ONE OF THE GRANDEST OF THINKERS AND MOST
ELOQUENT of oracles, Jeremy Grantham has long been the voice of
reason in an industry prone to excesses and embellishment. By taking the
long view, blending quantitative strategies and technical analysis with
sound and experienced judgment, Grantham, chairman of Boston-based GMO,
consistently uncovers with his team the best values among a wide range
of global asset classes.
The payoff is outstanding performance and risk
management. In return, clients have entrusted the firm with about $150
billion. As the man who warned early of a worldwide bubble forming, we
turned to him as that bubble has started bursting.
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| "It was late '06 when [Fed Chairman
Benjamin] Bernanke said he thought the high prices of homes in the
U.S. merely reflected a strong U.S. economy. Was he not looking at
the data?" -- Jeremy Grantham |
Barron's: You, along with George Soros,
have called this the worst financial crisis we've had in the post-war
era.
Grantham: This is much more global than, say,
the savings-and-loan crisis was. The world is obviously much more
globalized than at any time since the late 19th century and much more
interrelated in almost every way, certainly financially. To have the
leading economy and the reserve currency having a major-league credit
crisis would by itself make it more important than earlier ones.
Secondly, this occurred at a time of what I believe
is the first global bubble in pretty well all asset prices, so there is
a much greater degree of broad-based vulnerability. Then it is a
question of degree, and how carried away the sloppy lending was: It was
very carried away. Not just in the design of needlessly complicated
instruments, but in the enthusiasm -- recklessness one might say -- with
which they were sold.
Can
these bubbles burst if the Fed is easing the way they are?
Well, this is an amazing little tidbit. People think
the Federal Reserve can stop a bear market because they can throw money
at it and lower interest rates. It is even more certain we can
collectively stop a bear market if some fiscal stimulus is thrown in. To
which I say, 'Oh, you mean like 2000 and 2002?' -- when they threw what
I call the greatest stimulus in American history, an unparalleled series
of interest-rate cuts, cumulating in two, almost three, years of
negative real returns, real interest rates coupled with a really
substantial tax cut, which would never have happened without 9/11.
The combination would have gotten the dead to walk,
and it stopped the bear market eventually. But the Standard & Poor's
500 was down 50% and the Nasdaq -- which was all anyone talked about
back then -- went down 78%. And a puny five to six years later, people
are saying there is not going to be a bear market because the Fed is
going to lower rates and because the government is going to have a
stimulus package. But we have just been there, done that, and we had a
nice bear market.
What about places to hide?
That isn't something we can laugh off. Last time,
there were plenty of opportunities: Bonds were cheap and TIPS
(Treasury-inflation protective securities) were brilliant; real estate
was cheap and REITs were brilliant. Even within equities, emerging
markets were much cheaper than U.S. equities, and within U.S. equities,
value stocks were only a little expensive and small-caps were only a
little expensive and small-cap value was actually a little bit cheap. So
you could really hide and could reasonably expect to make money, which
we did in each of the three years of the bear market.
Since then, all those areas appear to have read the
book on mean-reversion. Ten years would be a perfectly normal period of
time to go from a peak of a great bubble [like the one in 2000], based
on the history of bubbles and their aftermath, to the low. I have long
thought that 2010 would be when we hit the biggest discount to fair
value. Trend-line value on the S&P, by the way, in 2010 is 1100.
(The S&P 500 traded at 1334 late last week.)
What should we expect from the market between now
and 2010?
In the fourth year of a presidential cycle, where you
have a lame-duck president, the typical pattern of S&P 500
performance has been something like 10% below the normal long-term
average (a 5.2% gain, inflation-adjusted), and worse if it is an
overpriced market. A first year is never very pleasant: They average
about 3% below normal. If they are overpriced, they do four points worse
than that.
But if the party in power changes, first years tend
to be eight points below normal. The following year is ugly, too. The
average year two, since 1932, has been 10 points below normal and, if
the market is overpriced, 15 points below normal. This is unpleasant. By
a nice coincidence, those averages suggest the market will decline to
1100 in 2010, which is exactly the number we get to from a completely
different technique -- building it from the grass roots through
fundamental value. We do that by taking average corporate-profit
margins, actually a generous average, assigning a normal market
price/earnings ratio, and that gives you 1100 in 2010. This year, next
year and the year after will all be uncomfortable years. One of them
might be up, but my guess is it won't be up by much.
What exactly will make them more
uncomfortable?
Profit margins, the great prop to the market,
surprisingly defied the laws of gravity for three years in the developed
world and, particularly, in the emerging world and even in Japan. That
was because the global economy was stronger than any corporation counted
on and, in the U.S., consumption was always higher and our savings rate
was always lower than any corporate economist would have suggested,
going into negative territory. But there are a few near certainties in
this business -- not many, but a few -- and one of them is that
abnormally high profit margins will go back to normal. The timing is
unfortunately shrouded in fog. The other near certainty is that house
prices will go back to a normal multiple of family income. In the end,
we, the people, have to be able to afford the houses and they are
affordable at something around 2.8 times family income. When they peak
in Boston at 6 times and nationally at 3.9 times, you know you are in
for tough times.
Incidentally, it was late in '06 when [Fed Chairman
Benjamin] Bernanke said he thought the high prices of homes in the U.S.
merely reflected a strong U.S. economy. Was he not looking at the data?
Did he not measure long-term house prices? Had he not seen how they
ebbed and flowed as a multiple of family income, which they do here and
in the U.K. and everywhere else? And with it being so obviously a
bubble, how could he have said that?
He was taking his cue from Alan Greenspan, who
said we should all be taking out adjustable-rate mortgages.
Greenspan and Bernanke have taken a hands-off
approach for two consecutive great bubbles, first in TMT --
telecommunications, media and technology -- and second, in housing. A
hands-off approach is a polite way of saying they facilitated this. And
what is the point of a 125-basis-point rate reduction, other than to
provide reinforcement for the people who borrow short and lend long?
From bankers who have committed every crime you could possibly accuse a
banker of, to hedge funds who borrow short, leverage, and invest long in
the stock market -- that's who really benefits from the interest-rate
reduction. The economy, broadly defined, does not.
I have an exhibit that shows the 30 years prior to
1982 when the debt-to-gross domestic product ratio was completely flat
at 1.2 times. Total debt is defined as government debt, personal debt,
corporate debt and financial debt. Then in the 25 years after 1982, the
flat line goes up at a 45 degrees angle from 1.2 times to 3.1 times GDP.
Massive. In the first 30 years, when debt is flat, annual GDP growth is
its usual battleship, growing at 3.5% and hardly twitching. After the
massive increase in debt, GDP, far from accelerating, grew at 3%. So
debt in the aggregate does not drive the economy. The economy is driven
by education, man-hours worked, capital investment and technology. It is
not driven by what I owe you and you owe me.
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So the Fed's actions won't stave off a
slowdown?
Since when did the thought of an economic slowdown
induce such hysteria? That was a response to the decline in global
markets. It was aimed at the stock market. It was aimed at banking
disorder and banking profits. It doesn't have that much of a powerful
effect on the economy. If it had any more profound effect, there would
be a positive relationship between debt increasing and GDP growth, and
there is none.
But it is driving down the dollar.
It drives down the dollar, which is inflationary,
and, eventually, it could be seriously inflationary.
I understand you are most concerned with further
fallout in the private-equity arena?
Yes. I have yet to meet a private-equity firm that
put into its spreadsheet the assumption that system-wide profit margins
could decline by 20% to 30%. They have taken the current, abnormally
high profit margins as a given and then determined to improve them by,
let's say, 15% and assume everything works out pretty well.
But if the base declines by 20%, even if they end up
improving margins by 15%, they are going backwards. And if they pay the
25% premium up front, which was normal, and if they leverage 4-to-1,
which was normal, then they almost precisely wipe out all of the
clients' money, all of the 20% in equity and if, perish the thought,
they don't add 15%, but add perhaps zero to 5%, then they do more than
wipe out the equity, they leave the underlying debt in ragged disarray.
That is the next shoe to drop on the credit side.
Where else does this housing crisis lead
us?
It has a lot to go. It still has to drop 20% to 25%
to reach more normal levels, or if you prefer, it could wait five years
for income to catch up, barring no big recessions. With the housing
market gone, people turned to credit cards and with economic times
slowing down -- whether there's a recession or not -- consumers are
going to slow down a lot, are slowing down or have slowed down a
lot.
What about the dollar?
Currency is a real problem, I've got to admit. There
was a time not that many years ago when we had a huge high-confidence
bet against the dollar. It was technically overpriced, and we were
running a huge trade deficit. Now, it is technically substantially
cheap. But we are running an even bigger deficit. It is a conundrum. I
don't think it should be a major, major bet. We are reasonably happy
owning emerging currencies as a packet against the dollar for a
several-year time horizon. I'm not particularly happy owning a packet of
other developed currencies against the dollar.
Personally, I'm long the yen, the Singapore dollar
and the Swiss franc. I'm certainly not long the pound: shorting the
pound is a better bet than shorting the dollar.
What other bets would you take here?
My favorite bet on Jan. 1 and today, for that matter,
is going long very-high-quality U.S. blue chips with 50% of my dough,
and long emerging markets for 50%, and shorting the Russell 2000 for
100%, or a complete hedge. In that bet, I'm long value because both of
those components are cheaper than the Russell 2000. I'm long liquidity
on average. I'm long momentum on average.
What about growth stocks? Isn't there value
there?
Growth stocks are expensive, but not quite as
expensive as value stocks or low-growth stocks. Quality stocks are
expensive but substantially less so than anything else. Emerging is
expensive, but less so than anything less, and the fundamentals are so
much superior to the rest of the world. Everything is expensive. All we
are trying to do is extract some relative money, or by going short,
actually make some real money.
But how do you define quality these
days?
We always defined high-quality companies as those
with high and stable returns and low debt. Recently, we had to override,
and exclude several banks from that list. Whether you like it or not,
you have got to treat banks separately.
What about the deal market, will that provide any
lift to stocks? Microsoft's bid for Yahoo! hasn't done much for the
market.
You might say that is a company in serious trouble
being acquired by a company that is worried, maybe desperate. And that
doesn't sound like a very strong deal to anybody.
Fascinating as always, Jeremy. Thank
you.