Jeremy Grantham: Collapse is Over, But Monumental Challenges Remain

In his latest market commentary, fund manager Jeremy Grantham of Grantham, Mayo Van Otterloo strikes both a bullish and bearish tone - and is must-reading as always. Grantham's essays are particularly difficult to excerpt, since they are dense with meaning and develop thoughts gradually, but here are a couple paragraphs in any case. And don't miss Grantham's "Appendix of Well-Informed Guesses" that summarizes his current forward thinking. (The entire commentary is embedded below.):

The financial and economic collapse that I described as “the most widely predicted surprise in the history of finance” about 18 months ago is behind us. More precisely, we believed that bubbles had formed in global profit margins, risk premiums, and U.S. and U.K. housing prices, and that all three were “near certainties” to break, with severe consequences for the economic and fi nancial system. All have thoroughly burst and are in their overcorrection phase with the single exception of U.K. house prices, which I’m confident will do their duty...

If we are looking for any further drawn-out negatives, I suspect we could add the more touchy-feely factor of confidence. We have all lost some confi dence in the quality of our economic and fi nancial leadership, the effi ciency of our institutions, and perhaps even in the effectiveness of capitalism itself, and with plenty of reason. This lack of confi dence will not make it easier for animal spirits to recover. This does not mean necessarily that we haven’t already seen the low, for, in my opinion, it is almost 50/50 that we have. It is more likely to mean a long, boring period where making fortunes is harder and investors value safety and steady gains more than razzle dazzle. (The flaky, speculative nature of the current rally thus bears none of the characteristics that I would expect from a longer-term market recovery.)

Jeremy Grantham, Quarterly Letter

Comments

[Ricard:]

Seems Grantham is betting on a global 'suckers' rally'.

"To be honest, I believe that most of you readers are likely to be grandparents before you see a new inflation-adjusted high on the S&P."

"Well, what I’m proposing could be known as a VL recovery (or
very long), in which the stimulus causes a fairly quick
but superficial recovery, followed by a second decline,
followed in turn by a long, drawn-out period of sub-normal
growth as the basic underlying economic and fi nancial
problems are corrected."

And who said Grantham is not a perma-bear?

May 07 09:53 AM

[Oregonrain:]

This guy has been about as perfect in his calls as anyone though this. He is a bit early sometimes but he freely admits this. He is not a market timer but a value investor. . But when the S&P hit around 650 in March he was yelling BUY. So..whatever he says I would listen very carefully. One of the best ever.

May 07 10:26 AM

[deuxsous:]

He really puts the whole thing into perspective without glossing over or parading out wishes and hopes.

We've had a serious loss and it won't be cured quickly or easily. So accept it and get on with what's left.

May 07 11:27 AM

[mwswi:]

Any idea(s) what particular investments Jeremy Grantham is leaning towards or favors during the "V" run-up and what investments he would retreat into during the "L" portion/era? It's difficult to interpret what investments he would direct (1) his clients monies and (2) his own personal portfolio from this, his current thesis.

May 07 12:36 PM

[Maya_:]

As always Mr. Grantham's work is a pleasure to read. Though this time round it confuses me. On the one hand he observes that in real terms, the index may well take 20 years to recover. On the other, the recent 7 year asset class return forecast indicates real returns of 7.5% on US large cap and 7.4% on small caps at end of March 2009. With SP500 at 797 at end March, in about 9.5 years the real index expectation in today’s $ could run to 1584 (higher in nominal terms) which is somewhat higher than the Index high in the economic cycle just past.

I also get the feeling that the despair and anger in the publication comes because Mr. Grantham is shifting out of the bearish camp where the visibility was clear to a more normal opaque environment which will apply to the future. He is out of his comfort zone and it is clouding his vision.

On his comments about the bank rescue & moral hazard; I think he is wrong. Allowing the banks to fail would have disrupted society and destroyed wealth like never before - besides the loss of intellect, idle factories and minds are destroyed wealth. I do not see any moral hazard; when you give a kid too much candy he/she eats it; surfeit of sweatness leads to sourness; at least in the tummy. Do you blame the kids or the giver of Candy. Banks created a bubble actively encouraged, even forced, by the Fed; now that time to pay has come, and the price must be paid. While the worst might be over, it is likely that the price will be paid through restrained growth for many years - until inflation and growth (albeit slow) debase the debt now undertaken to a lower level. The option of letting banks fail is inconceivable - the idle managements, scientists, factories would lead to a massive and spiralling destruction of wealth. What the Obama administration is doing is distasteful but exactly right - rescue, then regulate and later unwind. It is a delicate task and one where the outcome is by no means certain. I think Mr. Grantham is missing the point that there are several paths to the same destination; and sometimes an amiable amble is more fun than a vigorous work out.
I also think he is wrong on China. Domestic consumption will rise and rise and rise with no reduction in the savings rate. The consumer rise will come from increased wealth and earnings as opposed to withdrawal from the ATM that is the home. The problem is over consumption and under saving in America NOT under consumption and over saving in Germany/China etc.
My view on the next economic cycle is slower growth (1.75%-2% GDP); higher inflation (3.5%-4%); weakening $; rising risk premiums (5% over earnings yield); rising savings rate (7%-8%). Debt supply will fall below equity. Quality large cap companies with high debt levels (D not more than 50% of E but not less than 20% of E) because I feel these will benefit from ability to raise debt ahead of debasement of debt through inflation will outperform. You can look forward to the next economic cycle delivering earnings of roughly 69 {2% annual growth over the prior cycle average earnings of 60} and multiples of 8X to 18X of the average prior cycle earnings depending on sentiment. Market fair value based on this is 1250; adverse sentiment market bottom is 550. Most likely bottom has been seen at 666.
New bottom lower could be formed in 2014.At this time I think market will do well in 09, not too good in 10 (because impact of stimulus will go and not be fully replaced by private consumers). 2011 / 2012 should be good years presidential cycle will make sure public is happy through growth oriented fiscal and monetary policy); 2013/2014 gets too far out but based on historic comparables, I think these will be difficult years; probably very difficult because the hangover this crisis will leave behind will be monumental.

May 07 12:52 PM

[Maya_:]

Go to his website (gmo.com), register (its free) and read his quarterly updates - these provide substantial details of allocation to equity and specific shares invested. I suspect his own monies will be invested in a substantially similar manner, probably through in house managed funds.

On May 07 12:36 PM mwswi wrote:

> Any idea(s) what particular investments Jeremy Grantham is leaning
> towards or favors during the "V" run-up and what investments he would
> retreat into during the "L" portion/era? It's difficult to interpret
> what investments he would direct (1) his clients monies and (2) his
> own personal portfolio from this, his current thesis.

May 07 12:58 PM

[mwswi:]

Thanks for your reply, Maya_. I did register at GMO and read the "GMO 7-Year Asset Class Forecasts (1Q 2009)," the "1Q 2009 GMO Quarterly Update" and just as importantly, the "1Q 2009 International Active Update." I came away with a better understanding of GMO's investment strategy as a whole.

I also enjoyed reading, "Valuing Equities in an Economic Crisis," written by GMO's Ben Inker.

Again, I appreciate your reply...

-- mwswi --


On May 07 12:58 PM Maya_ wrote:

> Go to his website (gmo.com), register (its free) and read his quarterly
> updates - these provide substantial details of allocation to equity
> and specific shares invested. I suspect his own monies will be invested
> in a substantially similar manner, probably through in house managed
> funds.
>
> On May 07 12:36 PM mwswi wrote:

May 07 05:59 PM

[Donkey Kong:]

You would benefit from reading thoughtful, high-quality research and GMO should certainly be on your list. Making investments based on random observations about what is happening at Facebook, etc. or relying solely on technical analysis is NOT how to generate, superior risk-adjusted return over the long-term (10-20 years). I continue to snicker as people crow about their great returns since the market bottom. A 2-month return stream is NOT MEANINGFUL!!!


On May 07 12:35 PM Cetin Hakimoglu wrote:

> I'm optimistic, but not cautiously so. I'm exuberant, but rational.
>
>
> ----------------------...
> Grantham's essays are particularly difficult to excerpt, since they
> are dense with meaning and develop thoughts gradually, but here are
> a couple paragraphs in any case. And don't miss Grantham's "Appendix
> of Well-Informed Guesses" that summarizes his current forward thinking.
> (The entire commentary is embedded below.):

May 07 06:39 PM

[Jason Rines...:]

I will continue to repeat my forecast. It's a W shaped event. I think Maya is pretty close to my estimates. In general, I believe America will look at the years 2008-2018 as a lost decade. I believe civil unrest is unavoidable as entitlement spending is slowly but surely cut and taxes via inflation or directly continue to frustrate young families wondering where the American dream went.

May 07 11:04 PM

[Ricard:]

I agree with your self-characterization except for the last word. You seem to 'believe' in a market rally, one that is not at all supported by any factual content that you or anyone else has brought to the table. It is one thing to be swayed by facts and/or experts to hold an opinion one way or another - it is something else entirely to fabricate a viewpoint, and have it supported by nothing other than 'faith'. I find you to be the pinnacle of irrationality, as optimistic, exuberant, and reckless as you may be.


On May 07 12:35 PM Cetin Hakimoglu wrote:

> I'm optimistic, but not cautiously so. I'm exuberant, but rational.
>

May 08 12:04 AM

[TheEconomyK...:]

I have been reading Mr. Grantham's quarterly letters since I graduated from undergrad back in '07. Him and his letters played a huge part in why I became interested in finance and economics and how I chose the career path that I did.

That aside (please excuse the background talk) - everyone's comments on this page are extremely insightful, well-written, and in some ways reflect my own thoughts. I remember being chewed out back in 2007 by a fund manager at a gym in Boston for a comment that I had made alluding to the markets as a magic carpet ride that was about to have the air pulled out from underneath it.

I still feel the same way about this current "bear market rally." However, as some have pointed out, the rally is ignoring market fundamentals, particularly short-term - we see the same in the energy markets on a consistent week in week out basis. Irrational exuberance does come to mind. I also wholeheartedly agree with Ricard's post.

One major auto company declare bankruptcy and a second one inevitably on the way. The commercial real-estate shoe is starting to drop - seeing more companies simply hand over their assets to the banks. Jobs are still being cut left and right, but hey it's not as bad as the market guestimated! The banks are not increasing lending - if anything they continue to tighten their terms (I speak from recent personal experience). Some other quick points: an overwhelming amount of my former classmates and friends that graduated in the years following have not been able to find professional work. I also recently went down to my town hall and found out that tax liens have grown exponentially and since they take precedence to mortgages, banks have been trying to buy out the liens so they can foreclose on the properties.

My final point and question - and I posed this to a coworker the other day. What if it is in the country and the economy's best interest to ignore the obviously deteriorating fundamental picture? Almost similar to a red pill vs. blue pill situation. Do people really want to see how deep the rabbit hole goes and live in the "real world" of a potentially high double digit unemployment, the attainability of the American Dream ending, and potentially hazardous social chaos and unrest?

Or do we take the other pill and continue to live in an air-inflated dream and tell ourselves everything is alright? Ignore the fundamentals and let the market move sideways for the next 10 years in a tight range becoming our own lost decade.

Excuse the questions if thought naive.

May 16 01:38 PM