Jeremy Grantham'a Market Outlook - The Next Asset Bubble
Jeremy Grantham is Chairman of the Board of Grantham Mayo Van Otterloo (GMO), a Boston-based asset management firm with $107 billion under management as at December 2009. GMO is one of the largest investment firms in the World. He built his firm and reputation by correctly identifying the tech bubble of 2000 and the asset bubble of 2007.
Jeremy Grantham's Quarterly Letter "Night of the Living Fed" is something all should read. I posted Grantham's 18 summary points at the bottom of this article as a substitute from reading the rather long letter.
Today during a CNBC interview (transcript - see below to watch Video) with Maria Bartiromo, Grantham suggested investing in stocks with top franchise name, over weighting emerging markets and over weighting cash. Below are what I think are the highlights of the interview.
- And surely— emerging countries will go to a big premium on— every dollar of earnings that they make. And they're beginning to. But, I think they've got at least a few years left. The bad news for us, because we're fairly purest value managers for mainly institutional clients, is we don't like to play games with overpriced assets.
- The Fed is driving the S&P, which is overpriced— the Standard & Poor's 500— a broad measure of the U.S. market, is driving it from already substantially overpriced into what I would call dangerously overpriced. This is about the boundary line. We expect on a seven-year horizon one percent only plus inflation from the U.S. market. And now, as you push it up another 20 percent perhaps in the next year, it becomes dangerously overpriced. A bubble territory and ready to inflate to considerable pain.
- If— if you want to go with the flow, don't fight the Fed as they say— you should be prepared to speculate on very nimble feet. It's not our style as a firm. But, I think it's— probably a game that you could play with a pretty good chance of winning for— for a few more quarters.
- Our institutional clients— sell very gracefully into this rally. We've already started to sell. We're not even— averagely weighted. We're modestly under weighted. And you must remember bonds are even worse than stocks on a seven-year forecast. So, you get caught in this paradox.
- (The Fed) wants us to go out there and buy stocks, which are overpriced because bonds they have manipulated into being even less attractive. So, we’re being forced to choose between two overpriced assets. That is not always a terrific choice to make because there is a third choice, and that is don't play the game and hold money in cash.
That is interesting because I too have a large position in CASH as I sold my bonds, hold good stocks for the long term, hold TIPS and IBonds but sold all my other bonds and bond funds not indexed to inflation.
- And what cash is is an available resource. It buys you the right to buy the U.S. market if the S&P drops from 1,220 today to 900, which is what we think is fair value.
Hold a gun to Grantham's head and he recommends:
- There's another complexity and that is that we believe that the old-fashioned, super blue-chip franchise companies like Coca-Cola are also much cheaper than the rest of the market. So, if someone put a gun to my head and said, "I've got to buy stocks. What should I buy?" I'd say, "Buy two units of the Coca-Colas. They're the cheapest group in— in the equity world. Buttress it with a fairly large dose of emerging markets. They're a little overpriced. But, they've got potential. And— a lot more cash than normal for opportunities should the bubble blow up."
He recommends commodities for those with a very long (20-year) time frame.
- I have an eccentric view on commodities not necessarily shared by my colleagues or by— almost anybody. And that is we're running out of everything.
- ... locking up resources in the ground is a terrific idea. Or locking up— timber, agricultural land will do just fine. A great inflation hedge. You will win, in my opinion. Very high probability over a long horizon. Now, have these things gotten ahead of themselves in the short term?
- Quite possibly yes. And that— that's what makes investing so tricky. If they were to break for whatever reason at all in the next year, I— I would suggest that is a great buying opportunity.
Grantham likes individual companies that have reserves or minerals in the ground but not those who process them who have to go out and pay for these items.
- But— if they've got stuff in the ground. The oil industry since 2000 has doubled against the stock market. They didn't double because they got brilliant. They doubled because oil in the ground became worth four times what it was. And that is a wonderful thing for an oil company with good reserves.
- But, the same if you had mineral reserve(s). That— that's the play, I think, on commodities.
Back to the Federal Reserve:
- And what the Fed is trying to do is to make cash so ugly that it will force you to take it out and basically speculate.
- I think, therefore, under these conditions, low rates is actually hurting the economy. It's taking more money away from people who would have spent it — retirees — than are being spent by passing it on to financial enterprises and being distributed as bonuses to people who are rich and, therefore, save more.
On Market Valuation and targets:
- The trouble with bubbles is when they go, it's very hard to know how painful it will be. But, typically, they go racing back to fair value. So, if this market goes to 1,500 in a couple of years, by then, fair value might be at 950— 950 is painfully below 1,500.
- It's usually the case that it doesn't stop at fair value— 950. So, it might go to 700. And— and you're talking another market that halves. It halved in 2000, and we thought it would by the way. We predicted a 50 percent decline. It halved this time in— in '08, '09. And I think it might very well halve again if it gets back to 1500.
This is a very important comment from "Night of the Living Fed" that reflects what I've been writing and talking about. That is low interest rates punish savers and responsible people who pay their regular mortgage payments.
Pg 11 excerpts:
The Underestimated Costs of Lower Interest Rates For all of us, unfortunately, there is still a further great disadvantage attached to the Fed Manipulated Prices. When rates are artificially low, income is moved away from savers, or holders of government and other debt, toward borrowers. Today, this means less income for retirees and near-retirees with conservative portfolios, and more profit opportunities for the financial industry; hedge funds can leverage cheaply and banks can borrow from the government and lend out at higher prices or even, perish the thought, pay out higher bonuses.
Yet the normal effect of low interest rates can be seen to be minimal if indeed they exist; if they do exist, they come packaged in this very dangerous game of asset price stimulus involving booms and busts. In a number of years, after academic wheels have turned, I suspect this policy approach will be totally discredited. And the sooner, the better! In the meantime, as far as I can see in the data, it is probable that an engineered low interest rate policy has no net benefit at all, even in normal times. It is quite likely in these abnormal times that it even has a negative effect – it holds back economic recovery!
Here is Grantham's summary of the rest of his letter that builds his case that lower rates stimulate the economy is a myth, it creates massive bubbles that in the end destroy he economy.
- Long-term data suggests that higher debt levels are not correlated with higher GDP growth rates.
- Therefore, lowering rates to encourage more debt is useless at the second derivative level.
- Lower rates, however, certainly do encourage speculation in markets and produce higher-priced and therefore less rewarding investments, which tilt markets toward the speculative end. Sustained higher prices mislead consumers and budgets alike.
- Our new Presidential Cycle data also shows no measurable economic benefits in Year 3, yet point to a striking market and speculative stock effect. This effect goes back to FDR, and is felt all around the world.
- It seems certain that the Fed is aware that low rates and moral hazard encourage higher asset prices and increased speculation, and that higher asset prices have a beneficial short-term impact on the economy, mainly through the wealth effect. It is also probable that the Fed knows that the other direct effects of monetary policy on the economy are negligible.
- It seems certain that the Fed uses this type of stimulus to help the recovery from even mild recessions, which might be healthier in the long-term for the economy to accept.
- The Fed, both now and under Greenspan, expressed no concern with the later stages of investment bubbles. This sets up a much-increased probability of bubbles forming and breaking, always dangerous events. Even as much of the rest of the world expresses concern with asset bubbles, Bernanke expresses none. (Yellen to the rescue?)
- The economic stimulus of higher asset prices, mild in the case of stocks and intense in the case of houses, is in any case all given back with interest as bubbles break and even overcorrect, causing intense financial and economic pain.
- Persistently over-stimulated asset prices seduce states, municipalities, endowments, and pension funds into assuming unrealistic return assumptions, which can and have caused financial crises as asset prices revert back to replacement cost or below.
- Artificially high asset prices also encourage misallocation of resources, as epitomized in thedotcom and fiber optic cable booms of 1999, and the overbuilding of houses from 2005 through 2007.
- Housing is much more dangerous to mess with than stocks, as houses are more broadly owned, more easily borrowed against, and seen as a more stable asset. Consequently, the wealth effect is greater.
- More importantly, house prices, unlike equities, have a direct effect on the economy by stimulating overbuilding. By 2007, overbuilding employed about 1 million additional, mostly lightly skilled, people, not counting the associated stimulus from housing- related purchases.
- This increment of employment probably masked a structural increase in unemployment between 2002 and 2007, which was likely caused by global trade developments. With the housing bust, construction fell below normal and revealed this large increment in structural unemployment. Since these particular jobs may not come back, even in 10 years, this problem may call for retraining or special incentives.
- Housing busts also help to partly freeze the movement of labor; people are reluctant to move if they have negative house equity. The lesson here is: Do not mess with housing!
- Lower rates always transfer wealth from retirees (debt owners) to corporations (debt for expansion, theoretically) and the financial industry. This time, there are more retirees and the pain is greater, and corporations are notably avoiding capital spending and, therefore, the benefits are reduced. It is likely that there is no net benefit to artificially low rates.
- Quantitative easing is likely to turn out to be an even more desperate maneuver than the typical low rate policy. Importantly, by increasing inflation fears, this easing has sent the dollar down and commodity prices up.
- Weakening the dollar and being seen as certain to do that increases the chances of currency friction, which could spiral out of control.
- In almost every respect, adhering to a policy of low rates, employing quantitative easing, deliberately stimulating asset prices, ignoring the consequences of bubbles breaking, and displaying a complete refusal to learn from experience has left Fed policy as a large net negative to the production of a healthy, stable economy with strong employment.
My outlook and disclosure: I own and recommend in my newsletter an asset allocation that consists of "franchise names" and small stocks that I think will do well over the long term no matter what the economy does. I have sold ALL bonds and bond funds not indexed to inflation but have positions in TIPS, TIP funds and iBonds that have very nice gains already and should do more if we get an inflation bubble. I also have a significant position in cash to take advantage of buying opportunities such as those suggested by Grantham.