Jeremy Grantham: We're Watching A Slow-Motion Train Wreck

by: Jeremy Grantham

jeremy granthamGMO's letters to clients are important reading for money managers: Jeremy Grantham's focus on long term investing, asset allocation and valuation gives him broad perspective, and his track record is outstanding.

Here's an excerpt from Grantham's 2Q 2007 letter, entitled 'The Blackstone Peak and the Turning of the Worms':

In 40 years I believe I have been offered three obvious and extreme opportunities to make - or at least save - money. The first in 1974 was presented by the extreme undervaluation of small cap stocks in absolute terms – many were below 5x earnings and even more yielded over 10%. And compared to the Nifty Fifty – the great high quality franchise stocks – they were almost ludicrously underpriced.

The second opportunity was in 1999 and 2000 when the extraordinary overpricing in absolute terms of growth stocks, especially technology and the internet, meant that in round numbers everything else was relatively reasonable and some assets, notably real estate and U.S. TIPS, were simply very cheap, even in absolute terms.

Well, the third great opportunity is now upon us in my opinion, and that is anti-risk. It is almost certainly the most important of the three because of its diffusion across assets and countries. That is the good news, for most of the time we have to make do with modest opportunities and this one is the real McCoy.

The bad news is that for equity managers the first two opportunities were easy to spot and easy to execute. Anti-risk in comparison is a diffused and complicated opportunity, and is as much or more in fixed income with all its new complexities as it is in equities. The ideal way of playing this third great opportunity is perhaps to create a basket of a dozen or more different anti-risk bets, for to speak the truth none of us can know how this unprecedented risk bubble with its new levels of leverage and new instruments will precisely deflate.

Some components, like subprime and junk bonds, may go early and some equity risk spreads may go later. Some will prove unexpectedly rewarding and some, no doubt, will be disappointingly modest. Such uncertainties would be moderated by a complicated package approach. It will not be very easy, but some of the best hedge funds will, I’m sure, pull it off even as most of them pay the price for too much risk taking. Where we have the funds, the mandates, and the skill we will also try our very best to capture the spirit of the exercise.

To conclude, I have been trying to come up with a simple statement that would capture how serious the situation is for the overstretched, overleveraged financial system, and this is it: In 5 years I expect that at least one major “bank” (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist. I have often been too bearish about the U.S. equity markets in the last 12 years (although bullish on emerging equity markets), but I think it is fair to say that my language has almost never been this dire.

The feeling I have today is that of watching a very slow motion train wreck.*

* An exception was in the last great market aberration. In a late spring issue of Forbes in 2000, I debated Henry Blodget on the future of internet stocks. I argued that it was not about losing money, but survival: “80% of these companies will cease to exist.”