Tuesday, March 25, 2014

Why Jeremy Grantham Refuses To Buy Overvalued U.S. Stocks

It is that time during the cyclical stock market recovery where 99.99% of the world is rushing head first into the market. While money managers could not find a single investor in 2009, they are having their doors beaten down today with new capital to invest. These managers make commissions by placing those funds into the stock market casino. If a manager refuses to invest the capital and recommends holding some cash, they will either under perform the market in the short term and lose the clients or lose their job entirely. While it is almost impossible today to find a remaining rational money manager, the commentary below comes from one of the all time greatest. 

The following two interviews are with Jeremy Grantham, the manager of GMO which currently holds $112 billion under management (one of the largest asset management funds in the world).

In the first interview with Forbes which took place in 2009, Graham discusses why he took his client's money out of the markets in 1998. He said that doing the right thing, pulling some money out of a massively overvalued market, caused him to lose 60% of his asset base. Investors could not psychologically handle watching from the sidelines with any portion of their capital and "miss out" on the spectacular returns received by everyone around them. 
Steve Forbes: Well thank you, Jeremy, for joining us today. First, since you have bragging rights in this situation, what made you a bear, [a] great skeptic? Between 1999 until about a couple of months ago, you were saying, “Stay out.”
Jeremy Grantham: Well, really very simple. Not rocket science. We take a long-term view, which makes life, in our opinion, much easier.
Steve Forbes: Well everyone says it, but you certainly practiced it.
Jeremy Grantham: We actually do it. Well, we tried the short-term stuff and it was so hard; we thought we’d better do the long-term. We just assume that at the end, in those days, of 10 years, profit margins will be normal and price-earnings ratios will be normal. And that will create a normal, fair price. And more recently, we’ve moved to seven years, because we’ve found in our research that financial series tend to mean revert a little bit faster than 10 years–actually about six-and-a-half years. So we rounded to seven.
And that’s how we do it. And it just happened from October ’98 to October of ’08, the 10-year forecast was right. Because for one second in its flight path, the U.S. market and other markets flashed through normal price. Normal price is about 950 on the S&P; it’s a little bit below that today.
And on my birthday, October the 6th, the U.S. market, 10 years and four trading days later, hit exactly our 10-year forecast of October ’98, which is worth talking about if only to enjoy spectacular luck. The P/E was a little bit lower than average and the profit margins were a little bit higher, so they beautifully offset. And given our methodology, that would mean that on October the 6th, the market should have been fairly priced on our current approach. And indeed it was–that was even more remarkable–950, plus or minus a couple of percent.
Steve Forbes: And what did you see during that 10-year period that made you feel–other than your own models–that this was something highly abnormal, that this couldn’t last?
Jeremy Grantham: Well, first of all, the magnitude of the overrun in 2000 was legendary. As historians, you know we’ve massaged the past until it begs for mercy. And we saw that it was 21 times earnings in 1929, 21 times earnings in 1965 and 35 times current earnings in 2000. And 35 is bigger than 21 by enough that you’d expect everyone would see it. Indeed, it looks like a Himalayan peak coming out of the plain.
And it begs the question, “Why didn’t everybody see it?” And I think the answer to that is, “Everybody did see it.” But agency risk or career risk is so profound, that even if you think the market is gloriously overpriced, you still have to get up and dance. Because if you sit down too quickly–
Steve Forbes: Famous words of Mr. Prince.
Jeremy Grantham: If you sit down too quickly, you’re likely to get yourself fired for being too conservative. And that’s precisely what we did in ’98 and ’99. We didn’t dance long enough and got out of the growth stocks completely, and underperformed. We produced pretty good numbers, but they’re way behind the benchmark. And we were fired in droves.
I think our asset allocation, which is the division I’m now involved in, we lost 60% of our asset base in two-and-a-half years for making the right bets for the right reasons and winning them. But we still lost more money than any other person in that field that we came across, which is a fitting reminder that career risk runs the business.
The second interview with Fortune took place this week. I highly suggest reading the entire interview, but I will include just a portion of it below. 

Grantham tells Fortune that just like 1998, his models show a negative 7 year return on the S&P 500 based on the current valuation. You'll note that Grantham believes the markets could rise another 25% from here, but he refuses to put client's money into a bubble that will at some point take it all away. 

Fortune: You believe the Fed's policies, particularly quantitative easing, have slowed the recovery. What's your proof?
Grantham: It's quite likely that the recovery has been slowed down because of the Fed's actions. Of course, we're dealing with anecdotal evidence here because there is no control. But go back to the 1980s and the U.S. had an aggregate debt level of about 1.3 times GDP. Then we had a massive spike over the next two decades to about 3.3 times debt. And GDP over that time period has been slowed. There isn't any room in that data for the belief that more debt creates growth.
In the economic crisis after World War I, there was no attempt at intervention or bailouts, and the economy came roaring back. In the S&L crisis, we liquidated the bad banks and their bad real estate bets. Property prices fell, capitalist juices started to flow, and the economy came roaring back. This time around, we did not liquidate the guys who made the bad bets.
Fortune: But the Fed does seem to have boosted stocks. Even if it did nothing else, doesn't a better market help the economy?
Grantham: Yes, I agree that the Fed can manipulate stock prices. That's perhaps the only thing they can do. But why would you want to get an advantage from the wealth effect when you know you are going to have to give it all back when the Fed reverses course. At the same time, the Fed encourages steady increasing leverage and more asset bubbles. It's clear to most investing professionals that they can benefit from an asymmetric bet here. The Fed gives them very cheap leverage on the upside, and then bails them out on the downside. And you should have more confidence of that now. The only ones who have really benefited from QE are hedge fund managers.
Fortune: Okay, but then I guess that means you think stocks are going higher? I thought I had read your prediction that the market would disappoint investors.
Grantham: We do think the market is going to go higher because the Fed hasn't ended its game, and it won't stop playing until we are in old-fashioned bubble territory and it bursts, which usually happens at two standard deviations from the market's mean. That would take us to 2,350 on the S&P 500, or roughly 25% from where we are now.
Fortune: So are you putting your client's money into the market?
Grantham: No. You asked me where the market is headed from here. But to invest our clients' money on the basis of speculation being driven by the Fed's misguided policies doesn't seem like the best thing to do with our clients' money.
We invest our clients' money based on our seven-year prediction. And over the next seven years, we think the market will have negative returns. The next bust will be unlike any other, because the Fed and other centrals banks around the world have taken on all this leverage that was out there and put it on their balance sheets. We have never had this before. Assets are overpriced generally. They will be cheap again. That's how we will pay for this. It's going to be very painful for investors
For more on what the remaining smart money is doing in the market see:

Insiders Dump U.S. Stocks At Record Levels

h/t MISH

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