Pavlov’s Bulls
GMO
By Jeremy Grantham
January 26, 2011
About 100 years ago, the Russian physiologist Ivan Pavlov noticed that when the feeding bell was rung, his dogs would salivate before they saw the actual food. They had been “conditioned.” And so it was with “The Great Stimulus” of 2008-09. The market’s players salivated long before they could see actual results. And the market roared up as it usually does. That was the main meal. But the tea-time bell for entering Year 3 of the Presidential Cycle was struck on October 1. Since 1964, “routine” Year 3 stimulus has helped drive the S&P up a remarkable 23% above any inflation. And this time, the tea has been spiced with QE2. Moral hazard was seen to be alive and well, and the dogs were raring to go. The market came out of its starting gate like a greyhound, and has already surged 13% (by January 12), leaving the average Year 3 in easy reach (+9%). The speculative stocks, as usual, were even better, with the Russell 2000 leaping almost 19%. We have all been well-trained market dogs, salivating on cue and behaving exactly as we are expected to. So much for free will!
Recent Predictions …
From time to time, it is our practice to take a look at our predictive hits and misses in an important market phase. I’ll try to keep it brief: how did our prognostication skill stand up to Pavlov’s bulls? Well, to be blunt, brilliantly on general principle; we foretold its broad outline in my 1Q 2009 Letter and warned repeatedly of the probable strength of Year 3. But we were quite disappointing in detail.
January 2011
Although “quality” stocks are very cheap and small caps are very expensive (as are lower quality companies), we are in Year 3 of the Presidential Cycle, when risk – particularly high volatility, but including all of its risky cousins – typically does well and quality does poorly. Not exactly what we need! The mitigating feature once again is an extreme value discrepancy in our favor, but this never matters less than it does in a Year 3. This is the age-old value manager’s dilemma: we can more or less depend on quality winning over several years, but it may well underperform for a few more quarters.
I fear that rising resource prices could cause serious inflation in some emerging countries this year. In theory, this could stop the progress of the bubble that is forming in U.S. equities. In practice, it is unlikely to stop our market until our rates have at least started to rise. Given the whiffs of deflation still lingering from lost asset values, the continued weak housing market, weak employment, and very contained labor costs, an inflationary scare in the U.S. seems a ways off.
Commodities, Weather, and Markets
Climate and weather are hard to separate. My recommendation is to ignore everything that is not off the charts and in the book of new records. The hottest days ever recorded were all over the place last year, with 2010 equaling 2005 as the warmest year globally on record. Russian heat and Pakistani floods, both records, were clearly related in the eyes of climatologists. Perhaps most remarkable, though, is what has been happening in Australia: after seven years of fierce drought, an area the size of Germany and France is several feet under water. This is so out of the range of experience that it has been described as “a flood of biblical proportions.” More to the investment point: Russian heat affects wheat prices and Australian floods interfere with both mining and crops. Weather-induced disappointment in crop yield seems to be becoming commonplace.
For my money, resource problems exacerbated by weather instability will be our biggest and most complicated investment problem for years to come.
Looking Forward
- Be prepared for a strong market and continued outperformance of everything risky.
- But be aware that you are living on borrowed time as a bull; on our data, the market is worth about 910 on the S&P 500, substantially less than current levels, and most risky components are even more overpriced.
- The speed with which you should pull back from the market as it advances into dangerously overpriced
- territory this year is more of an art than a science, but by October 1 you should probably be thinking much more conservatively.
- As before, in our opinion, U.S. quality stocks are the least overpriced equities.
- To make money in emerging markets from this point, animal sprits have to stay strong and not much can go wrong. This is possibly the last chapter in a 12-year love affair. Emerging equities seem to be in the early stages of the “Emerging, Emerging Bubble” that, 3½ years ago, I suggested would occur. How far a bubble expands is always anyone’s guess, but from now on, we must be more careful.
- For those of us in Asset Allocation, currencies are presently too iffy to choose between. Occasionally, in our opinion, one or more get far out of line. This is not one of those occasions.
- Resource stocks, as in “stuff in the ground,” are likely to be fi ne investments for the very long term. But short term, they can really ruin a quarter, and they have certainly moved a lot recently.
- We think forestry is still a good, safe, long-term play. Good agricultural land is as well.
- What to watch out for: commodity price rises in the next few months could be so large that governmental policies in emerging countries might just stop the global equity bull market. My guess, though, is that this is not the case in the U.S. just yet.
Things that Really Matter in 2011 and Beyond (in one person’s view) for Investments and Real Life
- Resources running out, putting strong but intermittent pressure on commodity prices
- Global warming causing destabilized weather patterns, adding to agricultural price pressures
- Declining American educational standards relative to competitors
- Extraordinary income disparities and a lack of progress of American hourly wages
- Everything else.
Part 2: On the Importance of Asset Class Bubbles for Value Investors and Why They Occur
I unabashedly worship bubbles. Forecasting bubbles, though, is problematic. It is hard work and involves predictions and career risk. Whether bubbles will break, though, is an entirely different matter. Their breaking is certain or very nearly certain.
Stock market sectors have bubbled unfailingly – growth stocks, value stocks, Japanese growth stocks, etc. In fact, they’ve been very dependable. To ignore them, I believe, is to avoid one of the best, easiest ways of making money. Responding to the ebbs and flows of major cycles and saving your big bets for the outlying extremes is, in my opinion, easily the best way for a large pool of money to add value and reduce risk. In comparison, waiting on the railroad tracks as the “Bubble Express” comes barreling toward you is a very painful way to show your disdain for macro concepts and a blind devotion to your central skill of stock picking. The really major bubbles will wash away big slices of even the best Graham and Dodd portfolios. Ignoring them is not a good idea.
(c) GMO
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