Jeremy Grantham: Pavlov’s bulls living on borrowed time

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Jeremy Grantham has become a familiar and very popular face on this site. For those treasuring his insight, wisdom and prescient calls, the co-founder and chairman of Boston-based GMO has just published the January edition of his quarterly newsletter entitled “Pavlov’s Bulls!”.

Here is his opening paragraph:

“About 100 years ago, the Russian physiologist Ivan Pavlov noticed that when the feeding bell was rung, his dogs would salivate before they saw the actual food. They had been “conditioned.” And so it was with “The Great Stimulus” of 2008-09. The market’s players salivated long before they could see actual results. And the market roared up as it usually does. That was the main meal. But the tea-time bell for entering Year 3 of the Presidential Cycle was struck on October 1. Since 1964, “routine” Year 3 stimulus has helped drive the S&P up a remarkable 23% above any infl ation. And this time, the tea has been spiced with QE2. Moral hazard was seen to be alive and well, and the dogs were raring to go. The market came out of its starting gate like a greyhound, and has already surged 13% (by January 12), leaving the average Year 3 in easy reach (+9%). The speculative stocks, as usual, were even better, with the Russell 2000 leaping almost 19%. We have all been well-trained market dogs, salivating on cue and behaving exactly as we are expected to. So much for free will!”

He concludes as follows:

Looking Forward

  • Be prepared for a strong market and continued outperformance of everything risky.
  • But be aware that you are living on borrowed time as a bull; on our data, the market is worth about 910 on the S&P 500, substantially less than current levels, and most risky components are even more overpriced.
  • The speed with which you should pull back from the market as it advances into dangerously overpricedterritory this year is more of an art than a science, but by October 1 you should probably be thinking much moreconservatively.
  • As before, in our opinion, U.S. quality stocks are the least overpriced equities.
  • To make money in emerging markets from this point, animal sprits have to stay strong and not much can go wrong. This is possibly the last chapter in a 12-year love affair. Emerging equities seem to be in the early stages of the “Emerging, Emerging Bubble” that, 3½ years ago, I suggested would occur. How far a bubble expands is always anyone’s guess, but from now on, we must be more careful.
  • For those of us in Asset Allocation, currencies are presently too iffy to choose between. Occasionally, in our opinion, one or more get far out of line. This is not one of those occasions.
  • Resource stocks, as in “stuff in the ground,” are likely to be fi ne investments for the very long term. But short term, they can really ruin a quarter, and they have certainly moved a lot recently.
  • We think forestry is still a good, safe, long-term play. Good agricultural land is as well.
  • What to watch out for: commodity price rises in the next few months could be so large that governmental policies in emerging countries might just stop the global equity bull market. My guess, though, is that this is not the case in the U.S. just yet.

Things that Really Matter in 2011 and Beyond (in one person’s view) for Investments and Real Life

  • Resources running out, putting strong but intermittent pressure on commodity prices
  • Global warming causing destabilized weather patterns, adding to agricultural price pressures
  • Declining American educational standards relative to competitors
  • Extraordinary income disparities and a lack of progress of American hourly wages
  • Everything else.

Click here for the full report (registration is required).

Source: Jeremy Grantham, GMO, January 2011.

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