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Grantham Nails It: "The Industry So Much Prefers Bullishness...So Does The Press"
Tyler Durden's picture
Submitted by Tyler Durden on 02/24/2012 21:35 -0500

In his most recent quarterly letter titled appropriately enough "The Longest Quarterly Letter Ever" GMO's Jeremy Grantham literally kills it. Well, maybe not literally but certainly metaphorically.

Do yourself a favor and read the whole thing cover to cover, but in the meantime here is a choice selection:

Believe in history. In investing Santayana is right: history repeats and repeats, and forget it at your peril. All bubbles break, all investment frenzies pass away. You absolutely must ignore the vested interests of the industry and the inevitable cheerleaders who will assure you that this time it’s a new high plateau or a permanently higher level of productivity, even if that view comes from the Federal Reserve itself. No. Make that, especially if it comes from there. The market is gloriously inefficient and wanders far from fair price but eventually, after breaking your heart and your patience (and, for professionals, those of their clients too), it will go back to fair value. Your task is to survive until that happens.

...

Try to contain natural optimism. Optimism has probably been a positive survival characteristic. Our species is optimistic, and successful people are probably more optimistic than average. Some societies are also more optimistic than others: the U.S. and Australia are my two picks. I’m sure (but I’m glad I don’t have to prove it) that it has a lot to do with their economic success. The U.S. in particular encourages risk-taking: failed entrepreneurs are valued, not shunned. While 800 internet start-ups in the U.S. rather than Germany’s more modest 80 are likely to lose a lot more money, a few of those 800 turn out to be today’s Amazons and Facebooks. You don’t have to be better; the laws of averages will look after it for you. But optimism comes with a downside, especially for investors: optimists don’t like to hear bad news. Tell a European you think there’s a housing bubble and you’ll have a reasonable discussion. Tell an Australian and you’ll have World War III. Been there, done that! And in a real stock bubble like that of 2000, bearish news in the U.S. will be greeted like news of the bubonic plague; bearish professionals will be fired just to avoid the dissonance of hearing the bear case, and this is an example where the better the case is made, the more unpleasantness it will elicit. Here again it is easier for an individual to stay cool than it is for a professional who is surrounded by hot news all day long (and sometimes irate clients too). Not easy, but easier.

...

Resist the crowd: cherish numbers only. We can agree that in real life as opposed to theoretical life, this is the hardest advice to take: the enthusiasm of a crowd is hard to resist. Watching neighbors get rich at the end of a bubble while you sit it out patiently is pure torture. The best way to resist is to do your own simple measurements of value, or find a reliable source (and check their calculations from time to time). Then hero-worship the numbers and try to ignore everything else. Ignore especially short-term news: the ebb and flow of economic and political news is irrelevant. Stock values are based on their entire future value of dividends and earnings going out many decades into the future. Shorter-term economic dips have no appreciable long-term effect on individual companies, let alone the broad asset classes that you should concentrate on. Leave those complexities to the professionals, who will on average lose money trying to decipher them

...

If you can be patient and ignore the crowd, you will likely win. But to imagine you can, and to then adopt a flawed approach that allows you to be seduced or intimidated by the crowd into jumping in late or getting out early is to guarantee a pure disaster. You must know your pain and patience thresholds accurately and not play over your head. If you cannot resist temptation, you absolutely MUST NOT manage your own money. There are no Investors Anonymous meetings to attend.

...

On the other hand, if you have patience, a decent pain threshold, an ability to withstand herd mentality, perhaps one credit of college level math, and a reputation for common sense, then go for it. In my opinion, you hold enough cards and will beat most professionals (which is sadly, but realistically, a relatively modest hurdle) and may even do very well indeed.

...

the current U.S. capitalist system appears to contain some potentially fatal flaws. Therefore, we should ask what it would take for our system to evolve in time to save our bacon. Clearly, a better balance with regulations would be a help. This requires reasonably enlightened regulations, which are unlikely to be produced until big money’s influence in Congress, and particularly in elections, decreases. This would necessitate legal changes all the way up to the Supreme Court. It’s a long haul, but a handful of other democratic countries in northern Europe have been successful, and with the stakes so high we have little alternative but to change our ways.

...

Karl Marx went on and on about the tendency of capitalism to so fixate on growth that in time it would forget the need to put on a friendly face for society and would drive home too clearly and brutally its advantage over labor. Ironically, in some way he and Engels looked forward to globalization and the supranational company because they argued it would make capitalism even more powerful, over reaching, and eventually reckless. It would, they claimed, offer the capitalists more rope to hang themselves with or, rather, to be hung with, in the workers’ revolution. The rope for the job, they suggested with black humor, would be bought from briskly competing capitalists, eager till the end for a good deal. Well, time marches on and it’s going to be hard to have a workers’ revolution with no workers. Organizing robotic machine tools will not be easy. However, Marx and Engels certainly got the part right about globalization and the supranational company increasing the power of capital at the expense of labor. To interfere with Marx’s apocalyptic vision, we need some enlightened governmental moderation of the new globalized Juggernaut (even slightly enlightened would be encouraging) before capitalism gets so cocky that we have some serious social reaction.

...

Capitalism, by ignoring the finite nature of resources and by neglecting the long-term well-being of the planet and its potentially crucial biodiversity, threatens our existence. Fifty and one-hundred-year horizons are important despite the “tyranny of the discount rate,” and grandchildren do have value. My conclusion is that capitalism does admittedly do a thousand things better than other systems: it only currently fails in two or three. Unfortunately for us all, even a single one of these failings may bring capitalism down and us with it.

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the S&P 500 is materially overpriced, with an imputed return on our 7-year forecast of about 1% real, and because the high quality quarter of the S&P is priced to deliver 5.5% real (about a fair return), the 75% balance of the S&P has a slightly negative return. The rest of the world’s equities were (when I sat down to write this in January) on average slightly cheap at close to 7% real, so that non U.S. equities plus U.S. quality stocks offered a slightly higher average return than normal (a normal mix is about 6.1% real). (Today, after a dazzling rally, the forecast for the same global equity mix has dropped by 1.1%, to very slightly expensive.)

....

The 800-pound gorilla (the one that prefers bond holders to bamboo) is not in the room yet, but you can hear him thumping his chest up in the hills. He will come eventually, and before he does, you should remember that stocks are underrated inflation hedges. The underlying corporations have real assets, employ real people, and sometime even make real things, although a good idea embedded in a small thing (like an iPad) or a service is just as good. Equities have been tested over and over again in different places and in different decades and they have always been found to be very effective hedges. Serious resources – oil and copper in the ground and forestry and farmland – will almost certainly also be good and very probably much better than broad stocks in the short run. Gold may be good too.... But for stocks to work dependably as inflation hedges one has to have a several-year time horizon: in the short term, rising inflation can hurt stocks badly, for as mentioned last quarter, inflation is usually a powerful negative behavioral input. Investors hate jumps in inflation because they sharply raise the levels of uncertainty.

...

When I read the 120 contradictory bits of advice in the Financial Times alone, I find myself asking the question: who is an expert? To the extent that anyone has profitably specialized in this type of problem, I suppose it is George Soros. There are also, in my opinion, one or two investment management groups that seem to talk sense (which groups will go nameless for weasely competitive reasons). This is the problem: these probable experts are much more worried than the general market. This fact is giving rise to a new, tentative but definitely uncomfortable theory: perhaps the default assumption when dealing with ignorance or lack of confidence and skill is to assume everything will muddle through okay. Certainly we were amazed by this attitude generally displayed by the world (and most competitors) in the build-up to the 2000 and 2008 bubbles. Now we at GMO are calmly sitting around playing equities by the numbers, which are not too bad, and the market in general seems quite relaxed, while those few who look like experts on this crisis are pulling out their hair in fright. As I said, this is just a theory. But it is scary.

... and the punchline ....

The U.S. market was terrible for the last 10 years, gaining a pathetic 0.5% per year overall, after inflation adjustments and even including dividends. Without dividends, the index itself has not gone up a penny in real terms from mid-1997 to end-2011, or 14½ years. This is getting to be a long time! Are we expected to be bullish out of patriotism? You might think so given the flood of optimistic views for the last 10 years (or is it 100?). The industry so much prefers bullishness. It is much, much better for business. So, in general, does the press, and I do sympathize – optimism really does make for more compelling reading. I’ll tell you what. Try taking it out on the army of well-known bulls who blew the trumpets in 1999 and 2007 and waved everyone into the rather bloody breach. (Did you know that trumpeters were killed out of hand in the Middle Ages because of their pernicious role? How about that for a precedent when we get to the next burst bubble?)


Summary of Recommendations (with apologies for the lack of changes)

Heavily underweight U.S equities, but not the high quality quartile, which is almost fair price. Non-quality equities, in contrast, have a negative imputed 7-year return after their handsome rally in the last 3 months through to mid-February.

Slightly overweight other global equities, which are almost fair price, down from a little cheap at year end.

In total, be about neutral in global equities. Yes, there is more than our normal fair share of potential negatives lurking around, but on our data: a) most of the negatives are reflected in stock prices; and b) all fixed income duration is dangerously overpriced. This last situation is, of course, engineered by the Fed, which hopes to drive us all into taking more risk, notably by buying more equities. I hate to oblige, but at current equity prices it just makes sense to do what they want. As mentioned earlier, equities are also good long-term hedges against inflation.

Underweight as much as you dare long-term bonds, especially higher-grade sovereign bonds.

In the long term, resources in the ground, forestry, and agricultural land are attractive, but come with the usual caveats of the risk of short-term over pricing, so average in.

Ironically, the point in a nutshell was precisely that: stock market opinions must be read with a careful understanding of the time period being used. Apparently contradictory opinions are often wholly or partially the result of using different times periods. As an extreme example I gave three very different views of the market, all of which I find useful, that draw their differences from their time horizons. Here are the three:

1) Financial historians interested in the very long term would notice that all of the great bull markets before Greenspan ended by going below their trend line for several years. In the Greenspan-Bernanke era, declines were aggressively curtailed as policy. We should all be aware that the possibility exists of an old fashioned bear market overcorrection. Few have experienced a 1970’s type bear market and therefore it would be found particularly difficult to deal with. The usual expectations of long rallies would be serially disappointed.

2) In the very short term, the Inker-Grantham “comfort” model for explaining P/E points out that the “normal” response (over response would be better) both to current high profit margins and to current low inflation would call for a substantially higher market than existed three months ago (the gap has been half closed in the intervening months). To me this suggests that just like last year, the U.S. market will fight bad news and try to go up and that it is unlikely to go down much until either the current, extremely high profit margins decline or some very big wheels fall off: Europe, China, or the U.S. That is to say, in the near term, periodic moderate bad news of any kind, except about profit margins and inflation, is unlikely to keep the market down.

3) In the intermediate term – seven years – the GMO forecast suggests that global equity prices on December 31 were, boringly, about normal, if you avoid lower quality companies in the U.S. (today they are modestly overpriced). Our GMO forecasts do not allow for overruns (point 1) or behavioral inputs (point 2) but have had a good record. So, you see, we had something for everyone: bullish, bearish, or fair value. You just had to pick your time frame.