Jeremy Grantham: Time to be serious (and probably too early) once again

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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 Part 2 of the 1Q 2011 edition of his newsletter. His report begins with an admonition to reduce risk sooner rather than later, then looks back at some historical outlier market events, examines how Year 3 of the Presidential Cycle is faring, and offers recommendations for the future. (In case you missed Part 1, please click here.)

Here are the first few paragraphs of Grantham’s thoughtful newsletter:

“Lighten up on risk-taking now and don’t wait for October 1 as previously recommended. But, as always, if you listen to my advice, be prepared to be early!

“A word on being too early in investing: if you are a value manager, you buy cheap assets. If you are very “experienced,” a euphemism for having suffered many setbacks, you try hard to reserve your big bets for when assets are very cheap. But even then, unless you are incredibly lucky, you will run into extraordinarily cheap, even bizarrely cheap, assets from time to time, and when that happens you will have owned them for quite a while already and will be dripping in red ink. If the market were feeling kind, it would become obviously misvalued in some area and then, after you had taken a moderate position, it would move back to normal. That would be very pleasant and easy to manage.

“But my career, like most of yours, has been filled with an unusual number of real outliers. That certainly makes for excitement, but it also delivers real pain for even a disciplined value manager. Following is a snapshot of some of those outliers. In 1974, the U.S. market fell to seven times earnings and the U.S. value/growth spread hit what looked like a 3-sigma (700-year) event. U.S. small caps fell to their largest discount in history, yet by 1984 U.S. small caps sold at a premium for the first time ever. By 1989, the Japanese market peaked at 65 times earnings, having never been over 25 times before that cycle! In 1994, emerging market debt yielded 14 points above U.S. Treasuries, and by 2007 had fallen to a record low of below 2 points. By 1999, the S&P was famously at 35 times peak earnings; in 2000, the value/growth spread equaled its incredible record of 1974 (that I, at the time, would have almost bet my life against ever happening again). Equally improbable, in 2000, the U.S. small/large spread beat its 1974 record and emerging market equities had a 12 percentage point gap over the S&P 500 on our 10-year forecast (+10.8 versus -1.1%). Further, as the S&P 500 peaked in unattractiveness, the yield on the new TIPS (U.S. Government Inflation Protected Bonds) peaked in attractiveness at over 4.3% yield and REIT yields peaked at 9.5%. Truly bizarre. By 2007, the whole world was reveling in a risk-taking orgy and U.S. housing had experienced its first-ever nationwide bubble, which also reached a 3-sigma, 1-in-700-year level (still missed, naturally, by “The Ben Bernank”).

“Perhaps something was changing in the asset world to have caused so many outliers in the last 35 years. Who knows? The result, though, for value players, or at least those who wanted to do more than just tickle the problem, was overpriced markets that frightened them out and then, like the bunny with the drum, just kept going and going.”

He concludes as follows:

“My very long-term personal recommendations remain the same: forestry and good agricultural land, ‘stuff in the ground,’ and resource efficiency plays. The caveats on entry point risk have recently been mentioned.2 Should commodities crash in the near term because of good weather, problems in China, or both, I think it will create another ‘investment opportunity of a lifetime,’ much like the several we have had in recent years.”

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

Source: Jeremy Grantham, GMO, April 2011.

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