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Jeremy Grantham Guarantees Gold will Crash
By Robert Huebscher
May 18, 2010

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Jeremy Grantham

Jeremy Grantham, the investor celebrated for his ability to spot and exploit bubbles in asset classes, guaranteed yesterday that the current bull market in gold will end.  His proof?  He bought some – for his own account – at the end of last week.

His tongue-in-cheek comment was part of a discussion about relative value in various segments of the market.  Indeed, Grantham is bullish on two asset classes – which I’ll address in a moment – but gold is not among them.

Grantham, the Chairman of the Boston-based investment firm Grantham Mayo Van Otterloo (GMO), spoke at the CFA Institute annual conference in Boston, where he delivered the keynote address.

Finding value in asset classes

Mean-reversion is the unifying concept behind Grantham’s approach to asset class valuation.  “We have a very simple approach to all assets,” he said.  “Everything goes back to normal.”

For this approach to work, one must have a clear idea of fair value and a way to determine when prices deviate from it.  Price-to-earnings ratios are one of the variables Grantham looks at to determine whether an asset class has deviated from its fair value. Specifically, he uses Shiller’s “normalized” PE ratios, which averages earnings over at least 10 years.  “PEs that are not normalized are worth nothing,” he said.

Using those PE ratios, Grantham regularly forecasts returns over seven-year time horizons, which he said was “as close as possible to the periodicity of the market.”  He has performed this exercise 28 times since 1994 – forecasting returns for major global asset classes – and claims that he has a perfect record of predicting returns using this “simple-minded” (his words) technique.

Grantham combines his PE forecasts with those for other variables to arrive at projected return for an asset class, as in this example for the S&P 500, for the seven years beginning 4/30/10:

Loss
from
PE Contraction

Gain
from
Margin Increase

Gain
from
Sales Growth

Dividend
Yield

Total
Return

-5.7%

+0.4%

+3.8%

+2.3%

=0.3%

Long-term PE ratios have averaged 14 and they are currently 22.7.  Grantham expects them to go to 15, and that translates to a 5.7% reduction in projected return.  Similarly, profit margins have averaged 4.5%.  They are currently 5.8% and Grantham generously expects them to increase to 6%, giving rise to a 0.4% increase in total return.  Sales growth per share has been 1.8% and is now 1.9%; he expects it to increase to 3.6%, contributing 3.8% to total return.  Including the dividend yield of 2.3% produces a total return of 0.3%.

This methodology, he said, should be used to rebut optimistic forecasts for market returns.  “When someone comes up with a bigger number, get them to fill in the individual components,” he said – you may disprove their analysis.

Those components are rolled up into a comprehensive forecast, which is below and is also available via GMO’s web site:

GMO 7-year Asset Class
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