Time To Be Serious (and probably too early) Once Again
GMO
By Jeremy Grantham
May 11, 2011
Below is an excerpt of this commentary. To read the full text, please go to www.gmo.com
The Bottom Line
Lighten up on risk-taking now and don't wait for October 1 as previously recommended. But, as always, if you listen to my advice, be prepared to be early!
A word on being too early in investing: if you are a value manager, you buy cheap assets. If you are very “experienced,” a euphemism for having suffered many setbacks, you try hard to reserve your big bets for when assets are very cheap. But even then, unless you are incredibly lucky, you will run into extraordinarily cheap, even bizarrely cheap, assets from time to time, and when that happens you will have owned them for quite a while already and will be dripping in red ink. If the market were feeling kind, it would become obviously misvalued in some area and then, after you had taken a moderate position, it would move back to normal. That would be very pleasant and easy to manage. But my career, like most of yours, has been fi lled with an unusual number of real outliers. That certainly makes for excitement, but it also delivers real pain for even a disciplined value manager. Following is a snapshot of some of those outliers. In 1974, the U.S. market fell to seven times earnings and the U.S. value/growth spread hit what looked like a 3-sigma (700-year) event. U.S. small caps fell to their largest discount in history, yet by 1984 U.S. small caps sold at a premium for the fi rst time ever. By 1989, the Japanese market peaked at 65 times earnings, having never been over 25 times before that cycle! In 1994, emerging market debt yielded 14 points above U.S. Treasuries, and by 2007 had fallen to a record low of below 2 points. By 1999, the S&P was famously at 35 times peak earnings; in 2000, the value/growth spread equaled its incredible record of 1974 (that I, at the time, would have almost bet my life against ever happening again). Equally improbable, in 2000, the U.S. small/large spread beat its 1974 record and emerging market equities had a 12 percentage point gap over the S&P 500 on our 10-year forecast (+10.8 versus -1.1%). Further, as the S&P 500 peaked in unattractiveness, the yield on the new TIPS (U.S. Government Infl ation Protected Bonds) peaked in attractiveness at over 4.3% yield and REIT yields peaked at 9.5%. Truly bizarre. By 2007, the whole world was reveling in a risk-taking orgy and U.S. housing had experienced its fi rst-ever nationwide bubble, which also reached a 3-sigma, 1-in-700-year level (still missed, naturally, by “The Ben Bernank”). Perhaps something was changing in the asset world to have caused so many outliers in the last 35 years. Who knows? The result, though, for value players, or at least those who wanted to do more than just tickle the problem, was overpriced markets that frightened them out and then, like the bunny with the drum, just kept going and going.
Well, those dramatic opportunities certainly hooked me, and I jumped enthusiastically into every one and was, of course, too early. Some of them went from looking like 1-in-40-year opportunities to 1-in-700!
So, I have had a long and ignoble history of being early on market calls, and on two occasions damaged the fi nancial well-being of two separate companies – Batterymarch and GMO. On the other hand, at long and bloody last (in the fi gurative, not the British, sense), the big bets we made have all been won, with quality and cash still pending. But, as I like to say, we often arrive at the winning post with good long-term results and less absolute volatility than most, but not necessarily with the same clients that we started out with. Our bets have been part of the public record for the last 20 years and before that the bets (including those made while I was at Batterymarch) were so big that no one could have missed them: while at Batterymarch in 1972, betting (two years too early) on small cap value against the “nifty-fi fty” IBM types (and with 100% of the portfolio!); betting against Japan three years too early in 1986 (as in zero percent Japan against 60% in the benchmark!); betting against the Tech bubble, two and a half years too early, and against the recent Housing and Risk-taking Bubble, much less painfully but, once again, two years too early. But, what I really want to emphasize today is my current opportunity to be two years too early once again by betting against the broad U.S. market.
As readers know, driven by my increasing dislike for being early by such substantial margins, I have been experimenting recently with going with the fl ow. In defense of this improper behavior, rest assured that it was motivated not by chasing momentum, but by my growing recognition of the immense power – sometimes the thoroughly dangerous power – of the Fed. Nowhere is this power more clearly revealed than in the ease with which it can move asset prices, particularly stock prices, and nowhere is this revealed more clearly than in Year 3 of the Presidential Cycle. I will not infl ict on you once again the amazingly lopsided results of the Cycle, but will take this opportunity to introduce my new pet variant of Year 3 power: “Sell in May and go away.” This nugget came up recently, so we tested it. Bingo! In the fi rst seven months of the third year since 1960, Year 3 has returned 2.5% per month for a total of 20% real (after infl ation adjustment). In contrast, the second fi ve months after May have delivered an average return of 0.5% per month, as does the fourth year of the cycle. Now, 20% is perilously close to the total for the whole 48-month cycle of 21%. This means, of course, that the remaining 41 months collectively return a princely 1%. This offers a brilliant, lazy investor’s rule: “Sell in May of Year 3 and go away for 41 months.” Whoopee! The unfortunate caveat is that there are only 11 entries for this analysis so it may well be pure luck. Still, it’s intriguing, especially if you like sitting on the beach for 41 months.
In addition to entering Year 3 last October, we also had Bernanke’s QE2 … a kind of underlining of the seemingly eternal promise of a bailout should something go wrong, as if Noah had been sent not just one rainbow, but two! So, even though the market was substantially overpriced by last October 1, I found myself atypically writing that it was likely that the market would race up to the 1400 to 1600 range on the S&P 500 by October 1. Of course – I hasten to add – I emphasized the caveat that more serious, risk-averse, long-term investors would not want to play fast and loose with a market then worth only 900 on the S&P. I also added that GMO played pretty strictly by the value book for our clients, shading only a little here and a little there. But I personally (no doubt driven mad by the tooearly syndrome) took a little more risk in honor, as it were, of the Fed’s behavior. Behavior I, of course, completely disapprove of. But that’s an old story.
Well, believe it or not, the third year has behaved perfectly for the fi rst seven months. At the end of April, the S&P had offered up 21% in total return. And the market at 1360 needs just a 3% rise to reach my lower limit of 1400 in the fi ve months remaining.
All of this has occurred as if everything is normal: as if the economy is recovering strongly, as if the housing market has started to regroup after an unprecedented two years fl at on its back, and, most importantly, as if special and exogenous shocks have not tried to tag-team Year 3. Yet, all of those presumptions are at least partly wrong. In fact, it is beginning to feel like an unfair contest. One minute we have the Year 3 effect chugging along, with us Pavlovian investors responding faithfully to the Fed. The next minute we are dealing with not one, but two, exogenous shocks: the Tunisia-Egypt-Libya-Yemen-Syria shock and the dreadful tsunami shock. In general, exogenous shocks famously have little effect after the fi rst few days (or occasionally weeks) of exaggerated psychological sell-offs. The painful exception to this rule is, unfortunately for us now, an oil shock. (Happily, there have been only two bad ones – in 1974 and 1979 – as well as two or three scares.) An oil shock is like a tax on business and a tax on consumers. It quickly transfers wealth to often undesirable government coffers and poses a “recycling” of wealth problem. It will usually depress consumer demand quite quickly as gasoline prices rise; it will usually depress GDP growth, generally a little later; and it will always unsettle business confi dence. The stock market, perhaps anticipating this, has declined rapidly and severely when it has sensed a serious oil crisis.
Yet this time the market bounced back with the Year 3 effect winning handily. But doesn’t the current situation there clearly reduce any certainties about the Mediterranean Arab world (which have, in any case, never been that high)? Can’t this crisis clearly spread to Saudi Arabia or other Gulf states sooner or later? For once, in my opinion, the short-term effect is underestimating the potential for trouble – a real testimonial to the Year 3 confi dence (and speculation) effect.
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