investment officer of a pension fund could solve all of this.

Kaye: But they don’t because they’re not incentivized to. The whole reason for hiring a consultant is to create a buffer so that you were never responsible for anything. You’re being paid a lousy salary. If you knew anything about investing, you’d be out there making a lot more money than you can make as the senior person at a pension fund. Those guys aren’t well paid. These guys don’t know anything about investing.

Faber: From your comments, I don’t think you like consultants very much?

Kaye: Do you?

Faber: I have two dogs. It is much easier to deal with dogs than consultants. But I think the whole business of investing has become too big. Take indexing. When indexing started in the 1970s it was an unusual idea and very few people did it. But every time an idea becomes big and everyone follows it, it defeats its purpose. It’s just gone too far. Around 20% of the money in the US is directly linked to indices. But the other 80% is related to these indices too. You may be an active manager, but you have to stick around the index or else you lose your client.

Q: Are indices actually a perversion of capitalism?

Faber: Yes, it is misallocating capital. Let’s say you have an index with 10 stocks and each stock has an equal weighting. One company goes out and announces that it has a new engine that runs on water. So when new money is invested into index funds they have to buy that fraud stock, because it has that market weight.

Duhamel: You are assigning a lot of power to the index managers, and taking it away from the index providers who make those calls.

Faber: It’s ridiculous the way they do it. You have a stock that gets put in the Russell 2000, then it gets taken out, then put back in. You have to ask yourself are you managing money based on the fundamentals of a company, or are you managing based on your knowledge of what a stupid committee will put in the index next and take out next. It’s like lawyers with jury selection – you check out the background of the people, and decide who to pick.

Duhamel: We are an index manager with $400 billion under management. We also have an active, absolute return portfolio of $250 billion.

Faber: I suppose an index manager sleeps quite well at night.

Q: Would index funds suffer if there was a massive correction in the US? People have bought the index after all because it has been going up.

Faber: The next bear market will destroy the concept of indexing. I think people will go back and say it doesn’t work. We have to go back and buy value stocks.

Tran: It will also destroy the concept of the tracking error.

Guarnieri: It will destroy the concept of relative performance. People will go back to absolute return.

Q: But if pension fund managers are mediocre, surely it is less risky for them to choose an index fund manager rather than trying to find a good active manager?

Duhamel: That’s what has made indexing do well. The larger you become as a pension fund manager the harder it is to find active fund managers. There are some very good ones out there. But you run out of talented active managers quite quickly. At some point you face capacity problems and internal hurdles. With State Street index funds you know exactly what you get. There’s no pretensions. But when you hire some of these other firms which have been through many changes and mergers in the last few years, the image may not match the reality. People have left and their long term performances are irrelevant. But they still have the IBM factor. It’s comfortable for the pension fund manager to hire one of the top 10 firms.

Kaye: I still think it’s all a cop-out. Everyone’s doing what’s easy for them. They’re doing a job and not having to work very hard. I can understand that. They’re given a job and an opportunity to be lazy and everyone wants to be lazy. The pension fund guy doesn’t want to be responsible for results so he hires a consultant. You have a bad year, so it was the consultant who recommended all these bad money managers. We fire the consultant, everything’s fine and my job’s not at risk. The consultant says, it’s really quite hard running around finding good fund managers, with organizations that can produce good results. So I’m going to encourage the use of index funds. This is retarded.

Duhamel: I wish it were true. But none of the consultants in Asia go for index managers. I can count on one hand our index fund mandates from clients in the region. Most pension funds will go with the big established institutions – the old boys network that has been there forever. Going for the index managers would be the intelligent thing to do.

Kaye: You’re considered to be a smart money manager if you beat the index, for example the MSCI, in any given year. And dumb if you don’t. Now I object to the process. It seems to overlook the actual needs of the beneficiaries whose money is being risked. I think you should have some kind of hurdle rate, let’s say 10%. The pension fund manager should say to the consultant, find me the smartest money manager you can find. Do the visits and do the due diligence and tell me who is going to blow up and who is safe. Then the instruction should be to compound my 10% return over five years and I’ll pay you a big bonus if you beat it. But if you lose more than 10% in any given year you’re fired. That’s sensible and straightforward. What’s wrong with that system?

Tran: How about if the markets are up 25%, and you go to the clients and say I’ve made 12% for you, and they say you’re fired.

Kaye: They can’t fire you because it’s on a five year view. Look at Warren Buffett. I don’t think he suddenly got stupid in the last five years but he tremendously underperformed a variety of indices. I don’t think Buffett is stupid because he didn’t own Cisco. Over time he has compounded 20% a year which is extraordinarily good. Therefore you don’t fire him. What I am saying is you want to set the incentives so that guys like Buffett keep their mandate. It’s when the tide flows out and there’s a correction that you see who is swimming naked.

Tran: Yes, but we’re in an environment where the tide has been flowing in. At the end of the day, no client is going to be happy with you if you make your target 10% and everyone else makes 30%.

Kaye: But the target is set by the client.

Tran: Clients are very good at setting multi-targets. You have to beat both the index and the competition.

Kaye: That’s crap. It’s kind of like a football coach saying you guys have got to go and win and by the way you’ve got to win by seven because I’ve got a side-bet on the game.

Tran: We don’t have a single investment management agreement where there is only one objective.

Kaye: That’s what I am objecting to.

Tran: The CIOs of the pension plans – who are our clients – some of them get paid quite well, and they get paid bonuses depending on how they perform relative to their competition. So the whole industry has become relative.

Q: Is it a fair statement to say that if you buy an index fund you are buying mediocrity?

Guarnieri: You are buying an average. In an ideal world, if you could find the good ones you would select active managers.

Kaye: From what I can gather if Warren Buffett was hired today he’d have been fired.

Tran: He’d have been fired six months ago actually.

Kaye: The process has to be flawed if it leads to those types of results.

Faber: You mentioned sports before. There are some people who can win at tennis because they can place the ball in the right spot, but most people, the average, their major goal is not to make a mistake. In the investment field it is very much the same. In the last 25 years, the indexer was the average player and you did well, because it is difficult to identify the few winners. It’s like in sport – if you take 20 tennis players when they are 13 how do you know who will be the Pete Sampras of the future. Most people cannot identify who will be the big winner. So there is a justification for buying index funds as you get to buy the average. The problem is that indexing has worked so well, and everyone has endorsed the concept so you have tremendous distortions in the marketplace.

Kaye: The objection I have is that the decision as to who gets capital allocated to them is being made by some gnome at the MSCI. You are taking the responsibility away from the investing public of deciding who deserves capital and putting it on the shoulders of some bureaucrat at the MSCI.

Duhamel: Then it becomes the responsibility of the active managers, who are the other 80% of fund managers.

Kaye: Actually, my argument is that everyone has gotten greedy. In fact, people should say that over the long term it’s very good if you can compound money at 10% per year. Forget what happens in any given year.

Duhamel: You are saying the same thing that the Swiss private banks have been saying for the last 200 years. But in the last 25 years we’ve had extraordinary returns on capital and basically while the norm is bonds at 6% and equities at 8%, in the last 25 years the new norm for equities is going up 25% per year. This has led to people being more relative.

Returning briefly to China Mobile, in my discussions with consultants they tell me that none of the institutional money managers are benchmarked against the Hang Seng Index. They are benchmarked against MCSI or an FT index. The MSCI Hong Kong doesn’t contain China Mobile. The only way a lot of those managers have been outperforming the MSCI Hong Kong is by allocating 10% of their porfolio to China Mobile, even though it is not in their benchmark index.

Tran: Listen to this one – bond managers are benchmarked against the Salomon index or whatever and the only growing component is JGBs so they’re all busy buying JGBs.

Kaye: That's a really good idea. Why don’t we lend money to the government of Japan and not get any interest.

Faber: The longer they keep a budget deficit, the more weight an index bond fund will have to have in Japan.

Tran: Yes, because European and US government paper is shrinking so they have no choice.

Kaye: If you’re Japan you think why don’t we just have a 20% budget deficit, and pay no interest on it at all. Here is a country with awful fundamentals. You look at the deficit versus GDP, the ageing population, and the return on invested capital. It’s abysmal. At the end of the day they’re going to solve this problem they way every sovereign does. They’re going to print a lot of money, the yen will weaken and all the guys that own those JGBs are going to get hammered. I can’t say when it will happen, but it is inevitable. And I can’t recall any time Asia did well when the yen was weak.

Q: Marc, you live mostly in Thailand now. In terms of its balance of trade, what are its comparative advantages?

Faber: One is very obvious. The second is golf. Thailand is still largely a rural economy. But you know, when I go into the countryside I am always amazed at how little evidence there is of recession. The same is true of Indonesia. You don’t see starvation.

Tran: The problem is pharmaceuticals. A lot of these need to be imported.

Faber: Yes, but in a country which is overpopulated you don’t want people to live too long. There are terrible social consequences in Asia if everyone lives to 90 years old…

Tran: And drives a car…

Faber: Yes, then the oil price will be $300 a barrel.

Tran: Going to Alaska made me realise that we really have too many people. You look at wildlife and it’s all a question of habitat.

Faber: In China, thanks to their one child policy, if the population ages too much, it will be a huge social burden. People can more or less choose the day they’re born – or rather their parents can. But I think a new social system should decide when someone dies.

Kaye: It’s funny, I had this conversation with a senior guy from the Bank of Japan a few years ago. We were talking about Japan’s demographic problems and he goes over to this whiteboard and starts drawing charts to show how bad it gets. This timebomb becomes unmanageable at 2025 or something. And I say what will you do about it. And he says “We must convince these people to die younger.” He said it with a real emphasis. I laughed and he just looked at me. He wasn’t joking.

Tran: So in fact we should encourage smoking.

Kaye: They do in Japan.

Faber: Someone in England has just published a book on this subject and he said the retirement age in England was set in 1920 when the average life expectancy was 20 years less than it is now. So nowadays people should retire at 75-78.

Q: Bill, are you still negative on Malaysia?

Kaye: Malaysia is being treated the way it deserves to be treated. The problems there are not going away. I don’t see a way out. There’s no leadership, and the problems are huge. Where they’ve gotten lucky is they fixed their exchange rate cheaply. Every time I go there, I get reminded of the cronyism. I see no basis for owning anything in Malaysia.

Faber: In Asia you now have an interesting situation today. In the US from 1930 until 1954, equities were yielding more than bonds. And here in Asia, you have lots of companies that have a higher dividend yield than the local deposit rate. You can choose a basket of stocks that are likely to maintain their dividends and you get paid for waiting. And the smaller stocks are especially distressed because the index and the consultants don’t care about them.

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