A Barron's Interview With Jeremy Grantham (from SI)
Sucker Punch Coming
An Interview With Jeremy Grantham -- Clients of Grantham, Mayo, Van Otterloo & Co. have been gathering the past two weeks at the venerable investment firm's Boston headquarters for its annual assessment of the state of the world's markets. In other words, to hear "Jeremy's jeremiads." With 35 years experience under his belt and $48 billion under management at the firm he helped found, Grantham is well worth listening to. His foresight and fastidiousness are the stuff of legend, as is the firm's ability to deliver superior results across asset classes around the globe over the long haul. For Grantham's latest prophecies, please read on.
Barron's: New bull market? Bear market rally?
Grantham: The simple story is the market is overpriced and will go to a trendline P/E, which we now believe is 16 times based on research that shows earnings tend to be overstated over time because assets tend to be underdepreciated during times of technological progress. Currently, the market is around 24 times trailing earnings, on a fairly generous earnings estimate. This is not just a bear market rally but the greatest sucker rally in history.
Q: There's nothing comparable?
A: Nothing in American history. In bear-market rallies, in the not-too-distant future, a new low is made. But the new low is only verified in hindsight. The normal characteristics of the leadership in a bear market rally flash back to the old leadership of the prior bubble.
That's not the case in a new bull market. In the three substantial, but not huge, rallies that occurred in 2000, 2001 and 2002, technology and growth stocks led the way, particularly flaky little companies. The scope of the speculation and the leadership of tech and the surviving Internet stocks is just not typical of a serious new bull market.
New bull markets typically start when the great bubbles have broken badly and stocks become very cheap: Eight times depressed earnings and way under half replacement cost. After this bubble burst, the market hit 19 times earnings, barely below the prior peak of the two previous great bull markets. Then it staged a big rally, with all of the indicators of a bear market rally except one: Bear market rallies typically don't have legs and in the U.S. have never lasted a year.
Jeremy's jeremiad: The vast overhang of debt which, unlike in other cycles, continues to grow, means a major "housecleaning" still lies ahead for the market.
Q: But this one will?
A: It is the third year of a presidential cycle. The presidential cycle is enormously important. The presidential cycle for me starts in 1932. Before then, the whole idea of stimulus hadn't sunk in. Keynes explained the concept and in Franklin Delano Roosevelt he had a very interested listener.
From then on, administrations understood it is a good idea to stimulate the economy in year three, so that in year four unemployment -- and this is key -- is dropping. It's fine to have a strong economy, but it is unemployment that really drives the vote, our research shows. The third year in a presidential cycle is not just a bull market year, but one with a bubbly flavor to it where growth wins. It's the only year in the cycle that growth wins. The speculative stocks outperform the quality stocks and small caps do very well.
Q: How does this third year stack up against those in the past?
A: This is a classic third year. The absolute return, minus inflation, is 17% in the third year and believe it or not that is exactly where we are, up 17%. Growth outperforms its normal relationship to value by 5% and that is exactly where it is today, to the penny. Small cap does very nicely and this time has done twice as well because it has benefited from another kicker.
While there isn't a very strong connection between the economy and the stock market, there is one very useful connection: In the 12 months, sometimes 24 depending on conditions, but always 12 following a low in the economy, small caps do very well. Low quality or junk does spectacularly.
What we found, too, is that the third year is fairly indifferent to value. Years one, two and four are reasonably sensitive to value. In year three, it doesn't matter whether the market is cheap, expensive or in between, the market goes up. In 1999, the most expensive year in American history up to that point, the market went straight through the roof, like a pea bouncing off a tank.
Q: What should we expect in year four?
A: Year four is neutral. The market comes in on average, small cap is about average, junk still wins -- a little echo effect -- and surprisingly value comes back and typically has the best year on average in the cycle. Value matters.
This is, of course, a glorious heaven-sent opportunity to take advantage of the rally and reposition portfolios. This is a very important rally and it will probably last through the year and may easily carry over into one or more quarters next year.
But next year is much more up for grabs. It is a very expensive market and that will be a drag. We still have very low capacity-utilization and all the problems of excess spending that went on. We have the problem of debt.
Q: How critical is the question of debt?
A: What is unique to this cycle is debt has not declined. It has, in fact, risen dramatically at the government level, quite dramatically at the corporate level, dramatically at the foreign level and very substantially and steadily at the consumer level. This is not a good picture.
Normally, it rises in bad times and falls in recoveries. This time it has not. This is a long way from today, but 2005 and 2006 will be a much clearer call than most years.
Q: How is that?
A: They will be painful years. A black hole.
Q: Why do you say that?
A: Housecleaning needs to be done, whether a new administration or old, and we have got a really dirty house. There is debt everywhere, and there are problems that have not been addressed, only postponed, by this administration and the Federal Reserve. In addition, we have a horrifically overpriced market. It is the third most expensive year ever recorded.
Q: What should investors do?
A: There are fewer places to hide than any time in my 35-year career.
Bonds are not horrific, but they are vulnerable to someone deciding the way to get rid of all this debt is to inflate. TIPS (Treasury inflation-protected securities) are okay, but fairly priced. The returns at these levels are not terrible but neither are they satisfactory.
In stocks, value has come in and won't be too much help on the downside, nothing like 2000-2001. Same with small cap. Small cap has done brilliantly all the way down and all the way up this year. Small cap is not cheap in the U.S. Do not expect it to provide any material help on the downside; it may even underperform.
Real estate has been like a cat with nine lives. Housing prices have continued to rise to a multiple of income that is dangerously high. The next time at bat, you really have to count on the housing market coming down, not disastrously, but if the S&P comes down through 700, which is our estimate of fair value, it will very likely be accompanied by at least a modest decline in housing.
All the reasons that propped it up will have flowed through the system. It would be hard to imagine a two-year decline in the market that was coincident with a continued climb in real estate. Real estate is getting very expensive and quite unaffordable, and when rates rise that will make it much more so.
Meanwhile, REITs [real-estate investment trusts] went up in 2000-'01-'02 when the U.S. market went down. Then we have a 20% rally in the S&P this year and REITs are six or seven points ahead. Since we spoke last year, REITs are up 33.4% to the S&P's 23.9%, almost 10 points ahead.
Q: Why the outperformance? Aren't REITs out of favor now that other dividend-paying stocks receive a tax advantage?
A: Of all the questions I find hard to answer, that is No. 1. I can give you plausible B.S. but I don't know why REITs have done so well. They changed the tax on dividends, but not for REITs, and therefore other high-dividend stocks should surely handsomely outperform REITs. Yet REITs, without the tax advantage, are far ahead of other high-yield stocks. Go figure.
Everyone knows the fundamentals of office space are terrible and apartment rents have fallen and vacancy rates are up. We've had three years of brilliant outperformance in the worst bear market since 1974, and still REITs are outperforming. I don't get it, except underneath it all there is still a big gap between the expected return from REITs and the S&P. We are down to about a 4.5% estimate in REITs from 8.1% a year ago. Now 4.5% is not enough, but it is a lot better than about negative 1% a year, which we expect from the S&P.
Q: Are you still anti blue-chip?
A: I'm anti blue-chips in terms of absolute return. In terms of relative return, one of the places to hide in the U.S. market will be quality stocks. Quality stocks, whether large-cap, or small- or mid-cap, provide noncontroversial, straightforward return on equity, stability of profits and balance-sheet strength. Meat and potatoes. Those characteristics have underperformed continuously all year. This has been a junk year by every parameter.
The net effect is that quality is already pretty cheap. If this bear-market rally continues for quite a long time, then quality will become about as cheap or cheaper than it has ever been. In the event the market goes another leg down, accompanied perhaps by some measures aimed at the overleverage in the system, quality could be a terrific defense against huge declines. Quality stocks will still go down, unfortunately. But they will provide real resistance to big declines. They will be pretty heroic as will REITs on a relative basis. That's the important idea in the U.S. But the real play, of course continues to be foreign and emerging stocks and bonds.
Q: Still?
A: The dollar has probably not seen its low. Even though we don't score it as cheap on traditional purchasing-power parity, we have a strong suspicion it will continue down because of the trade gap. Now the place to hide in relative terms is in foreign stocks, emerging markets and, paradoxically, high-quality U.S. and, if you insist, REITs.
The problem is, what do you do in absolute terms? Foreign is no longer cheap. It is a little expensive. The best you can say for it is if you are going into the second leg of a major bear market, it is better to go with the sectors that are only a little expensive. They will go down in sympathy with the U.S. but I think they will go down substantially less and the currency kicker will make a big difference.
The only one that may buck the trend is emerging markets. Emerging may actually go up in a fairly serious decline. We've been saying this for a long time and last year the S&P was down 22% and emerging was minus 2%. It almost made it; it almost did the impossible. Emerging is still absolutely a bit cheap. It is the only equity category that is absolutely a little cheap. Its profit margins are improving. Its GDPs are improving. If there is no out-of-left field crisis in, say, China -- and "if" should be underlined two or three times -- they are in better shape than they have been for years in terms of financials and currencies.
Q: Are you mostly focused on emerging Asia?
A: No. We like Brazil a lot. We like Argentina. We like Eastern Europe. We don't like Korea. It is picking and choosing. But emerging is the only category that might actually go up.
I am intrigued, too, by the growing interest in emerging equity. We are seeing fairly massive increases in institutional interest in emerging markets. And that is a market where a little bit goes a long way. If this speculative phase in the U.S. market were to continue for as long as nine months from today, I wouldn't be surprised if emerging markets didn't go up another 40%. It has got everything lined up for it. If the market here fades quicker than that, then it won't happen, but it still might do pretty well.
Q: What are your views on China?
A: It is working out very well, for the time being. Their imports are growing faster than their exports. Their imports are up 40% year over year. Mind boggling. Chinese imports represent almost one-third of the increase in imports globally. A country with an official GDP that puts it No. 7 or 8 in the world is accounting for 30% or so of all the growth in global importing. Stunning beyond belief. If it keeps rolling a lot of things are going to change in the world.
One of the interesting things is commodity prices. I always make a big fuss that there are only two commodity prices that have risen in the long run: fish and forestry.
What do they have in common? They started as free goods. When you start free and move to cultivation, that is known in the trade as an infinite increasing cost. Okay, it is an exaggeration but at least it makes the point that you can have a long, steady increase in price. Fish and forestry have risen and everything else has gone down in price.
It doesn't matter whether it is oil or soybeans, they have all gone down in real terms. And they've gone down because even those that have marginal increases in costs, such as oil, have had their productivity clock in a little higher than the rising marginal costs of extraction. It doesn't have to be that way, it just happens to be that way.
If China keeps up its growth rate, productivity -- which will not change just because China is growing rapidly -- will come in below the increasing marginal costs of extraction, and those commodities will tend to have a rising real price. Even though they haven't for a hundred years, they will have real price increases. If you push resources at the rate China is doing now, we are going to live in a world where commodity prices rise.
No doubt other interesting effects will fan out from that. With China increasing its imports by 40% and its exports something like 35% this year, what effect does that have on shipping? They're growing faster than they can build ships. Shipping rates have gone through the roof. China may push the whole infrastructure of shipbuilding pretty hard. It may take a few years to gear up to build enough ships to keep up with the incremental effect. Now if the rest of the world slows down a bit, that will mitigate the pressures enormously.
Q: So, how do you feel about the loss of manufacturing jobs in the U.S. to China?
A: There are only 14 million manufacturing jobs, down from 17 million four years ago. How many of those 14 for technical reasons are always going to be in America? Say 8 million. So between now and forever you are going to lose another 6 million jobs. You just lost 3 million in the last four years. It is really seriously hard to get too excited in a population of 250 million about the eventual loss of an incremental 6 million jobs.
The huge pain of the economy going from 80% manufacturing in 1900 is behind us. That is really bullish. There are plenty of countries where this is a serious factor, but for the U.K. and the U.S., the two most advanced in this way, what used to be bad news has become the good news. The U.K. and the U.S. are service-driven economies.
Q: What about the migration of services jobs at this point?
A: Migrating service jobs is much more complicated. You certainly wouldn't want them to go too fast because that is the area where we are growing and that's where our comparative advantage always has been.
But in the end, global trade benefits everybody. It may also hurt some people, but net-net, it increases the total wealth of the majority of people and so it will go on. We should welcome it. But it is tough if you are the computer programmer who just lost his job to someone in Mumbai.
Q: And so are you investing in commodities?
A: Commodities will probably be a nice place to hide and well worth looking at. We have been considering doing a real-asset fund using stocks. We probably will not, but we are working on it just to have an extra weapon to consider according to the circumstances.
A fund we will probably do is a quality stock fund. A lot of our funds are tied to benchmarks and there is a limit to how much they can tilt to high-quality stocks or should. A quality fund will allow us to target quality stocks more emphatically.
Q: Thanks, Jeremy.
