PART II -- differing opinions
Barron's: How Far Is Down?
A money manager explains how to discover when the market finally reaches fair value
An Interview With Jeremy Grantham -- The G in GMO, a Boston-based money manager with $25 billion in institutional assets -- otherwise known as Grantham, Mayo, Van Otterloo -- is a tough act to follow. No more so than when he, himself, is called upon to live up to the virtuoso performance he gave a year ago in these pages, on Aug. 6, 2001. Then, he called the market to a T. Drawing on wisdom and computer models compiled in more than 30 years assaying markets and asset classes worldwide, no one had a better handle on the course the stock market would take and where it was possible to profitably hide than the 63-year-old Grantham. Yet even one so astute and insightful as he couldn't have predicted the horror of Sept. 11, or the shame of a seemingly ceaseless wave of corporate shenanigans. For where we are in the trend line, and how the unpredictable fits into his calculations, we give you Grantham.
-- Sandra Ward
"Be very, very careful about blue chips in general -- growth or value. They are badly overpriced."
Barron's: When we spoke nearly a year ago, you figured the Standard & Poor's 500 was fairly valued at a price-earnings ratio of about 17, allowing for a world that would be a safer, more predictable place. Have you had to reevaluate?
Grantham: The terrible events of Sept. 11 were unusual in that you had to reply to it. Clients expected you to have answers. And so I had one. I was unusually optimistic. I said it's a very uncertain world, and if another big disaster happens, then, of course, everything is up for grabs, but that my instinct was this would turn out to be like the Crash of 1987. The day after the Crash in '87, I was talking to a pension-fund group in Manhattan, and I asked, "How do you feel about the risk premium? Aren't you going to need more of a risk premium now, because you suddenly find yourself in a stock market that can drop 23% in a day?" Every single one of them voted no. I thought they were making a big mistake. But they were actually right. There was no hint of an increased risk premium after 1987. The market, in fact, was launching into a 13-year period of unprecedented low risk premium and high P/E. There was no after-effect. It was like dropping a big stone in the pond. It disappeared, and the water settled down. It was as if it had never happened. So, my instinct with Sept. 11 was that it would be an outlier. The memory will be with us a long time. It will affect people's behavior on the margins. But as time passes, it will seem more like 1987: a monstrous and important event, but a one-off.
Q: So corporate accounting turns out to be the scariest part of the world right now?
A: What I missed last year was the substantial number of worms in the accounting apple that have begun creeping out, one after another. One of the biggest projects we have is improving the quality of book-value and earnings estimates that go into our work, the things that assess the quality of earnings. Quantitatively, what we might be able to do is produce a pattern of events that cause some suspicion.
A traditional manager has a bit of a problem with that. He likes the company. He sees the pattern that may, statistically, raise some doubt, but there isn't proof. Yet quantitatively you can say: Here are 100 companies with this pattern that cause some doubt. We know, on average, that 15% to 20% of the companies will turn out to suffer from some sort of weaseling. We don't know which 20. But we can reduce the weight of all 100 in our program. That's the way the quant thinks and it is a bit of an advantage. In any case, the economy turned out in the first quarter to be much stronger than anyone expected, anyway. At the end of the first quarter, the market was down. I would have expected it to have gone up 15%, based on past patterns. It went down. To me, that was real King Kong versus Godzilla stuff. You had an enormous, sustained stream of disappointing shocks on the accounting front on one hand, offset by a really splendid, outperforming economy on the other. The bad news won.
Q: You have said the great bubbles result in great pain. But is this pain different from past pains?
A: No. The mistake that normally accurate people make is they take the 12 last "ordinary" recessions or bear markets and they say, "One year after the bottom of an economic cycle, the market is up X on average." I say, guys, it isn't about the last 12 "ordinary" cycles. It's about the last three great bubbles -- 1929, 1965-72 and 1989 in Japan. Take those three, and look for principles.
Q: The multiple on the S&P 500 has contracted quite a bit. Is it approaching the 17 times you would find reasonable?
A: We put it at 23 times trailing earnings. The range is anywhere from 17 to about 30. That is where the heart of the pain lies; if you are going to come down to 17½ to get fair value -- and if there has never been any exception to this -- then there is going to be substantial pain. Whatever Greenspan does, whatever happens out there in the world, however strong the economy is, there is going to be a lot of pain. And then it will overrun its course. We think fair value on the S&P is about 700. A year ago we thought it was 750. This is one of the interesting and unusual features of this cycle. We try to get the trend-line value on the S&P. Typically, if you wait a year, the trend-line value will have increased a couple of percent in real terms. But this time, it's actually gone from 750 to 700 because companies have reached back into history and said, "Not only are some of our assets not there, not only is quite a chunk of the earnings we told you were there not there, but some of the sales weren't even there." When we run the same calculation now, we see the market was not as valuable as we thought it was a year ago. So today's trend line, instead of drifting up to 770, which might have been expected, has drifted down to 700.
Q: What about Nasdaq? Last year, your fair-value target was 1250.
A: On Nasdaq, which is much flakier in terms of data, the same approach suggests 1100 is fair value. However, if you look at the dollar pain lost from Nasdaq at 5000 all the way down to 1100, about 94% of the dollar pain is behind us and only 6% lies ahead. In other words, 6% of 5000 is 300 points. There are only 300 points to get to 1100 from 1400, and Nasdaq is now below 1400.
Q: Does this shorten the cycle of the bear market from what you expected?
A: Yes. The faster it goes down, the shorter the bear market will be. The market can rally any time it likes. There could indeed be important rallies, but before the smoke really clears, it's very likely we will overrun to a level below 700 on the S&P and below 1100 on Nasdaq. It's very scary. The overrun is something of a terra incognita. There is no methodology to calculate how much it will overrun. I can calculate how much it will correct to fair value because we have a pretty good read on fair value. We know that has always happened. But the degree of overrun in the market is always different. The only thing you can say with some statistical backing is that there is a strong tendency for the degree of overrun on the downside to be related to the degree of overrun on the upside. It's not a close relationship, but the very worst -- the very biggest bubbles -- tend to be followed by some of the worst overruns. Happily for us, there are exceptions because we wouldn't want this to be absolutely typical. To be absolutely typical this time you would expect one of the bigger overruns from 700 on the S&P, which simply doesn't bear thinking about. But you should at least, in the back of your brain, be prepared for that possibility.
Q: What was the overrun in the 'Thirties?
A: Huge. Don't even think about the 'Thirties. In the 'Thirties, assets were selling in the marketplace for half or less what it would cost you to build them.
Q: So is there any incentive to buy here?
A: When people get very discouraged, they really need a reason to be a hero and to step up and catch the falling knife. You need to know there is something in it for you. Why be brave? In 1974 Dick Mayo and I had a portfolio that was way, way under replacement cost. If something didn't yield 10%, we wouldn't put it in the portfolio. The government bond was 7½% and the T-bill was less. The assets were twice what they were selling for in the market. But 10% yield? You shouldn't have to be an intellectual to relate to 10% yield against a 7½% long bond. That year, 1974, was the last time people were completely demoralized. The main problem faced by professional investors was getting to work. It was left foot forward, right foot forward. It was miserable. It gives you some idea of how discouraged people can be. In a world where almost all professional investors are depressed, you need something really pretty powerful to get you to put your cash reserves to work because it's your cash reserves that have been making you look like a hero, relatively, month after month. Somewhere, from inside you, you have got to drag out the courage to whip out your cash reserves and throw them into battle.
Q: What's the replacement cost of the market at this point?
A: You can't walk into the world of the S&P 500 and easily find companies selling below the cost of replacing them. The replacement cost of the stock market has fallen like a stone to 1.5 times. But the yield has rallied all the way to 2%. What kind of inducement is this to be a hero? This worries me. The best you can say about this kind of market is it isn't as bad as it used to be. That's fine when you are a bull because you'll buy into weakness and stocks will likely rally. But when you are a bear, when you are now discouraged, and the best I can tell you about this market is it isn't as bad as it used to be, that isn't a very powerful reason to buy.
Q: What about the gap between value and growth?
A: When we spoke last year, the rally in value stocks was much closer to the end. About 80% of it was behind us and 20% lay ahead. Value has rallied more than 20% since then and so our data suggests, not surprisingly, value is in the overrun phase. Early in the overrun stage. So the value style will cushion the pain a little on the way down, but the real cushion is gone. You must now expect value, particularly large-cap value, to go down with the market. Unfortunately, that's exactly what's happened.
Q: What about gold?
A: I can say with a clear conscience that I have never made a mistake in gold because I have never had an opinion on gold. I have completely and assiduously avoided it. I feel uncomfortable with gold. It has no yield.
Q: What's your outlook on inflation?
A: I have never had any quarrel with inflation. I have had a quarrel with the people who thought that low inflation would stop a bear market. It isn't about low inflation. It's about the return you get from buying overpriced assets.
Q: What kind of return are you projecting for stocks now?
A: We think people should expect 5.7% from stocks after inflation over the indefinite future, which is what they will get when it gets to a 17½ P/E.
Q: That's the lowest figure I have heard.
A: You want 7%? Then you'll have to see a multiple of 14 on the S&P. That may well be the case. I have been conditioned by years of talking to clients who don't want to believe the data to use very friendly numbers. All the numbers we use are very friendly. A 17½ P/E is not the long-term average. The profit margins we use are a little above the long-term average. The growth rate we have used is substantially above long-term average. We are trying to get people to listen to the data.
Q: Where can people hide?
A: At times like this, it is getting the flavor of your portfolio right that is of overwhelming importance. Getting the right asset class is so much more critical as a protector or a driver of your returns than focusing on individual names. Individuals make a big error by spending too much of their time in worrying about the names and too little about how their portfolio is structured and whether they are diversified enough. They should take all that time they use reading about individual stocks and worry about asset classes. What was remarkable about this great bubble forming and breaking was the unprecedented number of places to hide that it offered two years ago. Right at the peak, there were wonderful asset classes and they have done a terrific defensive job.
Q: Are you concerned about consumer spending?
A: I have been worried for two or three years that the savings rate is too low. The savings rate will go back up. It needs to go back up for a healthy economy in the long run. As it goes back up, it will be a drain on consumer spending. The American consumer has been amazingly willing to keep on spending. It's been a nice sustaining factor. But reading the Economist recently, I was reminded that in Japan in the first two years of its bubble breaking, Japanese real estate -- land and property -- went up even as the Japanese market went down 50%. You might think the real-estate market would eventually be affected by animal spirits dropping a bit and consumer confidence coming down. As people become concerned by rising unemployment, they will likely save more. As they realize their pension funds are not in the shape they thought they were, they will save more.
Q: But if the bear market is shorter than expected, what are the implications?
A: Instead of spread out over seven years, it will be spread out over two from today. That would be a four-year bear market, which would be very, very short for a bear market of this kind. But there are some straws in the wind. The last important cycle for us was the great growth cycle. That was a very long sector cycle. Starting in 1982 and lasting through March 2000. Growth stocks got stronger and stronger and the market got stronger. But in the down cycle, value stocks -- which troughed on a relative basis in March 2000 -- made it all the way back to trend by October of last year, far faster than normal. In 1974, in the Nifty Fifty Era, it took until 1980 to close the gap, and then it overran until early 1982. Six years to close the gap and three years of overrun. This time, it was a year and four months to close the gap. The relationship between relative growth and value is a little more in favor of growth than normal, but the momentum in the market almost guarantees that before this market is finished on the downside, value will run further against growth.
Q: Would people be wise to start putting some money into growth stocks?
A: They'd be wise to be very, very careful about blue chips in general -- growth or value. What matters now is blue chips are still badly overpriced and confidence is falling. Faith is a very big thing in the market and it's substantially broken. Until you are given a good reason to buy blue chips, I wouldn't. In accounts where we were given complete discretion, where we weren't held to a standard benchmark -- we have had no blue chips over the last several years. Zero. We are not anti-equity, we are anti-blue chips, although increasingly we favor international blue chips to U.S. blue chips.
Q: What good news do you have for us?
A: The good news is the market is a whole lot more reasonably priced below 900 on the S&P than it was at 1550. Pain has occurred and 94% of the pain getting Nasdaq to fair value and 77% of the pain getting the S&P to fair value is behind us. Getting to reasonable levels doesn't mean it stops. But how you play it becomes, at least, more reasonable. You can justify owning stocks if the S&P gets below 700. Then life becomes more complicated for people like me as we go from shooting fish in a barrel at a time of one of the greatest disparities in history. There is no doubt in my mind that the next big mistake will be value managers investing too soon. Between 700 and 600 on the S&P, I won't really know what is what. Below 600, I am a bull. By 500, I am a big bull. Let's assume fair value goes to 390. By 390, I am going to look like an idiot because I will have been throwing in all of my cash reserves.
Q: Jeremy, thank you. |
