Jeremy Grantham: Reinvesting When Terrified

In his latest market commentary, legendary manager (and longtime bear) Jeremy Grantham of Grantham, Mayo Van Otterloo explains that it's all too easy for terminal paralysis to set in when faced with a crisis market, and recommends a battle plan. Key excerpts:

So almost everyone is watching and waiting with their inertia beginning to set like concrete. Typically, those with a lot of cash will miss a very large chunk of the market recovery.

There is only one cure for terminal paralysis: you absolutely must have a battle plan for reinvestment and stick to it. Since every action must overcome paralysis, what I recommend is a few large steps, not many small ones. A single giant step at the low would be nice, but without holding a signed contract with the devil, several big moves would be safer. This is what we have been doing at GMO. We made one very large reinvestment move in October, taking us to about half way between neutral and minimum equities, and we have a schedule for further moves contingent on future market declines. It is particularly important to have a clear definition of what it will take for you to be fully invested. Without a similar program, be prepared for your committee’s enthusiasm to invest (and your own for that matter) to fall with the market. You must get them to agree now – quickly before rigor mortis sets in – for we are entering that zone as I write. Remember that you will never catch the low. Sensible value-based investors will always sell too early in bubbles and buy too early in busts. But in return, you may make some important extra money on the roundtrip as well as lowering the average risk exposure.

For the record, we now believe the S&P is worth 900 at fair value or 30% above today’s price. Global equities are even cheaper. (Our estimates of current value are based on the assumption of normal P/Es being applied to normal profit margins.) Our 7-year estimated returns for the various equity categories are in the +10 to +13% range after inflation based on an assumption of a 7-year move from today’s environment back to normal conditions. This compares to a year ago when they were all negative! Unfortunately it also compares to a +15% forecast at the 1974 low, and because of that our guess is that there is still a 50/50 chance of crossing 600 on the S&P 500.

Comments

[Ricard:]

Well, Jeremy Grantham was right in that he saw stocks falling much lower than where they were in October/November. Didn't quite hit 600, but it did cross 700, and before last week, looked poised to cross that line.

Personally, I'm neutral one way or another - to put it into Grantham-speak, I'm already damned since I've done, and damned since I've not quite done enough.

Mar 16 02:29 PM

[mr freddo:]

Thank you Mr. Grantham. I believe that you are correct in your assessment over the long haul. I was wondering how you were able to get a fair market value of 900 given that earnings have declined rapidly and current estimates may still be too high.

Mar 16 02:34 PM

[William Cowie:]

I figured the best way to get invested at this stage of the game is with several dividend paying preferred stocks trading at a discount. That option delivers cash yields of 15-30% per year, more if one has a greater tolerance for risk. On top of that, when the market corrects itself, the prices of those stocks have to double or triple, depending on which issues were bought. While we wait, 15% per year in cash ain't all that bad.

Examples are HST, AHT, LHO, EPR preferreds, all fairly safe and all yielding double digit dividends.

Mar 16 02:39 PM

[mac.barron:]

A 50/50 chance of the S&P dipping below 600? Yes.

Seven years to return to some type of normalcy? Plausible.

A fair value of 900 for the S&P? A little higher than I would expect but not absurdly so.

Global equities more under priced than domestic ones? Definitely!

I wish that Mr. Grantham had delved into the the foreign markets as GMO sees them.

Mar 16 03:01 PM

[sr9web:]

Thanks for the names. A quick look says EPR look nice.

Here's some for you: AEH, PWE, CYRV, IGD, CHW, and AYR. Preferred's: SHO and NRF.


On Mar 16 02:39 PM William Cowie wrote:

> I figured the best way to get invested at this stage of the game
> is with several dividend paying preferred stocks trading at a discount.
> That option delivers cash yields of 15-30% per year, more if one
> has a greater tolerance for risk. On top of that, when the market
> corrects itself, the prices of those stocks have to double or triple,
> depending on which issues were bought. While we wait, 15% per year
> in cash ain't all that bad.
>
> Examples are HST, AHT, LHO, EPR preferreds, all fairly safe and all
> yielding double digit dividends.

Mar 16 05:52 PM

[Dante311:]

"...based on an assumption of a 7-year move from today’s environment back to normal conditions."

I agree that the market at some point will recover but I think that it's dangerous to use the phrase normal conditions. The market's more stabilized form of the future will look much different from the one we have seen over the last decade as regulation and the manner of doing business changes. One item that could drastically change the returns to expect could be altered philosophies on how much leverage is too much. And without the high leverage it will be more difficult to provide such high returns.

Mar 16 08:03 PM

[sundrenched:]

With all respect to Mr Grantham, and I mean that sincerely, the last of my worries right now is to miss a big, sustained rally. What I'm worried about is being like the guy who bought into Japan in 1991. Little upside, very significant downside. There's still so many ticking time bombs in the economy (Eastern Europe for instance), I can't believe how quickly sentiment has shifted from panic to hope again.

Nouriel Roubini rates the chance of an L-shaped recession (depression) at one in three now, and my impression from reading him between the lines is that he really thinks it's higher than that. Now, I do think the collapse in trade and manufacturing of the past months is related to destocking and that this will reverse itself sometime soon, which some people will interpret as the first rays of spring, but I'll take that as a trading opportunity, not a time to go back in.

Mr Grantham makes a good point about having a plan about when to get fully invested again. For me it will be when there's a clear bull market again. The next 5-10 years I plan to swing trade and use options strategies to make money.

Mar 17 04:14 AM

[prudentinve...:]

I agree with you entirely, the time to invest is when you are terrified, assuming you still have money to put at risk.

Having been largely in cash since 2006, I did indeed invest a bit over the past few months; but have decided to maintain enough powder dry, partly by selling in rallies, as I exepect to become even more terrified in the coming months.

Mar 17 01:53 PM

[Nick Waddell:]

Was just talking to my broker about this very mindset. Of course, he always says buy something...

Mar 17 01:53 PM

[Chris B:]

Consider the next year to be a test.

If you fail to invest while you are terrified, or worse, if you sell (or have sold) as the bottom approached, then you should give up forever on the dream of buying low and selling high. You should construct a portfolio of AAA bonds and bank CD's, with perhaps 10% in an index fund like VTI with a strict buy-and-hold rule applied. If you can't manage to control your emotions enough to buy-and-hold, don't even invest that last 10% in stocks. The downside is that in the long run you'll underperform stocks by about 3%, but earning a far more consistent return of around 6% per year. The upside is that you won't lose double-digit percentages buying high and selling low.

If you fail to jump into this scary market or if you find yourself selling low in a media-driven panic, just accept that not everyone is well suited to value investing, learn from the experience, and invest accordingly. DON'T jump into stocks as soon as they're "safely" up 40%.

Mar 17 02:19 PM

[NHSkier:]

ETFs are perfect for this kind of market where nothing is for sure. My IRA had been safely outpacing the S&P 500 for the last four years thanks to my picking strong mutual funds like DODGX, DODFX, VGENX, etc. Last year, I lost 3% more than the S&P. This year I've decided to nibble at the market with $500-$1000 blocks of LQD, CSJ, VUG, and VXF, given that buying similarly small blocks of my existing mutual funds would cost $50 per transaction. Trading in ETFs only incurs a $10 transaction fee and gives me the added bonus of diversifying beyond my current mutual fund holdings.

Mar 17 02:45 PM

[The Good Ne...:]

Thanks for the name of yet another perma bear, now speaking wisdom: "those with a lot of cash will miss a very large chunk of the market recovery."

No doubt the worst of the contraction has now past and any negative news will continue to come from lagging indicators (primarily from the large Q4 contraction and employment fallout).

We all now have a mounting pile of evidence that we are currently emerging from this recession.
bit.ly/2EDJe

As the leading indicators continue to move in positive directions,
equity prices will continue to firm...
mast-economy.blogspot....

GNE
goodnewseconomist.com

Mar 17 03:16 PM

[Robespierre:]

"Our estimates of current value are based on the assumption of normal P/Es being applied to normal profit margins."

Why would you think that normal P/Es and profit margins apply? Also what time period is your "normal" PE?

Thanks

Mar 17 03:25 PM

[William Cowie:]

So much bad news has been hitting us daily,
so many commentators are piling on prognostications of doom,
one wonders if we're reaching apoint of saturation/numbness.
if we believe in anything remotely resembling an efficient market,
the question is: how much of the bad news has been baked into market prices?

My gut feel (and we all know how realiable THAT is) is that we're getting close to saturation, very close.

Mar 17 03:32 PM

[LeoTheDog:]

This is hardly the case for entering or even staying in the market. The author cites a 50/50 chance of falling below 600 on the S&P. From today's close that represents a 50% chance of a decline of more than 23%.

Notwithstanding the claims of "saturation" of bad news, I would suggest that the following have not been fully priced in or appreciated by most investors and commentators (not because they are stupid, but because it is impossible to price these things in until we see how bad they are):

1. 1st and 2nd quarter earnings.
2. High risk of an Eastern European default.
3. Switzerland (Switzerland!) is devaluing its own currency. What does this portend for Japan or China, and by contrast how does a stronger dollar affect US growth estimates?
4. Alt A mortgages.
5. Credit card defaults.
6. The economic effects of 10% (or higher) unemployment.
7. Possibility of a commercial real estate crash.
8. Rising foreclosure and bankruptcies caused by continued job losses, weak job market and loss of healthcare.

I fear that additional shoes have yet to drop....

Mar 17 04:11 PM

[discov:]

I can't invest in a country that doesn't have jobs.

I see forward projections of inflation, earnings, fair value.... The problem is that we come up with projections using an old "tried and true" model. However, the unemployment numbers, inflation numbers....(all the inputs to the model) are not calculated the same way they used to be.

So we end up with an invalid projection. Personally, I think the jobs numbers are so far from reality (reality is much worse). To me S&P 900 won't be sustaiable, if we reach it.

concisetrading.blogspo.../

Mar 17 08:40 PM

[La Marque:]

Jeremy Grantham is right about investing now while you're terrified. His time period to normalcy seems to be 7 years; I think we are in America's lost decade. I have been inching back into equities because he is right about those with a lot of cash are going to miss out on the upsides. It is a good time to fill in the holes in one's portfolio, to pick up the sector stocks that many of us thought were overpriced for the last 5 years.

Mar 17 09:27 PM

[bricki:]

A lot depends on what you consider 'normalcy'. Does the word even make any sense in the dynamic markets that we see today? Is a calm unperturbed market normal? Or is it the exception?

I think we are in a normal secular bear market where trading and not buy and hold is the correct strategy. If normalcy means a secular bull market, don't hold your breath.

Mar 17 10:12 PM

[Old Trader:]

I think that's exactly right (maybe because I'm doing the same thing, LOL). Use the current rally to exit "weak" positions, and wait for a pull back to plug holes.


On Mar 17 09:27 PM La Marque wrote:

> Jeremy Grantham is right about investing now while you're terrified.
> His time period to normalcy seems to be 7 years; I think we are in
> America's lost decade. I have been inching back into equities because
> he is right about those with a lot of cash are going to miss out
> on the upsides. It is a good time to fill in the holes in one's portfolio,
> to pick up the sector stocks that many of us thought were overpriced
> for the last 5 years.

Mar 18 12:52 AM

[Moon Kil Woong:]

If you actually buy then you probably aren't terrified. Thus this advice, although correct in theory always fails on application.

Mar 18 03:37 AM

[frosty:]

I invested in top rated mutual funds - some of the best Fidelity and Hartford funds and lost a bundle. I invested in some of the top rated financial firms - AIG, Lehman, Merrill, Goldman, Morgan Stanley and lost a bundle. I invested in some of the top manufacturing firms - GE, UTX, Boeing and lost a bundle. Even BRKA. At no point did I feel that I was taking bigs risks because at the time, these investments were rated as among the best - AAA or their near equivalent. That happens in a bear market - the good turn bad, bad turn ugly, the ugly cease to exist.

So how will I make it back in then next bull market? Lots of people like those above will have ideas. In a true bull market the herd effect wil ensure most of these will enjoy some success, some will enjoy great success, a few will not pan out.

Our culture, society and economic structure are presently undergoing great change. So how do you pick winners of the future? Alternative energy, fuel efficient autos, digital technology, manufacturing, commodities, internet plays? Lots of people have ideas and will develop rationales for supporting them, but in reality these are nothing better than guesses. Which will turn out right? Which won't? This is the risk side of investing.

So here's my epiphany. The most powerful forces in the market are not you and me but mutual and hedge fund managers. Mutual fund returns in particular are routinely compared to the S&P 500, some do a little better, some not quite as well. In the total universe of funds, a small percentage of outliers are above or below the S&P and are usually specialty funds or targeted in some way. If the S&P is the standard for comparison, why should I gamble that I am prescient or lucky enough to pick the right fund (actually the right fund manager), or the right stock (which can tank if a great leader gets sick or takes a leave of absence), or the right hedge fund (who's manager and activities are great mysteries)? Why not just invest in the S&P 500? Like smaller companies? Russell 2000 or 3000. Like foreign companies? EEM. Perhaps a blend of the three.

Lots of people will argue that I will only get average returns with this strategy. In retrospect, I would love to have those average returns. I will throw a challenge to the staticians among you. I suspect that the majority of mutual fund managers and individual investors have NOT outperformed the S&P 500 over the long run. Hopefully we will see a future article on this.

Just like at the casino - if you play for awhile you're bound to win some but the vast majority go home with less money than they started with. However they usually tell confidants about their wins or, if they admit to losing, remind people that they went there primarily to be entertained anyway so the cost was worth it.

Mar 18 09:22 AM

[jse17:]

Excellent piece and key on point words:

"Without a similar program, be prepared for your committee’s enthusiasm to invest (and your own for that matter) to fall with the market. You must get them to agree now – quickly before rigor mortis sets in"

"Typically, those with a lot of cash will miss a very large chunk of the market recovery."

Mar 18 09:29 AM

[Tomcat101:]

I've been terrified since the end of September...

I'be made some money on some trades and lost some, but I'm not ready to jump in long yet. My concern is that we are repeating the Japan story, or this is Great Depression #2. If this is G.P.#2, the S&P could go down as much as 89% to around 150.

If it hits 150 I'm all in at that point.

Until then I'm making short term trades.

Mar 18 10:30 AM

[Oregonrain:]

I have been following this guy for about two years now. I have done nothing but make money. He is the real deal.

He called the top and has more or less called the bottom. He is of course too smart to say it is a bottom as we could easily sink back again.

But, I will say this...when he became ever so much more positive in his Jan newsletter I hung in a bit longer with my shorts...I am not after all moving billions around...but...went long about a month ago with SSO.

Thanks you thank you (again) Mr. Grantham. For all the people who have "thoughts" on CNBC and on here...I have found this guy to be dead...nuts...on. I highly highly recommend that Seeking Alphas pay close attention to him

Mar 23 10:37 PM