Grantham at Barron’s
Lance on Feb 11 2008 at 10:40 am | Filed under: Asset Allocation, Economics, Great Investors, Housing Market, Risk, Valuation
Jeremy Grantham echoes a few themes here at Risk and Return in this interview with Barron’s:
Secondly, this occurred at a time of what I believe is the first global bubble in pretty well all asset prices, so there is a much greater degree of broad-based vulnerability.
This is why traditional, long only diversification is likely to be less effective than in the last downturn, and even tactical, long only measures will be difficult to implement. What do you over weight if everything is expensive? In 2000 it was real estate, value, especially small cap value (like home builders) emerging markets, bonds, etc. Does anyone see those as a place to hide now?
People think the Federal Reserve can stop a bear market because they can throw money at it and lower interest rates. It is even more certain we can collectively stop a bear market if some fiscal stimulus is thrown in. To which I say, ‘Oh, you mean like 2000 and 2002?’ — when they threw what I call the greatest stimulus in American history, an unparalleled series of interest-rate cuts, cumulating in two, almost three, years of negative real returns, real interest rates coupled with a really substantial tax cut, which would never have happened without 9/11.
The combination would have gotten the dead to walk, and it stopped the bear market eventually. But the Standard & Poor’s 500 was down 50% and the Nasdaq — which was all anyone talked about back then — went down 78%. And a puny five to six years later, people are saying there is not going to be a bear market because the Fed is going to lower rates and because the government is going to have a stimulus package. But we have just been there, done that, and we had a nice bear market.
As stated here before, I watched a lot of people “not fight the fed” all the way to large losses last time around. Can we learn anything?
What about places to hide?
That isn’t something we can laugh off. Last time, there were plenty of opportunities: Bonds were cheap and TIPS (Treasury-inflation protective securities) were brilliant; real estate was cheap and REITs were brilliant. Even within equities, emerging markets were much cheaper than U.S. equities, and within U.S. equities, value stocks were only a little expensive and small-caps were only a little expensive and small-cap value was actually a little bit cheap. So you could really hide and could reasonably expect to make money, which we did in each of the three years of the bear market.
Uh, already addressed this, but let us look at another couple of themes of ours:
Profit margins, the great prop to the market, surprisingly defied the laws of gravity for three years in the developed world and, particularly, in the emerging world and even in Japan. That was because the global economy was stronger than any corporation counted on and, in the U.S., consumption was always higher and our savings rate was always lower than any corporate economist would have suggested, going into negative territory. But there are a few near certainties in this business — not many, but a few — and one of them is that abnormally high profit margins will go back to normal. The timing is unfortunately shrouded in fog. The other near certainty is that house prices will go back to a normal multiple of family income. In the end, we, the people, have to be able to afford the houses and they are affordable at something around 2.8 times family income. When they peak in Boston at 6 times and nationally at 3.9 times, you know you are in for tough times.
What about the magic elixir of lowering rates boosting economic growth?
It doesn’t have that much of a powerful effect on the economy. If it had any more profound effect, there would be a positive relationship between debt increasing and GDP growth, and there is none.
It doesn’t?
I have an exhibit that shows the 30 years prior to 1982 when the debt-to-gross domestic product ratio was completely flat at 1.2 times. Total debt is defined as government debt, personal debt, corporate debt and financial debt. Then in the 25 years after 1982, the flat line goes up at a 45 degrees angle from 1.2 times to 3.1 times GDP. Massive. In the first 30 years, when debt is flat, annual GDP growth is its usual battleship, growing at 3.5% and hardly twitching. After the massive increase in debt, GDP, far from accelerating, grew at 3%. So debt in the aggregate does not drive the economy. The economy is driven by education, man-hours worked, capital investment and technology. It is not driven by what I owe you and you owe me.
Of course it could have an effect elsewhere:
It drives down the dollar, which is inflationary, and, eventually, it could be seriously inflationary.
I think we have mentioned that we aren’t too hot on private equity as a diversifier for the moment, and we suspect it is in a bubble of its own. Jeremy nails down why:
I have yet to meet a private-equity firm that put into its spreadsheet the assumption that system-wide profit margins could decline by 20% to 30%. They have taken the current, abnormally high profit margins as a given and then determined to improve them by, let’s say, 15% and assume everything works out pretty well.
But if the base declines by 20%, even if they end up improving margins by 15%, they are going backwards. And if they pay the 25% premium up front, which was normal, and if they leverage 4-to-1, which was normal, then they almost precisely wipe out all of the clients’ money, all of the 20% in equity and if, perish the thought, they don’t add 15%, but add perhaps zero to 5%, then they do more than wipe out the equity, they leave the underlying debt in ragged disarray. That is the next shoe to drop on the credit side.
Jeremy was wise enough to avoid financials like the plague, and we took his advice last year. Thank goodness. Thank goodness we not only listened, but have a significant amount of assets invested with him. That, combined with our hedges, has turned out to be a profitable move.
His prediction, which seems about right given the numbers I have been watching, on the housing market:
It has a lot to go. It still has to drop 20% to 25% to reach more normal levels, or if you prefer, it could wait five years for income to catch up, barring no big recessions. With the housing market gone, people turned to credit cards and with economic times slowing down — whether there’s a recession or not — consumers are going to slow down a lot, are slowing down or have slowed down a lot.
Update: For those without a subscription, Seeking Alpha has the beginning of the interview.
