<<After the Deluge
An elegant thinker deconstructs the stock market's latest bubble and its likely aftermath
"It was a remarkable bubble with ridiculous prices based on a New Era that is not here."
An Interview With Jeremy Grantham ~>> this is an extensive article from Barron's Online,a pay site--i will post link and then give excerpts.This is NOT the whole article..---
interactive.wsj.com
<<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>>
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.--again i remind these P/E's are based on TRAILING earnings--max---
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: 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: 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.
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