An Interview With Jeremy Grantham [Barrons]
Duck and cover. That about sums up this investing great's view of how best to cope with what he thinks is likely to be a difficult year in the financial markets. A founder of Boston-based Grantham, Mayo, Van Otterloo, and steward of $80 billion for institutions and the wealthy, Grantham sizes up asset classes and seizes the best opportunities across the broad spectrum of available investments. Now, for the first time in his career, he's faced with what he calls the "asset-allocator's nightmare": asset classes of all stripes are either overpriced or fairly priced. So, what's an investor supposed to do? Grantham offered his advice in an interview conducted in late December. For some of the best advice in the business, please read on.
Barron's: You had a fairly accurate assessment of how the market's direction in 2004 would end up.
Grantham: In my fourth-quarter letter of 2003, we actually had a fairly detailed analysis of our 2004 forecast and how we got there. I concluded the S&P would be up 10.5%, plus or minus 5.5%, and as we sit here today it is up 10.25%.
Q: With some days to go!
A: Five or six trading days and a quarter of a point to go. That was based on the four-year presidential-election cycle and the value of the market. In Year Four, very, very seldom are there big declines. Going into next year, Year One, it's quite different. If you are in the overpriced half of the cycle, since 1932 two-thirds of those years have been down in real terms. We are now deep, deep in the overpriced half.
Q: The overpriced half?
A: The first two years of the cycle, when the administration cools it on stimulus and tax cuts and does some house cleaning, combined with an overpriced market, have not been a very profitable time to be in the market. The average expectation is minus 6% for the year. It is not catastrophic, but it is way, way below consensus expectations. The bad news is that the second year is about the same.
Q: Outside of the presidential-cycle pattern, are there other forces exerting pressure on the market?
A: How January goes matters quite a lot, with a bad January a good predictor of a probable poor year. The spin around the presidential cycle is pretty strong. Year Three tends to be very strong and tends to be very speculative, and the things to buy are high-volatility stocks. Year Four is a wash pretty much on everything. In the typical Year One and Two of a presidential cycle you want to avoid speculating and look at low-volatility and high-quality companies. What about relative valuation? Well, high quality is now really quite cheap, and low volatility, which is surprisingly different from high quality, is moderately inexpensive.
Q: How do low-volatility stocks differ from high-quality stocks?
A: The real surprise to us is there isn't a positive correlation. Everyone in our business, including us, has tended to think they are almost synonymous, and they simply aren't. The highest-quality 30%, what you might call "great" companies, and the low-volatility 30% have an insignificant negative correlation. Low-volatility stocks tend to be banks and utilities and food retailers. And the great companies tend to be soft-drink, food and drug makers, for example, and so they really are quite different.
Q: What other aspects affect this cycle?
A: There is more credit risk. There is more quality risk. There are more things that can go bump in the night. China could stumble. I don't think it will, but it could. Commodities could get out of control. That's not as high as 50-50, but it is quite likely. As for the credit risk, there could be a credit crisis because there is too much debt outstanding in a lot of countries. The U.S. and the U.K. and Australia are among the worst. Add them all up and there is more risk than normal, and a lot of the risks are, directly or indirectly, financial. The quality factor should be more important than normal. Low volatility should be more important than normal, with one exception: Because of the unprecedented length of the credit cycle since 1982, at which time we had 16% long Treasury bonds, we've all learned to give more credit and take more credit, and my guess is the banks are very vulnerable from a qualitative-risk point of view and are more risky than they look.
Q: Yet the common refrain is that the banks have never been healthier.
A: Well, what's been so difficult for them? Money is available. Rates are low. Real rates are negative. If you don't borrow, you don't understand. It is a wonderful borrowing environment that should be pretty nice for the banks and, of course, it has been. Their profit margins are way up and are way over normal. On a longer-term basis, the probability that profit margins at financial institutions deteriorate is huge. Whether they are going to deteriorate in the next six months or whether it is going to take a year or two is unknown, but they are going to come down. Why wouldn't they? We've had a huge 20-year credit cycle, and now, presumably, we are in the early stages of the downswing with interest rates rising.
Anyway, to get back to the point that the risks are greater this time, it is a very fortunate coincidence because quality stocks are relatively cheap after having done quite badly for two years, and so they should be taken more seriously than normal. That's a layup. Take less risk and underweight low quality. Do that in both the stock and the bond market. The risk premiums in junk bonds and emerging debt are very, very narrow.
Q: It's getting harder and harder to know what a quality stock is these days. Consider the drug stocks.
A: It is a little unfortunate, but these things come and go. But the nature of the great franchises is they are more durable than a couple of years of misfortune.
Q: But how do you define high quality?
A: Companies with high, stable returns and low debt. Low debt in this cycle is more important than it normally is. Typically, low debt is a distant third criterion, but in this cycle you want to be more careful about debt levels than normal. So the general advice is pretty straightforward: Underweight equities globally because they are expensive. Only emerging-market equities are close to fair value, and because of a brilliant November, they are up 9%, and emerging now could be considered a little overpriced. The asset class entered November at fair price and came out quite a bit overpriced. That was the last thing we were holding onto with any enthusiasm. It's still, relatively speaking, far and away the most attractive piece. If you want to take any risk now, that is the place to take it.
Q: What about timberlands and forestry?
A: It is much cheaper than anything else because there is nothing in the world that is fairly priced. But forestry, one of the lowest-risk asset classes, was almost ridiculously underpriced for a time. It is a wonderful diversifier. It is the only commodity that has had a rising real price over the last 100 years, and certainly in the last 20 years. Its yield was simply too high. One of the reasons for that is that people want to be bribed to tie up money for 10 years. There's a ludicrous premium to put on liquidity. And there's a premium for taking a nontraditional, career-risking position. Yet forestry has lost a bit of that premium because it is less nontraditional than it was. But it is still a mispriced asset class, it is still too cheap, and there are quite a few good decades ahead of it.
Q: But is there enough forest?
A: That's a problem. If it becomes a fad, and there is some hint of that, demand can get ahead of supply in the short term, and as prices rise, that will shake supply loose. It is a small asset class. If you make it faddish enough, you could drive the price up quite a long way.
Q: What about inflation at this point? You've always thought that's a bit of a bugaboo, right?
A: I always have, and even now I treat it as a probabilistic element. I don't know if inflation is going to get out of control, but I know that it could. It is one of the three or four risks floating around the system. It is yet another reason why you want to tread carefully the next couple of years. I would recommend commodities, but I wouldn't own necessarily more than 10% of commodities in a portfolio. I recommend them not because I am sure they are going up. I would own commodities primarily because they are different. They are different in one critical sense. Pretty well everything in your portfolio is vulnerable to inflation. If inflation unexpectedly picks up, stocks and bonds both get killed. But it tends to work in the opposite direction for commodities.
Q: Any particular commodities?
A: I would have a broadly diversified package. It will be negatively correlated with your portfolio when you really need it. If the rest is working and commodities go down, that is not the end of the world.
Q: Were you surprised at how well the bond market held up in 2004?
A: We came into the year neutral weighted. We thought the bond market was boring on Jan. 1 and a little bit expensive. We finished the year knowing the asset class is substantially expensive. But it is the overpricing of the bond market that is the asset-allocator's nightmare. If you believe, as I do, stocks everywhere are overpriced -- most of them badly and some, like emerging- market stocks, just a bit -- you need somewhere to park your money. Yet the long bond looks fairly substantially overpriced, and that creates a difficult problem and one we've never had before.
Q: Never?
A: This is substantially the worst breadth of overpricing in my career, and long before my career. Why wouldn't it be that way when you look at the credit cycle that has gone on? We have been overstimulating the system and overencouraging leverage for years. It has paid you to reach, and now it pays you not to reach. The most poisonous thing you can do is to reach for higher return by taking higher risk because you are desperate. This is not a good time to be reaching for an extra 3½ points, down from 16 extra points, in emerging debt, for example. To put it in perspective, it is 3½ points over U.S. Treasuries, which themselves are overpriced.
Q: What do you think of real-estate investment trusts at this point?
A: God bless them. I was counting on them to do well in the three-year bear market. I was really expecting that they would actually go up, which they did every year. What I was not expecting was when the market went up 28% in 2003, REITs went up 32%. Just sensational. This past year the market goes up about 10% and REITs go up about 25%. Amazing. Yet they now yield less than 5% after yielding 9% at the market's peak.
Q: How is GMO positioning its portfolios?
A: We run a global balanced fund for Evergreen and have about 37% in fixed income. We've pushed U.S. equities down to about 25%, and of that we are going to end up with almost half in a high-quality fund we developed ourselves. The balance will be tilted to value and quality in our core fund. We've sold all our small-caps from a 9% position, and we are down to our last 1% in REITs from 9%. We have about the maximum overweight we are allowed in emerging and international. In international we've sold down our small-caps and moved it toward blue chips. In all of the funds, including emerging markets, we've tried to take the quality of the equities up. In bonds we've moved below intermediate term and we've diversified from the U.S. long bond into a little bit of TIPS , which are overpriced but are different, and some foreign bonds. When I get on the telephone with stockbrokers who specialize in good, dirty questions, they say, this portfolio doesn't seem as bearish as you sound. And I say, touché.
They are right, probably, but we've learned the hard way that if you take too extreme a position, even though it will be the best in the long term, you won't have enough business left to celebrate the long term. So we try and stay in touch with what a reasonable person would consider a reasonable portfolio. Would it lose money in the next 21 months, which is the period I worry about most before the presidential cycle moves in our favor again? Yes, it probably will. If you want to make money in the next six months, stay with a 10% short S&P position and by June 1 make it a 30% short position as a percentage of the total portfolio.
Q: The past few years have been very rough on short sellers. Are you suggesting a new golden period for them?
A: It will probably be a pretty darn good period, and conservative hedge funds are the answer to a maiden's prayer. Even if they turn out to deliver a lower return than you expect going in because of the sheer volume of the competition -- say you expect 10% but get 5% -- that may turn out to be brilliant in the next couple of years. I personally have 50% of my money in such funds, which includes a net short fund but mostly conservative market-neutral funds. Of the balance, I'm very long emerging and international. I've shorted a few S&P 500 contracts against them, just to take some of the sting out of the next few years. Our highest-confidence strategy would be going long emerging markets and short S&P 500 contracts.
Our seven-year forecast for asset classes expects a real return of around 6% from emerging markets. We expect to add three or four points to that from active management for a total return of 9%. We expect the S&P 500, on the other hand, to deliver minus-2%. That's an 11-point spread. And emerging markets have never looked higher-quality than now. Their reserves are fabulous. Their currencies, consequently, all look pretty good. Their growth rates are fabulous. The back page of the Economist lists the 24 emerging countries. If you were to take the gross-domestic-product growth rate of the European Union for the last year and add it to that page, it would rank dead last on a list that includes Egypt, Israel, Turkey and Slovakia. They are all beneficiaries of China, have a terrific fundamental strength at the moment and a good qualitative position. Still in all, they may go bump in the night. But on a three-year basis, I think they are going to hammer the S&P again.
Q: What happens to the dollar?
A: The dollar is the thing that keeps me awake at night. I've never seen a bigger consensus than anti-dollar, and I've never been part of such a broad consensus in my investment career. We take the absolute consensus view that it is hard to imagine that, at some point out in the future in the next several years, the dollar will not be materially cheaper than it is today. Having said that, there is a potential for the dollar to rally viciously by 10% to 15%. That really makes me sweat, because that would cut across many of our portfolios as painfully as anything that could happen in the short term. We just don't know what to do about it.
The accumulating deficit seems such a profound factor on one hand, yet this overwhelming consensus makes it hard to be more conservative. Fundamentally, the dollar in purchasing parity doesn't seem too expensive. Two years ago, when the dollar was fundamentally expensive as well as technically vulnerable, it seemed like a no-brainer to short it, and I'm happy to say we made a very big bet. We've taken in that bet by one-third, but it is a much more speculative bet now. I sleep much less easily than two years ago. Now it's a sweat-it-out bet.
Q: What does the dollar's fate rest on?
A: I don't know anyone who sounds convincing or even convinced of what determines the direction of the dollar. We are going to spend a lot of our time in the next year studying currencies. We've already been doing it for a few weeks, and one of our findings, not surprisingly, is that in the long run relative export prices determine where currencies end up. On that basis, the yen looks cheap against its 50-year trend and the pound looks expensive.
Q: How do oil prices affect your outlook?
A: My view on oil is to treat it with respect. Do not assume because it is at 50 it will come down. Do not necessarily assume that there is a global shortage developing. Just be careful with oil. It can kill you on the upside, it can kill you on the downside, and there are better, higher-confidence bets for people like us.
Q: What does this outlook mean for the economy?
A: If the forecast of minus-6% for the market comes true and the housing market stops going up, that won't be a big deal for the economy. My guess is it will be a little less than forecast but perfectly respectable. You don't get rich fighting the U.S. economy because it always turns out to be more robust and resilient than the bears want to believe. But you do get rich fighting overpriced assets.
Q: What about the notion that corporate liquidity will provide a lot of support for stocks?
A: Corporate liquidity, private liquidity and any other form of liquidity is the perennial bull case. Go back to March 2000. Every time we opened the paper, we read that the overwhelming flood of money going into stocks would not allow them to decline. I used to say. "Oh, that must be the overwhelming flood that comes from a zero savings rate for the first time in American history." And the savings rate is, on the margin, the money that goes into stocks and bonds. We still have a low savings rate, and corporations have pretty good cash flow, but they have pretty good cash flow because their profit margins are abnormally high and their capital spending is abnormally low. Both will change.
Q: Happy New Year, Jeremy.
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