Jeremy Grantham on the Market's Outlook

The opinions of Jeremy Grantham, veteran investor and founder of Boston-based money-management firm GMO, have been featured regularly in posts on the Investment Postcards blog. Against the background of his general disregard for conventional wisdom, his turnaround in early March from a perma-bearish stance to a more bullish demeanour was particularly closely followed. He said in March in a newsletter entitled “Reinvesting when terrified“:

Be aware that the market does not turn when it sees light at the end of the tunnel. It turns when all looks black, but just a subtle less black than the day before.

Grantham also cautioned investors not to fall prey to “terminal paralysis” that often sets in after a financial crisis.

A recent interview by SmartMoney with Grantham provides insight on why he has changed his mind and his prognosis for the future. A few excerpts from the interview are shared below.

SmartMoney: In 2007 you were worried the global financial market could fall apart, and you said a market downturn was probably coming. Okay, say it: “I told you so.”

Jeremy Grantham: That seems so long ago. I felt like saying that a few months ago, but now onward and upward, and wait for the next unexpected twist.

SM: Why were you so certain things were going to get so ugly?

G: There wasn’t a whole lot of doubt where I was coming from. I thought the fair value of the S&P was 925; the S&P went to 1500. And by 2006 the housing bubble was at a 100-year peak. This was the 32nd asset bubble that we’ve tracked, and all but the U.K. housing bubble have popped.

SM: … for the first time in years, you like US stocks.

JG: We think a fair price for the S&P 500 index is 900. By sheer divine intervention we bought into the market on Mar. 6, the day it hit the recent low of 666. It’s likely, but far from certain, that we’ll go back and make a new low. You aren’t going to get to buy at the absolute low unless you have a time machine.

SM: Anything else besides US stocks?

JG: US stocks were nicely cheap, and frankly, the rest of the world was even cheaper. In early March, when we bought, we invested only in stocks we thought would have a 10 to 14 percent average annual return after inflation. That’s magnificent. We haven’t seen anything like that in 20 years. It was somewhat disappointing that prices moved up so fast in just a couple of weeks. The odds are a bit more than 50-50 that we will go back and test that low.

SM: So you’ve made a quick buck. Now what?

JG: You have a set of possibilities. First, if the market nosedives, it’s easy: You buy. The second is confusing, when the market just goes sideways, between 700 and 800. The market is irritatingly cheap then, but not super cheap. The longer that goes on, the less probability we will set a new low, so we’ll ultimately put money each month into the market.

SM: What if stocks keep rallying?

JG: If the market goes higher, above 950, and then starts moving sideways, between 950 and 1050, we probably do very little. Then the market is moderately overpriced.

SM: Over the long haul, is there any particular industry or sector you like?

JG: The people who move quickly in this market can make money. The people who invest in energy alternatives will make more. Alternative energies and combating climate change are the single most important economic initiatives over the next 10 years-really over the next 50 years. It will be a very exciting next 50 years.

SM: Will we get out of this mess?

JG: The stimulus is so great in the United States, China and the United Kingdom, it will kick the economy up. GDP will go back positive for two to three quarters. They’ll assume everything is settled, that throwing money at it has worked. But the long-term imbalance between overproducers [like China] and overspenders [like the US] will continue. It’ll be a multiyear drag on growth.

SM: We’re just throwing money at the problems?

JG: If the problem is that we consume too much and borrow too much, does it make sense to borrow more and spend more? It doesn’t make sense to solve alcoholism by giving an alcoholic a quart of whiskey, but everyone believes that we must stimulate. So that’s why we feel this is a temporary cure. This is like when you revive the drunk, he staggers down a few blocks, then falls down again.

SM: That does not sound promising.

JG: We’re not rich, and we’re undersaved and underpensioned. Those will be a real brake on economic growth. This will be a pretty long recovery period, longer than we’re used to, but hopefully not as long as Japan took. It will not be as long as the Depression, but it will be several years, and not just two. Lord knows we have had several fat years.

Source: Russell Pearlman and Jonathan Dahl, SmartMoney, May 21, 2009.

Comments

[Larry House:]

The fact that Grantham has changed his mind shows he was not a "perma-bear." If one reads closely, it is obvious Grantham is not a raging bull now. Anyone who tries to over-simplify this market and what we are going through right now is living on the edge.

May 28 12:25 PM

[user396040:]

A very helpful piece. I agree with Grantham about the alternate energy sector but I think it is maddenly hard to pick winners (nuclear vs. natural gas vs. various solar technologies vs. wind, etc.) and also very difficult to assess the timing of these markets. I definitely think that 100 years from now we will be using a very different fuel mix and using it in very different ways. Over the last 100 years, a great deal of money has been made by people who accurately handicapped these trends in fuel mix and fuel use.

May 28 12:40 PM

[thiazole:]

Clearly there is much that needs to be worked out of the system - I don't think there are many people here who dispute that, and it will have a significant long term toll.

The real division of philosophy in this forum are those of us who agree with Jeremy Grantham's outlook (myself included) who are somehow seen as the voice of irrational exuberance, and those who think that this recession will just drag out for the next 5 to 10 years or will turn into the apocalypse. Somehow it is hard to see Jeremy Grantham as the voice of irrational exuberance...

May 28 12:50 PM

[Larrysyr:]

This is a refreshing bit of balance. S&P underpriced at 666, fairly priced at 900. The market hasn't so much rallied as simply recovered from pricing in the end of the world.

Grantham's analogy to an alcoholic may have some meaning. Someone truly addicted to alcohol can be killed by going cold turkey. The economy badly needs restructuring, but it won't happen instantly.

May 28 03:05 PM

[Steve Pasq:]

It is optimistic to consider 900 fair value for the S&P 500 but if the market goes down too fast the populous gets restless. It will take time for everyone to get used to this deteriorating environment. Even with mark-to-make believe accounting, PPIP, TARP and the stimulus package earnings for the market will be less than $50. Probably $40 in 2010. Grantham's tunnel will start getting darker when he realizes that earning can get smaller for years and his 18 multiple should be more like 9.

May 28 07:27 PM

[Steve Pasq:]

It is optimistic to consider 900 fair value for the S&P 500 but if the market goes down too fast the populous gets restless. It will take time for everyone to get used to this deteriorating environment. Even with mark-to-make believe accounting, PPIP, TARP and the stimulus package earnings for the market will be less than $50. Probably $40 in 2010. Grantham's tunnel will start getting darker when he realizes that earning can get smaller for years and his 18 multiple should be more like 9.

May 28 07:27 PM

[CJJ:]

What is hilarious is all the time being wasted talking and analyzing and predicting the future...As things become more uncertain and harder to predict people get more entrenched into sides on how things will end up...All the while completely forgetting that things new inventions will crop up, the unexpected will occur and while some people will end up being "right" it probably won't be for the reasons they proclaimed.

In terms of "money"...people, especially on these boards, are nothing more than slaves to it. Not saying that as necessarily a bad thing, but there really are more important things than to waste such smarts(proclaimed or real) on such a stupid problem.

If Humankind does continue long enough the eventual outcome will be a "moneyless"(both paper and gold) world...And I won't go Paco E(whateverhislastnameis) and tell you when...We'll all be long dead by then.

May 28 11:23 PM

[History Buf...:]

Hopefully Grantham won't end up like Jesse Lauriston Livermore, who made a fortune in the crash of 1929 and then lost it over the next three years ...

I think in general he is right -- we haven't seen the end of the world here, just a rather wrenching adjustment. And the fact that he realizes we could retest the lows shows that he is still very much a realist.

The question is, do we go back to business as usual? It all comes down to the earnings. He's probably right, the stimulus will buy two or three quarters of positive GDP numbers. Then what? It is possible the American consumer will continue spending money like drunken politicians, but I would say a lot less likely than it was before. What happens to the economy if we see a permanent 25 to 50 % reduction in consumer spending going forward from this point?

May 29 10:54 AM

[fxmaven:]

Isn't the blog Postcards from Cape Town ? Far away, yes, but hardly the edge, it's quite a nice place actually.

May 29 11:24 AM

[Sober Realist:]

Analysis:
JG: "This was the 32nd asset bubble that we’ve tracked, and all but the U.K. housing bubble have popped."
---He's really good at spotting bubbles. Must be familiar with Austrian economics.

JG: "...By sheer divine intervention we bought into the market on Mar. 6, the day it hit the recent low of 666."
---- "sheer intervention", that is, dumb luck.

JG: "It’s likely, but far from certain, that we’ll go back and make a new low....The odds are a bit more than 50-50 that we will go back and test that low."
----That clears things up for me. He doesn't know any more than the garbage man knows.

JG: "The people who move quickly in this market can make money."
----get in and out quickly after making a 10-15% gain.

JG: "If the problem is that we consume too much and borrow too much, does it make sense to borrow more and spend more?"
----every rational person on SA knows this.

May 29 11:35 AM

[Schweizer:]

Where do these guys come up with their "fairly priced" numbers?

The Sp500 companies have already reported they collectively will have about $27 in GAAP earning in 2009. Times a PE of 15 that puts the SP500 at 400, and only 270 if you use the normal bear market low of a 10 PE.

May 29 11:37 AM

[MarketGrader:]

Future earnings growth must start with revnues. Revenues are still declining with earnings growth coming from cost cutting. The problem with p/e valuations is that the denominator keeps dropping so we never get to the historical low p/e marking a MKT bottom. Ditto dividends. Quality of earnings becomes even more important now. Look for companies adding economic value. Those with high MG grades are doing so, but the grades are based on the previous reporting periods.

May 29 12:08 PM

[Sober Realist:]

Schweizer,
Just read your well-written article:
Where Are The Markets Going? All Indicators Show Down
seekingalpha.com/artic...


On May 29 11:37 AM Schweizer wrote:

> Where do these guys come up with their "fairly priced" numbers?<br/>
>
> The Sp500 companies have already reported they collectively will
> have about $27 in GAAP earning in 2009. Times a PE of 15 that puts
> the SP500 at 400, and only 270 if you use the normal bear market
> low of a 10 PE.

May 29 12:15 PM

[SSALarry:]

Always good to hear the thoughts of someone who has some historical knowledge of the market and appears to be cautious in his approach.

I would disagree on one point though. I believe a lot of money is going to be lost, not made, on new energies in the coming years. A lot of money has already been lost by investors in ethanol stocks and solar stocks. At this point, no one know what the main energy source will be. Even if you get the source right, you then have to pick the winning company. Seems to me, an investment in good old oil stocks, may still be the winning hand.

May 29 01:52 PM

[ValueInvestor:]

That's because you are using current numbers. Value investors don't do that. They "normalize" earnings over a long period of time, so we would say the S&P 500 would have earnings of say ~$65 when things get "back to normal". Assuming a P/E of ~15 (the historic long term average) then the fair value would be $975.

Valuations swing from highs to lows, they usually don't stay near the "fair value" or "equilibrium" price very long, but they always revert to the mean eventually. The one problem is that we don't know how long it will take for things to revert. We simply take a position and wait.

Reversion to the mean is one of the strongest forces in economics.


On May 29 11:37 AM Schweizer wrote:

> Where do these guys come up with their "fairly priced" numbers?<br/>
>
> The Sp500 companies have already reported they collectively will
> have about $27 in GAAP earning in 2009. Times a PE of 15 that puts
> the SP500 at 400, and only 270 if you use the normal bear market
> low of a 10 PE.

May 29 01:58 PM

[cayman:]

I just read the charts and go with em. grantham has a nack for turning bullish or rather giving up on his bearish views at the wrong moment.

For all the talk of people being bearish most of the arguments I hear from money managers are bullish and they are buying with the idea that QE will work.

dont know myself but kinda subscribe to the bearish view and watching the situation day by day as it is very fluid.
Good luck out there

May 29 02:02 PM

[onebir:]

"This steep yield curve will help the banks earnings" - in more normal times this would be the case. But - unlike the UK where most mortgages are priced to floating short rates - most US mortgages are priced to rates further along the yield curve. And I've read (elsewhere on this forum) that many 'teaser rate' loans reset over the next 18 months. So the positive effects of steeper yields on banks interest margins could well be more than offset by negative effects on writeoffs.

Whether these writeoffs get incorporated in recorded earnings or not will depend on how tight the accounting regulations happen to be at the time...

"20% rally on the stock market ( logical or illlogical) will cause the consumer which is 70% of the GDP to spend more". Typically estimates of these wealth effects are pretty small - far less than for housing wealth which is/used to be easy to borrow against.

"the manufacturing sector will sell more american products because of our cheaper dollar" True, but US exports are a pretty small percentage of GDP; the US is a fairly large closed economy, & still has a pretty big trade defict. So unless the dollar weakens a great deal, not much of an effect here.

If the dollar does weaken a great deal, I imagine it would lose its safe haven status, and the US stock and bond markets would weaken significantly - with depressive effects more than offsetting stimulative effects via trade.

May 30 10:59 AM