It has been an eventful few weeks, culminating in the EU summit on Friday. The continued volatility in markets has tested the nerves of many an investor, and during times such as these it is important to look at the big picture trends and pay close attention to the views of market veterans. One such veteran, Jeremy Grantham, who runs the well known value fund manager GMO, published his "shortest quarterly letter ever" during the past week , which has some interesting observations on global markets. To summarise:

-His forecast of "seven lean years" of 2 1/2 years ago is being realised with a continuance of the large debt overhang, drop in asset values and general financial incompetence.

-In particular, the US and developed world is experiencing a permanent slowdown in GDP growth as result of slowing population growth, an aging profile and growing entitlements leaving inadequate resources for growth, together with a declining savings ate.

-In addition, an inadequate infrastructure, declining standards of education and ineffectiveness of government has made the US less competitive than other developed and some developing countries.

-Growth has also been held back by the growing inequality in the US leading to growing feeling of injustice, a weakening of social cohesiveness and a fall in the work ethic.

-Lack of income growth for the middle class has made demand more susceptible to changes in confidence and the willingness to take on more debt.

-The most critical long-term issues of depleting resources, a comprehensive energy policy and global warming have not been addressed in a serious manner.

-Looking ahead over the next year, the likelihood of bad outcomes are not as high as in 2008, but the possibility of extremely bad and long-lasting problems is as high as it has ever been.

-Yet the S&P 500 index has performed relatively well (compared to other global markets), driven by high profit margins and low inflation levels. Historically, these two factors are significant in determining P/E levels of the market and point towards levels which should be 20% higher if it were not for the numerous negatives facing the market.

-The S&P 500 index is unlikely to come down to its fair value of 975-1000 until profit margins decline. However, profit margins will eventually come down towards historical averages , dragging the market down with them.

-All major equity bubbles have broken below trend line values and stayed below them for years – the US in 1929 and 1965, Japan in 1989 – but the current market did not even reach the trend line in 2002 and took only 3 months to recover to the trend line in 2009. This is unprecedented and has been a result of the excessive stimulation of markets by Greenspan and Bernanke.

-Based on their study of the 10 biggest market bubbles (pre-2000) they calculate that it typically takes 14 years to recover the old trend line. With investors being conditioned to expect quick recoveries, an old fashioned downturn without the support of the Fed (whose arsenal is vastly depleted) could lead to a major decline in markets at some point.

-Following the market downturn in July, they found international developed equities , emerging markets and US high quality stocks to be relatively cheap with an expected 7% real return over 7 years. Despite the cheapness they remained a bit underweight due to the numerous negatives.

Recommendations:

-Avoid lower quality US stocks and remain near normal weighting in global equities.

-Have a bias towards safety.

-Avoid long term bonds and have enough cash on hand (and not be short-term greedy).

-Gradually build exposure to resources in the ground on a 10-year horizon. However, resources are likely to have further declines in prices due to a slowdown in China and better weather.

An insightful piece as usual - while pointing out the big issues facing the market, it does suggest maintaining core weightings in sectors such as US high quality, international developed equities, emerging market equities and commodities. At the same time, keep a reasonable amount of cash on hand to increase exposure on further market downturns. So stay the course, and try not to be incentivised to engage in either panic selling on downturns nor trying to pick the bottom to increase long exposure (as you are likely to be underexposed when the market begins to turn around). However, some amount of portfolio rebalancing when markets have big surges on the upside (to reduce long exposure) and on the downside (to increase long exposure) would be prudent.

The EU summit was an important event in that it set a long-term goal in terms of eventual fiscal union. This is a big positive as it does meet a key requirement for market stability – i.e. setting a long-term vision for the Eurozone. This opens the way for the ECB to play a more supportive role in the government bond markets , ranging from increasing its regular bond purchases in the secondary bond markets to quantitative easing (but a big bazooka announcement is unlikely unless market conditions warrant it). However, the actual path towards final stability is likely to be rocky as the finer details and processes are worked out over the coming months. Unfortunately, this implies continued volatility but, at the same time, the removal of a 2008 type meltdown scenario.

Have provided a chart below (from Soc Gen) which illustrates the relationship between the price of gold and the US monetary base over the last 90 years. This is the fundamental case for holding gold as part of diversified asset portfolio – as central banks across the world enter into further easing , gold is likely to continue to rise. So continue to buy on pullbacks!