Jeremy Grantham's GMO Q2 Letter - 'Summer Essays'

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Jul 22, 2014
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1 Bubbles Again: Setting Up for a Deal Frenzy Despite a shocking 2.9% setback in first quarter GDP (quarterly decline at annualized rate), the extent of which was forecast by no one, and despite a substantial decline in NIPA corporate earnings, the market has climbed slowly but steadily in recent months. Market volatility has declined to very low levels despite these setbacks and despite Middle Eastern problems. (The negative January Rule this year has, for that matter, also been ineffective so far.) So, all is apparently well, as we have arrived within three months of the dreaded (by bears) Presidential third year. Accordingly, my recent forecast of a fully-fledged bubble, our definition of which requires at least 2250 on the S&P, remains in effect.

What is worse for us value-driven bears, a further bullish argument has struck me recently concerning the probabilities of a large increase in financial deals. Don’t tell me there are already a lot of deals. I am talking about a veritable explosion, to levels never seen before. These are my reasons. First, when compared to other deal frenzies, the real cost of debt this cycle is lower. Second, profit margins are, despite the first quarter, still at very high levels and are widely expected to stay there. Not a bad combination for a deal maker, but it is the third reason that influences my thinking most: the economy, despite its being in year six of an economic recovery, still looks in many ways like quite a young economy. There are massive reserves of labor in the official unemployment plus room for perhaps a 2% increase in labor participation rates as discouraged workers potentially get drawn into the workforce by steady growth in the economy. There is also lots of room for a pick-up in capital spending that has been uniquely low in this recovery, and I use the word "uniquely" in its old-fashioned sense, for such a slow recovery in capital spending has never, ever occurred before. The very disappointment in the rate of recovery thus becomes a virtue for deal making. Previous upswings in deals tended to occur at market peaks, like 2000 and 2007, which in complete contrast to today were old economic cycles already showing their wrinkles. Worse than being in full swing, they were usually way over capacity. Thus, 2000 was helped along by the bubble in growth stocks to over 60 times earnings, allowing companies like Cisco, possibly correctly, to believe they were dealing with a near-zero cost of capital in making deal after deal for their massively overpriced stock.

In 2007 the housing bubble led to an extra one and a half to two million houses being built, with all the usual accoutrements of furniture sales and more jobs for realtors, bank officers, and Goldman Sachs designers of ingenious new ways to be of service to real estate speculators. Now that the smoke has cleared, the 2007 economy at its peak looks to have been 2% or so above trend capacity (allowing, incidentally, for the overstating of the U.S. long-term growth capability, a misjudgment that is still hanging around).

2 Another Look at Malthus: Where Said To Be Wrong, He Was Right. And, Vice Versa. The essence of Malthus’ work (1798 and later) was that humans, like all other creatures, would tend to grow in numbers up to the limit of their ability to find food. Perhaps he should have left it there because that seems like a reasonable proposition and clearly defines the first 200,000 years of our existence. But he tried to define this equation more mathematically by saying that our potential breeding rate was exponential, or compound, compared to our food production rate, which was arithmetic. Arithmetic growth, he argued, would allow for, say, 500 pounds more grain per acre, per year, which would become a smaller and smaller percentage gain. His simplification was that food production would proceed in the series 1, 2, 3, 4, 5, etc., where population would grow in the series 1, 2, 4, 8, 16. You can see the problem. And it is precise enough to describe the rat population problem in the Back Bay in Boston. You can’t control them by rat traps – they can out-breed your traps – but you can limit them by restricting their food supply.

Through the 20th Century and until recently Malthus’ critics said, yes, okay, the world’s population has indeed been growing fast, and if anything at an accelerating or hyperbolic rate, but, no, the food supply has not been arithmetic but has compounded and kept up with the people. Q.E.D. Malthus was wrong.

Continue reading Grantham's commentary here.

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