Jeremy Grantham's 4Q 2008 letter

Jeremy Grantham's GMO 4Q 2008 letter

Page 2

• But let us look for a minute at the extent of the loss in perceived wealth that is the main shock to our economic system. If in real terms we assume write-downs of 50% in U.S. equities, 35% in U.S. housing, and 35% to 40% in commercial real estate, we will have had a total loss of about $20 trillion of perceived wealth from a peak total of about $50 trillion. This relates to a GDP of about $13 trillion, the annual value of all U.S. produced goods and services. These write-downs not only mean that we perceive ourselves as shockingly poorer, they also dramatically increase our real debt ratios. Prudent debt issuance is based on two factors: income and collateral.
  
  Like a good old-fashioned mortgage issuer, we want the debt we issue to be no more than 80% of the conservative asset value, and lower would be better. We also want the income of the borrower to be sufficient to pay the interest with a safety margin and, ideally, to be enough to amortize the principal slowly. On this basis, the National Private Asset Base (to coin a phrase) of $50 trillion supported about $25 trillion of private debt, corporate and individual. Given that almost half of us have small or no mortgages, this 50% ratio seems dangerously high.
  
  But now the asset values have fallen back to $30 trillion, whereas the debt remains at $25 trillion, give or take the miserly $1 trillion we have written down so far. If we would like the same asset coverage of 50% that we had a year ago, we could support only $15 trillion or so of total debt. The remaining $10 trillion of debt would have been stranded as the tide went out! What is worse is that credit standards have of course tightened, so newly conservative lenders now assume the obvious: that 50% was too high, and that 40% loan to collateral value or even less would be more appropriate. As always, now that it’s raining, bankers want back the umbrellas they lent us. At 40% of $30 trillion, ideal debt levels would be $12 trillion or so, almost exactly half of where they actually are today!
  
  It is obvious that the scale of write-downs that we have been reading about in recent months of $1 trillion to $2 trillion will not move our system anywhere near back to a healthy balance.

His comments on Warren Buffett page 5-6

• First, Warren Buffett. At about 950 on the S&P on October 16, he announced that he was a personal buyer of U.S. stocks because they were cheap and their prices reflected widespread fear. This is not typical for him, but he certainly did it in 1974. When he said it back then, every stock in our portfolio at Batterymarch yielded almost 10%! The portfolio P/E was below 7.5x. Even with hindsight, if you value the market in 1974 using our current methodology, it was very much cheaper than it is today at 950, which is what we calculate as almost precisely fair value.
  
  His recent announcement made the market seem so much more exciting than boring old fair value. So what are the possibilities? Was he performing a civic duty? Certainly, animal spirits are a critical component of any recovery, so encouragement to take risk from an authoritative source makes perfect sense. Does he believe that 1974- type cheapness can never return, or is very unlikely in this particular case? If that were the argument, we would disagree; we suspect that cheaper prices are not just possible but probable, although admittedly far from certain. Has he perhaps a tactical market timing model that produces his obvious excitement, despite these ordinary values? Most unlikely, given his style. Or are our numbers wrong? Perish the thought! In any case, it is all an interesting conundrum.

On the Black Swan logic. Page 6

• Second, Nassim Taleb and the Black Swan logic, which I have previously admired in public. Taleb is completely dismissive – in a way only he can be – of any near certainties. He implies that we have just suffered from an outlier event crashing up against standard risk modeling that only assumes that events will occur in an approximately normal way. He argues that modeling the 95% or 99% normal range in Value at Risk (VaR) misses the whole point: that the real game is played out in the final 1%. It's hard to disagree with this criticism of VaR, but is it relevant in this case? Was the recent breaking of our credit and asset bubbles a totally unpredictable outlier?
  
  We believe that we live in a world where bubbles routinely form and where there are – in complete contrast to Nassim Taleb’s belief – some near certainties. One is that bubbles will break. Bernanke should not have said, “U.S. house prices have never declined,” thus implying that they never would. He should have said, “Never before has a three sigma, 1 in 100, U.S. housing bubble occurred, and be advised that all such analogous bubbles in other asset classes and in housing in other countries have always burst.” (Robert Shiller for the Fed! He would have said almost exactly that.) The bursting of the U.S. and U.K. housing bubbles, the profit margins, and the risk premium in global asset prices were all “near certainties.” This was a White Swan, a particularly White Swan. Taleb’s work will no doubt be correct when we have a genuine Black Swan, but this was most definitely not it. (Okay, Nassim. I can hear you thinking: this guy Grantham is a complete loser who has obviously missed my entire point.)

His recommendations..

• Re-introducing the Very First of Our 7-year Forecasts: Bullish Again!
  For many years, we used a 10-year forecast for asset class returns. In January 2002, we made our first 7-year forecast, dated December 31, 2001. We moved from 10 to 7 years because research proved that it was closer to the average time for financial series to mean revert. The data is shown in Table 1.
  
  As you can see, despite being called “perma bears,” we overestimated the returns for global equities, except for emerging, where we were more or less spot on. Government debt – not surprisingly, given our crisis – also moderately outperformed our estimate.
  
  Current Recommendations
  Slowly and carefully invest your cash reserves into global equities, preferring high quality U.S. blue chips and emerging market equities. Imputed 7-year returns are moderately above normal and much above the average of the last 15 years. But be prepared for a decline to new lows this year or next, for that would be the most likely historical pattern, as markets love to overcorrect on the downside after major bubbles. 600 or below on the S&P 500 would be a more typical low than the 750 we reached for one day.
  
  .... Emerging countries are, of course, a different story. They will probably recover more quickly, and will continue to grow at double (or better) the growth rate of developed countries.

Jeremy's commentary on the issue of Value Trap is excellent again. This is a must read section on page 8 and I will reproduce his first paragraph.

• The Year of the Value Trap
  Since time immemorial, the most successful value investors have been the bravest. The greatest advantage of value investing has always been that when your cheap stock goes down in price, it gets even cheaper and more attractive. This is the complete opposite of momentum stocks, which lose their momentum rating as they decline and hence become unattractive. But averaging down in value stocks can take lots of nerve and considerable ability in convincing anxious clients of the soundness of the strategy. For at least 60 years, those value investors who managed these problems and bought more of the stocks that had tumbled the most emerged with both the strongest performance and the most business success. (Of course, analytical skills also help, but let’s assume that these skills were distributed evenly between brave and nervous investors.) Major market declines in the past set up the best opportunities for brave value managers: the 50% declines of 1972-74 and 2000-02. Value investors in 1972 and 2000 were also able to buy value stocks at their biggest discounts to the general market at least since 1945. In addition, averaging down in those value stocks that fell the most eventually added substantially to an already strong return. Those value managers with the best analytical skills within this group became the few handfuls of super-successful investors.

I repeat what was posted in past posting Jeremy Grantham Joins The Bullish Camp!

• The Curse of the Value Manager
  
  We at GMO have a strong value bias, and our curse, therefore, like all value managers, is being too early. In 1998 we saw horribly overpriced stocks that at 21 times earnings equaled the two previous great bubbles of 1929 and 1965. Seeing this new “peak,” we were sellers far, far too early, only to watch it go to 35 times earnings! And as it went up, so many of our clients went with it, reminding us that career risk is really the only other thing that matters. The other side of the coin is that only sleepy value managers buy brilliantly cheap stocks: industrious, wide-awake value managers buy them when they are merely very nicely cheap, and suffer badly when they become – as they sometimes do – spectacularly cheap. I said as far back as 1999, while suffering from selling too soon, that my next big mistake would be buying too soon. This probably sounded ridiculous for someone who was regarded as a perma bear, but I meant it. With 14 years of an overpriced S&P, one feels like a perma bear just as I felt like a perma bull at the end of 13 years of underpriced markets from 1973-86. But that was long ago. Well, surprisingly, here we are again. Finally! On October 10 th we can say that, with the S&P at 900, stocks are cheap in the U.S. and cheaper still overseas. We will therefore be steady buyers at these prices. Not necessarily rapid buyers, in fact probably not, but steady buyers. But we have no illusions. Timing is difficult and is apparently not usually our skill set, although we got desperately and atypically lucky moving rapidly to underweight in emerging equities three months ago. That aside, we play the numbers. And we recognize the real possibilities of severe and typical overruns. We also recognize that the current crisis comes with possibly unique dangers of a global meltdown. We recognize, in short, that we are very probably buying too soon. Caveat emptor.

See past posting: Grantham Calls It "Cheapest In 20 Years"

Interview With GMO's Jeremy Grantham