Friday, October 24, 2008

Jeremy Grantham Joins The Bullish Camp!

Yes, Jeremy Grantham of GMO has joined the Bullish Camp!

Yes, another of the legendary investors has joined the bullish camp. ( Can you count how many already?)

However, before anyone jumps the gun, perhaps it's best we understand what Jeremy is saying here!

Several interesting issues he has written. Firstly I agree very much with his current assessment on what has happened. Here are his ten points.

  • The time to blame should be past, or at least in abeyance until the crisis is past, but I find it impossible to avoid it completely. Sorry. In any case, just to set the scene, it is necessary to review briefly the poisonous wind that we all sowed.

    1. We had an extended period of excess increase in money supply, loan growth, leverage, and below normal interest rates.

    2. This combined with a remarkably lucky global economic environment that we described as “near perfect” to produce a bubble in asset classes, as such a combination has done without exception according to our research. Since all these factors were global, the combination produced what we have called “the first truly global bubble” in all assets everywhere with only a few modest exceptions.

    3. While these asset bubbles were inflating, facilitated by easy money, the authorities – the Fed, the SEC, the Treasury, and Congress – rather than tightening existing regulations, partially dismantled them. They freed commercial banks while further reducing controls on investment banks, allowing leverage to take wing. More recently they almost gratuitously, without being pressured, removed the uptick rule for shorting. And this is just a sample. Simultaneously, attempts in some quarters to address growing risks were beaten back or diluted by Democrats and Republicans alike. Examples here include early efforts to rein in stock options and the attempt to add controls to Fannie and Freddie. (I’m biting my lip not to name names.) Worse yet, the regulating authorities appeared to encourage the worst excesses by admiring the ingenuity of new financial instruments (okay, that was Greenspan), and by repeating their belief that no bubbles existed (or perhaps could ever exist) and that housing at the peak “merely reflected a strong U.S. economy.” Finally, as the bubbles inevitably began to break, all was said to be contained and the economy was claimed to be strong.

    4. The combination of favorable conditions and irrationally exuberant encouragement from the authorities produced an even more poisonous bubble – that in risk-taking itself. Everybody, and I mean everybody, got the point that risk-taking was asymmetrical and reached to take more risk. The asymmetry here was that if things worked out badly they would help you out (this sounds very familiar!), but if all went well you were on your own, poor thing. Ah, the joys of pure capitalism!

    5. In this regard, some deadly groundwork had been laid by the concept of rational expectations, or market efficiency. This argued that we were all far too sensible for major bubbles to appear. This is a convenient theory for mathematical treatment, but obviously totally unconnected to the real world of greed and fear. It dangerously encourages the belief that if you take more risk you will automatically receive more reward. That condition might often, even usually, be the case because in normal quiet markets a rough approximation of that relationship is usually priced into the markets. But in wildly-behaving markets where risk is mispriced, it is not true. From June 2006 to June 2007 on our seven-year data, investors lulled by these beliefs and the conditions of the market were actually paying to take risks for the first time in history.

    6. Just as all bubbles have broken, these bubbles did. Far from being a surprise, the bubbles breaking were absolutely not outlier events, contrary to protestations. The bubbles forming in 1998 and 1999 and in 2003 through 2007 were the outlier events. The U.S. housing market, which was a clear bubble with prices at least 30% above a previous very stable trend, is well on its way back to normal, and equities and risk-taking may well have made it all the way back.

    7. The stresses on the financial and economic world of these bubbles breaking was always going to be great. To repeat a comment I made 18 months ago, “If everything goes right (as a bubble breaks) there will always be lots of pain. If anything is done wrong there will be even more. It is increasingly impressive and surprising how much we have done wrong this time!”

    8. By far, the biggest failing of our system has been its unwillingness to deal with important asset bubbles as they form (see last quarter’s Letter). I started a long diatribe on this topic in 1998 and 1999 and reviewed it in Feet of Clay (2002), which is aimed at my arch villain, Alan Greenspan. With the housing bubble even more dangerous to mess with than equities, Bernanke joined my rogues’ gallery. If we change our policy and move gently but early to moderate bubbles, this crisis need never be repeated. There are signs that the previously intractable authorities are reconsidering their bone-headed position on this topic. If they change, all this pain will not have been totally in vain. (See Part 2 of this Letter, titled “Silver Linings,” in two weeks or so.)

    9. The icing on the cake as far as the bust is concerned has been provided by Buffett’s “financial weapons of mass destruction” – the new sliced and diced packages of loan material so complicated that, shall we say, few understood them. The uncertainties and doubts generated by their complexities were impressive. Trust and confidence are the keys to our elaborate financial structure, which is ultimately faith-based. The current hugely increased doubt is a potential lethal blow to the system and must be addressed at any cost as fast as possible. Concern about moral hazard is secondary and must be put into abeyance for the time being. Wall Street leaders are in any case now fully scared and are likely to stay that way for a few years!

    10. To avoid the development of crises, you need a plentiful supply of foresight, imagination, and competence. A few quarters ago I likened our financial system to an elaborate suspension bridge, hopefully built with some good, old-fashioned Victorian over-engineering. Well, it wasn’t over-engineered! It was built to do just fine under favorable conditions. Now with hurricanes blowing, the Corps of Engineers, as it were, are working around the clock to prop up a suspiciously jerry-built edifice. When a crisis occurs, you need competence and courage to deal with it. The bitterest disappointment of this crisis has been how completely the build-up of the bubbles in asset prices and risk-taking was rationalized and ignored by the authorities, especially the formerly esteemed Chairman of the Fed.

And for the investor in you and me, the following two passages are of great read!

And I do think that his 'ask yourself what it is that you really know or think you really know' is absolutely spot on!

  • Basics
    At times like this it is good to ask yourself what it is that you really know or think you really know. For us (in our asset allocation division) it is defi nitely not the ins and outs of the financial system, although we’re trying harder and harder. The financial system is so mind-bogglingly complex that very few, even those with far deeper backgrounds than ours, fully understand it. Puzzlingly, despite our relative ignorance of financial details, we were more accurate than many experts in the last year about the big picture, and we can speculate why. First, as historians, we recognized that when bubbles break they almost invariably cause more pain than expected.

    Second, we are Minsky mavens and believe that, with sadly defective humans making up the markets, Minsky was right to see periodic financial crises as well-nigh inevitable. Thus in the middle of last year when the experts at Goldman Sachs said they expected write-downs of $450 billion, I immediately wrote that we’d be lucky if it wasn’t a trillion. I was playing off their detailed expertise and adding a generalized historical observation as I had done with the prediction that “at least one major bank – broadly defined – would fail,” and that half of the hedge funds would be gone in five years. In previous banking crises, major banks had failed, and this crisis seemed likely, to us semi-pros, to be worse than most. So we studied in broad strokes previous crises and armchaired that we should up the ante. We got lucky in an area in which we were not real experts, and we know we were lucky. We will attempt to keep the luck and hedge our bets by also increasing our skills. The addition of Edward Chancellor, an experienced financial journalist/historian with a focus on credit crises, has been a very helpful start.

    In contrast, what we do know, I believe, is asset class pricing and the behavior of bubbles, which are both derivatives of our single, big truth: mean reversion. for moderately more real growth in recent years. In the six years since October 2002, the trend line has risen to 975 (plus or minus a little – we are constantly fine-tuning a percent here or there). Needless to say, two weeks ago the market crashed through that level, producing Exhibit 1. So now all 28 burst bubbles are present and accounted for. Long live mean reversion!

Yes, nothing absolutely last forever, especially bubbles. Ask yourself, were you too bullish on your stocks, neglecting the fact that the earnings was boosted mainly by the insane bull run in your stock operating environment? And when bubbles burst, it is perhaps best we acknowledge that earnings will contract sharply!

And lastly this passage should be acknowledged by value investors!

  • 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.

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