In his latest quarterly letter to shareholders, legendary manager (and longtime bear) Jeremy Grantham of Grantham, Mayo Van Otterloo addresses the Minsky Meltdown, describing the current situation as the most important U.S. financial crisis since World War II. The letter was written January 12, and as Grantham astutely points out, it may certainly have been overtaken by more recent events. Key excerpts:
2007 Eggs-on-Face Awards
My first Greenspan prize goes to Chuck Prince for enthusiastically continuing to ‘dance’ the expanding credit polka into the summer; a most unfortunately timed demonstration of chutzpah. The second Greenspan prize – for “incomprehensible misreading of obvious data by an apparently well-informed source” – goes appropriately enough to Ben Bernanke for his late 2006 comment that, “U.S. housing prices merely reflect a strong U.S. economy.” In humble third place I have to put Hank Paulson for his view in the Spring that the subprime troubles were “contained.”
About 2 years ago I was introduced to Hyman Minsky’s argument on the development of credit bubbles. Remarkably, ‘stability is unstable’ really captures his point. Investors, when confronted with an apparent reduction in risk, will seek to return to their normal or desired risk by leveraging up. This attitude becomes contagious and reinforcing – risk is ignored and debt levels soar until at the peak capital gains are needed to merely pay the carrying costs. Then something, it doesn’t really matter what, goes wrong; the risk in the environment is seen to return to more normal levels. Many players are caught with risk levels far above their desired level and are forced to cut back on leverage and risk in general, which puts pressures on the prices of what they own and so on. It has a simple and powerful logic. Well, the Minsky Meltdown has clearly arrived, and one shoe after another of the market centipede drops onto the floor, and we are waiting for many more. This is the most important U.S. financial crisis since World War II: it is of course far more global than previous crises, with tentacles reaching everywhere, and it coincides with broad overpricing of assets.
... Stocks meanwhile, relative bystanders last year, are overpriced, particularly at the risky end of the spectrum. And profit margins are spectacularly above average precisely for companies at the riskier end of the spectrum. Margins are declining now and the markets are finally getting the point that all risk is dangerous. Markets are well into a massive repricing of both risk and asset prices but it has far to go outside the original subprime area, where repricing may have already run its course.
Recommendations for 2008
I’m afraid cash is the ugly answer that no one ever wants to hear. For the first time, in many bear markets, traditional value stocks are unlikely to help much and may even hurt, as they entered the decline badly overpriced. And, once again, if you literally cannot resist buying some stocks, we recommend a mix of the highest quality U.S. blue chips and emerging markets. The bigger the fundamental problems, the more quality stocks are likely to outperform.