Lots of useful articles in Barrons this week, e.g.
After the Deluge
An elegant thinker deconstructs the stock market's latest
bubble and its likely aftermath
An Interview With Jeremy Grantham ~
Walking through the offices of Grantham, Mayo,
Van Otterloo, a Boston-based money manager
to which institutions and individuals have
entrusted $22 billion, a visitor is told by one of
Jeremy Grantham's colleagues that the firm's
founder and chief investment strategist can seem
"Delphic" at times. On meeting Grantham, at 62
renowned and revered as one of the
philosopher-kings of the investment world, one is
struck more by his eloquence, and by his
down-to-earth nature. Grantham has spent more
than 30 years in the investment business,
managing money at Keystone Custodian Funds
and co-founding Batterymarch Financial Management along with Dean
LeBaron, before launching GMO in 1977 with Dick Mayo and Eyk Van
Otterloo. He is best known for his assiduous study of the relative values
represented by different asset classes and markets worldwide. Despite a
youthfulness derived from decades of playing soccer, Grantham was forced to
undergo hip replacement surgery last week as a result of those very same
sporting endeavors. Still, he graciously found the time to meet with us ahead
of his hospital ordeal, to explain what he thinks lies ahead for the U.S. stock
market, and to direct us to the sectors he believes will deliver the best value.
We share his thoughts with you.
-- Sandra Ward
Barron's: You've called this the "greatest value rally in history". How
long do you expect it to go on? Is this just the beginning?
Grantham: We are nowhere near the start. We took three years digging the
biggest hole by far in 21 years, and one year leaping out of it. At the end of
June, 95% of everything we look at registered a new high in terms of relative
performance against its benchmark. A year ago, that seemed almost infinitely
unattainable. It seemed as if the recovery would take three or four years.
Q: Do growth stocks still appear overvalued compared with value stocks?
A: In March 2000, value had never been cheaper relative to growth. That
was the all-time, world-record low -- by a wide margin. The second-place
candidate was the end of the Nifty Fifty period in December 1974. In 1974
the relative performance of value stocks hit a bottom, and from 1974 to 1983
value outperformed growth by more than a hundred percentage points. Value
stocks went from incredibly cheap to actually quite expensive, and small
stocks did the same.
Now, in the space of one year, 80% of the downward move in value stocks
has been retraced, mainly because growth -- and technology -- stocks
collapsed. But value is still 20% cheaper than normal. In the case of small-cap
value, let's say the Russell 2000 versus the S&P 500, probably 65% or 70%
of the gap has closed. And the gap between the S&P and international
small-cap, which is the best equity bet around, closed by about 60%. There is
still quite a lot of room left. The other good thing, from a value manager's
point of view, is that these great cycles, which can last 5-6-7 years, always
overrun when they are recovering from an extreme move. There are no
exceptions.
Q: So value stocks will overshoot the levels at which they might be
considered fairly valued?
A: Value stocks will become more expensive than their normal relationship to
growth. When we tell clients that value is still 20% cheaper than normal it
means value stocks eventually will gain more than 30%. And tech and growth
will overrun on the downside to become cheaper than normal.
Q: Then the worst for those stocks is not behind us?
A: The Internet-telecom-tech bubble was the biggest by far in American
history. Bigger than the railroads, bigger than anything. To put it in
perspective, the S&P peaked at 21 times earnings in 1929. In 1965, in the
other great cycle, the post-war cycle, it again peaked at 21 times earnings.
Both cycles were built on incredibly strong earnings and productivity gains. In
this cycle the index peaked at 33 times earnings, and as we sit here the S&P's
P/E is at 26 times earnings.
So, how can you believe that there is going to be a permanent low at a P/E
higher than the previous highs? There isn't much hope. My colleague Ben
Inker has looked at every bubble for which we have data. His research goes
back years and years and includes stocks, bonds, commodities and
currencies. We found 28 bubbles. We define a bubble as a 40-year event in
which statistics went well beyond the norm, a two-standard- deviation event.
Every one of the 28 went back to trend, no exceptions, no new eras, not a
single one that we can find in history. The broad U.S. market today is still in
bubble territory at 26 times earnings.
Q: What P/E represents the old trend- line for the S&P?
A: The long-term average is 14. I believe the P/E will come back to 17½
sometime in the next 10 years. A level of 17½ recognizes the world is a
better, safer place and therefore we can pay more for it. We think the P/E will
trend down gracefully. If it happens more quickly, it will be a lot more painful.
If it happens in 10 years, there will only be a modest negative return.
Q: Is the Nasdaq overvalued?
A: The Nasdaq is not any more materially overpriced than the S&P. We
think 1250 is fair value for Nasdaq. That said, we have been buying some
tech stocks in our large-cap value portfolios. In March we started buying Intel
and Microsoft. We added Compaq this spring, and we have been buying
Xerox, though that may not be considered a tech stock anymore.
Q: You say we're still in a bubble. Everyone else thinks this is a bear
market.
A: The peak was March 2000 and the market has come down a lot, but it
has a whole lot further to fall. Great bear markets take their time. In 1929, we
started a 17-year bear market, succeeded by a 20-year bull market, followed
in 1965 by a 17-year bear market, then an 18-year bull. Now we are going
to have a one-year bear market? It doesn't sound very symmetrical. It is going
to take years. We think the 10-year return from this point is negative 50 basis
points [a basis point is one one-hundredth of a percentage point] after
inflation. We take inflation out to make everything consistent.
Q: Yet, you see opportunities for investors.
A: We see them in emerging equities, fixed
income, and inflation-protected bonds. We see
a handsome but risky return in emerging-market
debt. I think of REITs [real estate investment
trusts] as the biggest no-brainer of the entire
cycle. When the market peaked in March 2000,
the real-estate industry represented by REITs
yielded 9.1%. Our data suggest that the increase
in payouts from REITs is within a percent of the
increase of the S&P 500. REITs had a growth
rate that was 80 basis points less than the S&P,
but yielded 9% while the S&P yielded 1.2%. In
the last year-and-a-quarter, REITs returned
36% versus negative 21% for the S&P. That's a
57-point swing and you've hardly heard a peep
about it. It was one of the great bets of all time and the asset class is still
cheap. It should be impossible to have that big a move and still be cheap. It is
a testimonial to how ridiculous everything was.
Q: Your outlook is not pretty. Yet, investors appear to be hanging tough.
Do you expect that to continue?
A: When a cycle or bubble breaks it so crushes people's euphoria that they
become absolutely prudent for the balance of their careers. I've been talking
to older people who went through a wipeout and my best guess is about 95%
of the people who have been through a bubble breaking never speculate in
that asset class again.
Q: That was true in the Depression. But now?
A: I got wiped out personally in 1968, which was the last really crazy, silly
stock market before the Internet era. I like to say I got wiped out before
anyone else knew the bear market started. After 1968, I became a great
reader of history books. I was shocked and horrified to discover that I had
just learned a lesson that was freely available all the way back to the South
Sea Bubble.
Q: What is keeping the market propped up at this point? Why is it still
trading at a P/E of 26?
A: Many bubbles that break don't actually bust with a great bang. Some just
come down gracefully. This one had so many reinforcing factors: the Internet,
telecom, tech, growth, small-cap growth, venture capital and the IPO frenzy.
In 1929, there was only 12% stock ownership among households. This time,
it was 50%. Any sensible magazine has a readership that is 90%
stock-owning. That wasn't true in 1929. So you have a different relationship
with data and stories and interest. You had much more fertile ground for a
frenzy to get going than ever before, because of the breadth of the media.
There was never a CNBC before, and amazing around-the-clock market
coverage, whereby you'd go out to lunch at the local greasy spoon and stock
prices would flash all around you as you ate.
Q: We've had six interest-rate cuts and the consumer is still spending.
What do you make of that?
A: The government has suggested the savings rate has not dropped for any
but the very rich. The poor have saved a little bit more in this cycle. The
middle class has saved about the same. But the rich, who really count in
savings, saved a whole lot less. What it boils down to is the very rich do not
feel their lifestyle is threatened yet by this decline. Most of them have pretty
broad portfolios. Most of them have property. They may feel a little poorer,
but they have faith they will get it back. They have faith the bear market is
mostly finished. Since they have faith they are going to get it back, why should
they change their spending habits? They are, after all, rich. They are a lot
richer still than they thought they would be five or 10 years ago. They may not
be as rich as they were a year ago, but they are still very rich, and so they
haven't altered their behavior pattern yet. And that is a real lagging indicator.
Q: What's your near-term forecast?
A: My forecast is the market rallies on an economic recovery. Anytime now,
there will be a fairly decent broad pickup, led by the consumer because of the
tax cuts and because of the many interest-rate cuts. It probably will be a
decent recovery. In this kind of knee-jerk stock market, at the first sign of a
healthy economy the stock market will kick up 10% at minimum, 20% at
best. That's the good news.
Q: And you're expecting this by the end of the year?
A: It could start any time, any day, you know, because even if the first good
quarter is the first quarter of 2002, it should be anticipated any day. If it is the
fourth quarter it should have been anticipated yesterday. The bad news is that
there is almost no way this could flow through to earnings. Earnings
themselves are a lagging indicator. The capital spending cycle is very
important to profits, and it is in full-scale retreat. However low interest rates
go, who is going to build a plant that they don't need? No one. So capital
spending continues down and corporate earnings are still under pressure.
If the market were to rally to the top end of my range -- up 20% on a
knee-jerk, oh-it-is-all-over, whoopee! -- reaction, the best that would
happen to earnings is they'd be flat to slightly off. The market would approach
its old high with a substantially higher P/E, because earnings would still be
down more than 20%. So instead of 33 times earnings, you'd see the S&P
priced in the high 30s or 40 times earnings. The economic recovery will be
quite short, two or three quarters, and weak. And then people will get a whiff
of the fact that GNP is going to settle back down into a 1.5% range again,
because of the capital-spending bust. Finally the negative savings rate will
begin to move up, and that will impact top-line growth. The market is no
longer in its old game. But this will not destroy the economy. I am not a big
bear on the economy at all.
Q: You could have fooled us.
A: Earnings will be weak and sometime in the middle of next year, or even
earlier, we'll get a whiff that things aren't as strong as we thought. With the
market at 40 times earnings, the next leg will be more vicious. That's what I
consider the bull case. But the great thing about that bull case, if it happens, is
that it will be one last great opportunity to lower your risk and move into asset
classes with higher implicit returns, of which there are, happily, plenty.
Q: That's not always the case.
A: Not always the case at all. There are a lot of market bubbles, like Japan's
in 1990, where there is nowhere to hide. But here there are plenty of places
to hide: real estate, REITs, emerging equity, emerging debt,
inflation-protected government bonds, regular bonds, small-cap value around
the world. All perfectly reasonably asset classes. There are also hedge funds,
and my favorite asset class, timber.
Q: Isn't that a somewhat controversial investment?
A: Timber is the only low-risk, high-return asset class in existence. People are
not familiar with it. What they are not familiar with they avoid. But timber is
the only commodity that has had a steadily rising price for 200 years, 100
years, 50 years, 10 years. And a unit of wood, just the price of a piece of
wood -- in real terms -- beat the S&P over most of the 20th Century, from
1910 to 2000. The price of a piece of wood actually outgrew the price of a
share of the S&P, which is an unfair context, because there is some growth
embedded in the share of the S&P and there is no growth embedded in a
single cubic foot of wood. The yield from timber averaged about 6.5%. The
yield from the S&P averaged 4.5% The current yield on the S&P is 1.25%
and the current yield on timber is 6.5%. In each of the three great past bear
markets that I've referred to -- 1929-'45 and 1965-'82, and a third one that's
off everyone's radar screen, which is post-World War I, 1917-'25 -- the
price of timber went up. It is the only reliably negatively correlated asset class
when you really need it to be. One reason for that is you can withhold the
forest. If you find the price of lumber is no good, you don't cut. Not only is
there no cost of storage, the tree continues to grow and it gets more valuable.
That is a very, very nice virtue.
Q: If you had your way we'd all be jumping into emerging-market stocks.
Yet people have been burned badly in that asset class.
A: The reason it is so attractive is that people have lost a lot of money and the
stocks have crashed. Back up 10 years and emerging equity was not
particularly cheap at all. Emerging equity sold at a higher P/E than the S&P
eight years ago. Now our portfolio trades at 6½ times earnings. We've not
seen anything like that since 1974. And the S&P is at 26 times earnings.
Q: People who were bullish at the start of the year are now concerned the
U.S. is going the way of Japan. Is that your view?
A: No. I think the U.S. economy is incredibly durable and tough. The
problem is not with the economy. It will probably be a little weak in the first
half of next year and then with any luck get back to normal in the second half.
The problem for us is that we are coming off a remarkable bubble with
ridiculous prices based on a New Era that is not here. Not even a New Era
would have sustained these prices. That is the joke.
Q: But what about all the talk of productivity gains?
A: People say productivity justified higher P/Es through higher profits. But I'll
give you a simple thought experiment because thought experiments are
incredibly useful. Say you come out with a seed corn that is twice as
productive -- that is, for every dollar of seed it will grow twice as much corn
in an acre. Give it to everybody at the same price as the old seed.
Productivity will double. But what will happen to the price of corn and what
will happen to the profits of the farmers in the following year? I think it is fairly
obvious to everybody that they will be drowning in red ink and there will be
corn coming out of every silo. Productivity does not necessarily equate with
profit.
However, let us give it only to a farmer in Illinois. What will happen to his
profits? They will go through the roof. He will grow twice as much corn per
cost as everyone else and he will get rich and famous. Productivity gains are
fine if there is a monopoly. If productivity is shared by everybody it flows right
through to the consumer. We get fat and happy because the price of
semiconductors comes crashing down, the power of the machines goes up,
everybody has it, it flows through. It is not a competitive advantage and
profits are completely unaffected by it. The whole productivity argument was
interesting but it has no relevance to how much money the system makes and
how high a P/E you should pay for it.
Q: But doesn't it have relevance in terms of inflation?
A: Productivity will keep inflation lower and inflation is what I call behavioral
influence on the market. Does inflation really alter the real cost of buying your
machines and your buildings and your tables? Of course not. Inflation is
obsessed about, but in terms of a 10-year horizon it is a complete red herring.
Productivity is nice to have because it has a very slight effect on an
accelerating growth rate and other things being equal everybody functions
better with a higher growth rate. But it is not a panacea. It doesn't guarantee
higher profits any time in the near future, often quite the reverse. If
productivity rises too steeply you can find that profits are falling because there
is too much capacity. Productivity can ruin you, which is what is happening.
Q: What sectors are you most excited about right now?
A: REITs are still the best group in equities that you can buy, closely followed
by international small-cap value. Not only does international small-cap value
have a 6.8% real embedded return in our opinion, but the stocks have a very
nice currency kicker on a 10-year horizon. We don't put that currency figure
in our numbers, but the data suggest that the currency in the U.S. is
vulnerable. I would expect a 1%-3% per year compounded bonus from
currency for international small-cap. And U.S. small-cap value looks pretty
good. All three of those categories have had big runs and all of them have
moved substantially back toward trend. But none of them are at trend.
Small-cap value, for example, has another 30-40 percentage points to run
against the market before it goes back to trend. These are big numbers. What
was typical in the 'Seventies, by the way, was the continued year-after-year
dominance of small-cap value.
Q: Is this a short-term forecast?
A: This is a 10-year forecast. People ask what is going to happen next year,
and I say I haven't the faintest idea. In general, the short term is unknowable
and in an uncertain world, it should be unknowable. The intellectuals say to
me if you can't predict the short term, how can you be certain about it
reverting to trend in the long run, when the long run is just made up of a series
of short runs? It's an elegant question and it took me a long time to find a
thought experiment to answer it.
Q: But you did.
A: Here's the thought experiment: Think of yourself standing on the corner of
a high building in a hurricane with a bag of feathers. Throw the feathers in the
air. You don't know much about those feathers. You don't know how high
they will go. You don't know how far they will go. Above all, you don't know
how long they will stay up. You know canaries in Jamaica end up in Maine
once in a blue moon. They just get swept along for a week in a hurricane. Yet
you know one thing with absolute certainty: Eventually on some unknown
flight path, at an unknown time, at an unknown location, the feathers will hit
the ground, absolutely, guaranteed. There are situations where you absolutely
know the outcome of a long-term interval though you absolutely cannot know
the short-term time periods in between. That is almost perfectly analogous to
the stock market.
Q: What is your outlook for Japan?
A: It is a big chunk of the market still, so it is hard to see it as irrelevant. But it
is impossible to predict. Prior to our anti-blue chips and value stand, which
we made three years ago and lost a lot of money on in relative terms --
although we've got it all back with interest -- by far our bravest and biggest
bet was anti-Japan. Three years before the peak we went to zero in Japan. It
had never sold over 25 times earnings and when it got to 45 we said this is
ridiculous. I know we play in a benchmarking world but at 45 times earnings
shouldn't you get out? So we got out and it rose and it rose and it rose to 68
times earnings and 65% of the entire benchmark and we had nothing. It
collapsed and we got it all back and then some. In the last five years we
moved our weighting back to neutral.
On the one hand, Japan has certain aspects of scrap-metal value, but its
fundamental problems are so uniquely bad and so obviously unresolved that it
is capable of making a huge rally if it gets lucky, stumbles on the right strategy.
But basically the stock market has no material value at all. If you mark down
their asset base by 25%, you'll find they are so leveraged there is no asset
base. Under the worst scenario, the entire corporate sector may have no
value. These kinds of thoughts are way off the radar screen. If they get it right
they can have a huge rally and be the strongest market in the world. If they get
it wrong they can basically evaporate. We choose to make no bet on that.
We have no insight. We have one insight and that is the range of outcomes is
so vastly uncertain as to be overwhelming. There are other bets we can risk
our firm's reputation on.
Q: What's the swing factor for Japan?
A: I am not a professional economist, but I'm a fan of Andrew Smithers in
London. He has lived in Japan for years, he has followed it for years. Ten
years ago he said it would be an absolutely bloodcurdling disaster and it
would go on for years and years and years. It was the best call I have ever
seen anyone make in my career. All the way down he said they haven't solved
a thing. His view and a few other people's view is that they need to
dramatically devalue the currency and dramatically increase their exports.
Q: Is your international weighting greater than that of the U.S.?
A: International is finally getting to be interestingly less expensive than the
U.S. And the currency is looking promising. Currency appears to be
mean-reverting like everything else. The trouble is, it can take so long to
revert you die of old age. The numbers suggest that the foreign markets are
substantially overpriced but much less so than the U.S. now. International
large-cap value can probably give a real return of 4%, and U.S. large-cap
value only 1.5%. International includes Europe and Asia but not emerging
countries. Emerging countries are quite different. They have had their
bloodbath. The index of the whole emerging equity market trades at a multiple
of 8.5 times earnings. It should probably be 15 or |
