Jeremy Grantham: Playing with fire, but stocks could race to old highs

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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 chief investment strategist of Boston-based GMO has just published the April edition of his quarterly newsletter entitled “Playing with Fire (A Possible Race to the Old Highs)”.

Here are a few excerpts from Grantham’s newsletter.

“So what do I think will happen? That’s easy: I don’t know. We have been spoiled in the last 10 years with many near certainties – mainly that real bubbles would break – but this is definitely not one of them. Not yet anyway.  (However, I am still willing to play guessing games despite the fact that “I don’t know.” So here, as Exhibit 1, is my probability tree.)

“The general conclusion is that the line of least resistance is a market move in the next 18 months or so back to the old highs, say, 1500 to 1600 on the S&P, accompanied by an equivalent gain in most risk measures, followed once again by a very dangerous break. If that happens, rates will still be low and thus difficult to use as a jump starter, the financial system will still be fragile, and the piggybank will be more or less empty. It is remarkably silly for the Fed to allow, even encourage, this flight path. It is also remarkably silly for investors to be so carefree, given their recent experiences. Fortunately, there are several less likely outcomes that collectively, I hope, are equally probable. We are definitely playing with fire and need some luck. The best kind of luck would be that Bernanke gets bitten by a Volcker bug.

“Our policy is simple: however complicated the world may be, we will play by the numbers. The global equity markets taken together are moderately overpriced, and the U.S. part is now very overpriced but not nearly so bad as it could be. Surprisingly, within the U.S. the large high quality companies are still a little cheap, having been left totally behind in the rally. They are unlikely to do very well in a bubbly environment, however long it lasts, but should be great in declines and in the end should win.

“A potential plus for quality franchise stocks in the next few years is that they are far more exposed to emerging countries and, as investors fall in love with all things emerging, this should be seen as an increasing advantage. A mix of global stocks, tilted to U.S. high quality, has a 7-year asset class forecast of about 5% excluding inflation compared with a long-term normal of about 6%. Not so bad. On balance, therefore, we are only slightly underweight equities.

“Within my personal portfolio, I have a stronger preference for the already overpriced emerging market equities than do my colleagues at GMO, and actually more than I should have as a dedicated value manager. The appeal of emerging’s higher GDP growth compared with the slow growth of U.S. developed countries is proving as compelling as I suspected, and I would hate to miss some modest participation in my one and only bubble prediction.”

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

Source: Jeremy Grantham, GMO, October 2009.

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