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Jeremy Grantham - 6 Current Investing Questions

November 02, 2010 | About:
Canadian Value


Jeremy Grantham recently released his most recent market commentary. He thoughtfully answers 6 current investing questions below.

Please be sure to note two comments that he makes withing this text.

1) He honestly believes that we are in a new world where we are running out of resources and that only China seems to "get" this. I've been writing frequently that we need to pay attention to the very clear message China is sending about their need for resources.

2) He believes that there has been a paradigm shift in the long term price of oil.

Current Investing Questions 1) Does this year being a Year 3 of the Presidential Cycle confuse the issue? Yes. Exhibit 2 shows the extent of the problem. In Year 3, risky, highly volatile stocks have outperformed low risk stocks by an astonishing average of 18% a year since 1964 (when good volatility data started).

Also, to repeat a favorite statistic, the record says that 19 Year 3s have occurred since FDR with not one serious bear market – in fact, just one Year 3 was down, fi nishing at -2%. Who wants to bet on the 20th being different this time? Yet, if ever there were an argument for "this time is different," this is it, isn't it? This year, a Year 3 has been preceded by two abnormally stimulated years when, typically, the Fed works to cool the markets down in Years 1 and 2. This time, Years 1 and 2 were turned into a sort of massive Year 3 in which low rates and moral hazard added to the market's natural refl ex to have a big rally after a major nerve-rattling decline. The market responded by rallying 82% in 13 months (to April 26, 2010), with risky stocks up by over 120%, both second only to the rally from the low of 1932. Also unique this time is the great bust of 2008 and the ensuing great bailout.

How much difference do you want? Even so, I expect that the bottom line will come down to short rates. Surely they will stay low for the entire Year 3. And, if so, the "line of least resistance" is for the market to go up and for risk to fl ourish.

In the last six months I've guessed on separate occasions that levels of 1400 or 1500 on the S&P 500 are reachable a year from now; this still seems a 50/50 bet. If we include more moderate market advantages, the total odds would be well over 50%. (I'm trying to wean myself from a recent dangerous habit of using precise probabilities.) Risks to this forecast are highlighted by some ugly near-term possibilities. The worst of these is that Senator Smoot and Representative Hawley, sponsors of the anti-trade bill of 1930, will pull a Night of the Living Dead and prepare a very dangerous opening salvo in the next global trade war. Indeed, today it feels as if there were an inexhaustible supply of politicians who would put their political/ philosophical principles way ahead of global well being. As mentioned earlier, the Fed is also stirring up a hornet's nest on the currency side of this issue with its quantitative easing. There is also the defi nite possibility that we could slide back into a double dip, so we may get lucky and have a chance to buy cheaper stocks. But probably not yet. And, of course, if we get up to 1400 or 1500 on the S&P, we once again face the consequences of a badly overpriced market and overextended risk taking with six of my predicted seven lean years1 still ahead. And this time the government's piggy-bank is empty. It is not a pleasant prospect.

2) Should we hold onto quality stocks?

For sensible long-term investors, the probable outcome of a further speculative rally as described above would be irritating and resolve testing. For good short-term momentum players, it may be heavenonce again. Being (still) British, this is likely to be my nth opportunity to show a stiff upper lip. There is, though, one quite friendly infl uence lurking around that may help us lovers of quality stocks. They are getting so cheap relative to the market that a wider range of buyers is fi nally noticing them. In the third quarter, in a market up a signifi cant 12%, quality stocks held the market.

To say the least, this has not been the law of nature recently: for the past eight years, quality stocks usually won in down quarters and usually lost badly in extreme up quarters. That the Fed Manipulation of Prices was still in force and that this was not a "risk off" quarter was proven by the continued outperformance of small caps and riskier stocks. So the better performance of quality stocks was clearly a bargain effect and not an antirisk move. This may be grasping at straws, but if the expected speculative rally takes place in this Year 3 starting now, I believe that there is a decent chance, say one in three, that quality stocks are so cheap that they will "unexpectedly" hang in. And, after this next 12 months, the odds move in our favor, and I believe (once again speaking for myself) that high quality stocks should have an even bigger win over low quality than our GMO numbers suggest. I think it is probable that the remaining six of my seven lean years will wear down low quality, leveraged companies. Their margins, which are currently far above average, will end up far below average some time during this period, and their relative stock performance may well be horrifi c.

3) How far can emerging equities go?

I have been showing late-career tendencies to wander off the reservation of pure historical value. The "Emerging Emerging Bubble" thesis of 2½ years ago (1Q 2008 Quarterly Letter) is in splendid shape. The idea is that within a few more years, emerging equities will sell at a substantial premium P/E because their much higher GDP growth (6% compared to 2%) will give a powerful impression of greater value. Everyone and his dog are now overweight emerging equities, and most stated intentions are to go higher and higher. Emerging markets are admittedly fully priced, but they still sell at a decent discount to the 75% of the S&P 500 that are not quality stocks – a particularly strange quirk in a strange market. With their high commodity exposure, their strong fi nances, and their strong GDP growth especially, I believe that they will sell at a premium to the S&P, perhaps a big one. How much of this premium to go for depends on an investor's commitment to pure value relative to the weight that is placed on behavioralism – the way investors really behave versus the way they should behave. This gives us quite a wide range for investing in emerging that might be considered reasonable. GMO will make its own decision on how "friendly" to be toward emerging market equities as a category. You must make yours.

4) What to do about raw materials?
The "running out of everything" thesis that I dropped into a black hole a little over a year ago (2Q 2009 Quarterly Letter) is creeping out of its hole (helped by the Fed's mooted QE2), and at least the idea of generalized shortages is heard now and then. The last two weeks (October 3-17) have been truly remarkable for commodity prices: on October 8 alone, the entire commodity index was up 2.5%! Tin, for example, is at an all-time high (in nominal prices, I admit) and, more importantly, "Doctor Copper" is almost back to its 2008 high, which was then four times its previous level. Imagine what this means: in a developed world with 9% unemployment and masses of spare capacity, commodities are acting much too strong for this to be simply a normal response to a rather anemic cyclical recovery. I really believe that we are in a new world in which we are running out of resources … a world that only China truly gets. (For the record, I singled out rare earths in my 2Q 2009 Letter.)

Some of these stocks have quadrupled in price, and at least one has tentupled! That would have been great for one of those "best ideas" dinners, where relevance to a large pool of money doesn't matter, since it's impossible to play rare earths in any size. My personal advice (i.e., how I invest my sister's pension fund, etc.) is to give the benefi t of any doubts for very long-horizon (20 years) investments to resources in the ground, agricultural land, and, above all, forestry. Resource stocks, though, have really run, and a serious price decline caused by, say, China's stumbling, would of course make for a much better entry point. On a seven-year horizon, GMO is enthusiastic only for forestry, which has, in so many ways, more certainty to it than most investments: the sun shines, the trees grow.

5) Should we buy overpriced stocks when bonds are even worse?

We plan to write more substantively on this topic in the near future, but for now the short answer is that bond prices are currently manipulated, and are yielding less than any market clearing price would suggest. They absolutely do not reflect the substantial fears in many quarters about inflation in the long term. Even in less manipulated times, bond prices can be quite silly for the usual behavioral reasons, as demonstrated most clearly by the 15% yield on the 30-year Treasury in 1982! Bonds are thus emphatically not a reasonable yardstick for measuring value in stocks. We use the long-term returns for stocks to decide what their fair value is. They are currently overpriced. Bonds are even less attractive. Yet, remember that in a strongly mean-reverting world, you need to be careful about enthusiastically buying the less ugly of two overpriced investments. Cash has an option value: on the chance that stocks or bonds or, better yet, both, decline, the investor will need resources from which to buy.

6) Religious wars (or, Should we buy gold?)

Everyone asks about gold. This is the irony: just as Jim Grant tells us (correctly) that we all have faith-based paper currencies backed by nothing, it is equally fair to say that gold is a faith-based metal. It pays no dividend, cannot be eaten, and is mostly used for nothing more useful than jewelry. I would say that anything of which 75% sits idly and expensively in bank vaults is, as a measure of value, only one step up from the Polynesian islands that attached value to certain well-known large rocks that were traded. But only one step up. I own some personally, but really more for amusement and speculation than for serious investing. It may well work and it may not. In the longer run, I believe that resources in the ground, forestry, agriculture, common stocks, and even real estate are more certain to resist any infl ation or paper currency crisis than is gold. Very Brief Recommendations

1) Emphasize U.S. quality companies, which are still cheap in an overpriced world.

2) Moderately overweight emerging market equities.

3) Moderately underweight the balance of global equities.

4) Heavily underweight lower quality U.S. companies.

5) Carry extra cash reserves for a volatile market with insecure fundamentals.

6) For the very long term (20 years) overweight resources, particularly if they have a sharp decline.

(This is my personal view rather than that of GMO, which on this topic is agnostic.)

Postscript: Australian and U.K. Housing I happily concede that the U.K. and Australian housing events are not your usual bubbles. Australia, though, does pass one bubble test spectacularly: we have always found that pointing out a bubble – particularly a housing bubble – is very upsetting. After all, almost everyone has a house and, not surprisingly, likes the idea that its recent doubling in value accurately refl ects its doubling in service provided, e.g., it keeps the rain out better than it used to, etc. Just kidding. So, the house is the same. Perhaps the quality of the land has changed? In any case, Australians violently object to the idea that their houses, which have doubled in value in 8 years and quadrupled in 21, are in a bubble.

The U.K. and Australia are different partly because neither had a big increase in house construction. That is to say that the normal capitalist response of supply to higher prices failed. Such failure usually represents some form of government intervention. In Australia, for example, the national government sets the immigration policy, which has encouraged boatloads of immigration, while the local governments refuse to encourage offsetting home construction. There has also been an unprecedentedly long period of economic boom in Australia, and the terms of trade have moved in its favor.

And, let's not forget the $22,000 subsidy for new buyers. But does anyone think that bubbles occur without a cause? They always need two catalysts: a near-perfect economic situation and accommodating monetary conditions. The problem is that we live in a mean-reverting world where all of these things eventually change. The key question to ask is: Can a new cohort of young buyers afford to buy starter houses in your city at normal mortgage rates and normal down payment conditions? If not, the game is over and we are just waiting for the ref to blow the whistle. In Australia's case, the timing and speed of the decline is very uncertain, but the outcome is inevitable. For example, the average buyer in Sydney has to pay at least 7.5 times income for the average house, and estimates range as high as 9 times.

With current mortgage rates at 7.5%, this means that the average buyer would have to chew up 56% of total income (7.5 x 7.5), and the new buyer even more. Good luck to them! In the U.K., which also has floating rate mortgages and, in this case, artificially low ones, the crunch for new buyers will come when mortgage rates rise to normal. But even now, with desperately low rates, the percentage of new buyers is down. Several of these factors, which do not apply to equities, make for aberrant bubbles, and clearly the Australian and U.K. housing markets fit the bill. In comparison, the U.S. and Irish housing bubbles behaved themselves. So let's see what happens and not get too excited. After all, these may be the first of 34 bubbles not to break back to long-term trend. There may be paradigm shifts. Oil looks like one, but oil is a depleting resource. If we could just start depleting Australian land, all might work out well.

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