Jeremy Grantham’s January Letter

Never one to pull a punch, Grantham’s latest quarterly letter is out and titled Obama and the Teflon Men, and Other Short Stories (Part 1).  (I’m not sure about who can register to get access to this.) This is going to be a long post, but one very much worth reading if you like to think about the big picture and investment trends.  If you want the quick bottom line: 2009 and even 2010 could easily see new lows in the stock markets but we will avert a new Great Depression.  The 7-year outlook for stocks looks good with traditional average annual returns over that time frame.

A quick review for new readers: Grantham is one of the titans of investing.  Not as well known as others who cherish exposure, but known to almost everyone inside the industry.  Jeremy is the inventor of the “quant” model of stock analysis – the dominant model today.  In the 1960s he was the first investor to use computers as a tool in analysis.  He was also one of the first to implement index investing.  He is one of the founders of GMO, a money manager for institutions, and a predecessor to hedge funds.

While his timing has not always been perfect, his themes have been prescient.  He clearly described the housing bubble in 2005 – a time when Alan Greenspan was vigorously denying it.  He also accurately forecast the current economic crisis stating in 2007 that within 5 years at least one major bank will have failed and half the hedge fund industry will have disappeared.

So, what does he say now?  Follow the link above to get the full analysis, but here are some highlights along with commentary.

The current disaster would have been easy to avoid by making a move against asset bubbles early in their lifecycle. It will, in contrast, be devilishly hard to get out of. But, we are deep in the pickle jar, and it seems likely that, in terms of economic pain, 2009 will be the worst year in the lives of the majority of Americans, Brits, and others.

Grantham has been railing against Fed policies for years.  He blames them for creating the asset bubbles we have experienced this decade.  Alan Greenspan and more recently Ben Bernanke are villains in his mind.  The result is that 2009 is going to be even worse than 2008 in terms of the real economy (not necessarily worse in terms of stock market returns).

Why did this happen?  Because “Greed + Incompetence + A Belief in Market Efficiency = Disaster”.  I think we’re all familiar by now with the greed on the part of so many at the top of the financial sector.  We’re also familiar with the incompetence shown by the regulators.  Which brings us back to one of my favorite topics: classical economics vs. behavioral economics.

A simple question that I keep asking myself is, if markets are truly efficient, then how do bubbles form?  Grantham’s answer is that markets are not efficient.

The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and governmental establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives, and wickedly complicated instruments led to our current plight. “Surely none of this could happen in a rational, efficient world,” they seemed to be thinking. And the absolutely worst aspect of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking – the very severe loss of perceived wealth and the stranded debt that comes with a savage write-down of assets. Well, it’s nice to get that off my chest once again!

Why is this important to us as investors?  Simply because the entire economic edifice that we have been operating under for decades is based on the idea of efficient markets.  The idea that government regulation is bad and that markets should be left to their own devices to self-regulate is based on a theory that just does not seem to hold up to scrutiny.

Looking ahead, rather than behind, Grantham thinks that the stimulus package will help our “animal spirits”, i.e., the emotions that are core to human behavior and hence behavioral investing.  But, the scope of the problem is now so large that recovery is going to take some time.  After discussing various paths to recovery might he states:

Each of the three realistic possibilities listed above would be extremely painful, each is loaded with uncertainties, and even the quickest of them would take several years. Our path this time is likely to involve a hybrid approach: we will certainly take some painful debt liquidations; this crisis will almost certainly take far longer than normal to play out; and probably, before a new equilibrium is reached, we will see inflation rates that are well above normal.

Grantham goes on to draw parallels between our current situation and Japan starting in the 1990s.  To summarize, while the parallels are not perfect, we are likely facing a similarly protracted episode.  The good news is that Japan avoided a depression and we are likely to as well.

To finish this section on an optimistic note (my civic duty), it is worth remembering that real wealth lies not in debt but in educated people, laws, and work ethic, as well as in the quality and quantity of fixed assets and the effectiveness of corporate organization. We, like Japan, are not proposing to destroy any of these assets. We, like Japan, have just tripped on make-believe assets and we now have to deal with chronic deleveraging and bruised animal spirits. When we have dealt with this crisis, all of our assets will still be sitting around waiting to be fully used once again. It is helpful to consider that after the Depression, the U.S. GDP got back on its original trendline as if the Depression had never occurred. Also remember that although your portfolio is down 40%, just as you own the same house, you still control the same number of shares and hence the same fraction of long-term wealth that you had before.

And while he believes that market returns will be normal on average over the next 7 years, they may not be over the next 2 years:

But be prepared for a decline to new lows this year or next, for that would be the most likely historical pattern, as markets love to overcorrect on the downside after major bubbles. 600 or below on the S&P 500 would be a more typical low than the 750 we reached for one day.


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