Jeremy Grantham is a very highly respected money manager and analyst. His firm, Grantham, Mayo, Van Otterloo (GMO), manages $22 billion. Grantham is a famous deep value investor. He was taking his clients out of stocks in 1998 and 1999 (and even earlier), as value, by his calculations indicated that, traditional stock portfolios simply got out of line. There are many in the investment industry who hold Grantham in almost, if not in fact, guru status. He has earned it.
He told us he lost 40% of his accounts during this period, which is a staggering number, since he manages nearly $20 billion. His large pension fund investors demanded that he keep up with other managers, and he refused, based on his sense of value. Now, these funds wish they had stayed, as Grantham has beaten the socks off his competitors.
How painful must it have been to lose that much business. It is a testimony to his character that he stood by his belief in value even as his income went down. But the clients that stayed also need to be commended, as it is hard to sit out the dotcom bubble as your peers are participating. I remember the articles about how Warren Buffett just didn’t get it.
Grantham’s basic investment theory is that over time investment classes come back to the average. When asset classes are well above trend he avoids them, and when they are well below trend he buys them. While it can take a long time for some classes to revert to the trend, if you have time and are patient, this style has been successful. Grantham has been very successful at simply investing for the long term using history as his guide.
As a student of history, I like his approach. It let’s you get on the right side of long-term trends. You will miss bubble tops and get in too soon on irrational bottoms, but patience and time will see you rewarded. We are going to look at two separate pieces of received wisdom from Mr. Grantham, one from an interview in Barron’s in 2001, with great relevance for today, and the other from a debate with Professor Jeremy Siegel, author of Stocks for the Long Run and a major proponent of buy and hold. (We will also dissect Siegel’s arguments.)
Let’s first look at the Barron’s interview (remember, this is 2001), picking it up mid-sentence:
“…And tech and growth will overrun on the downside to become cheaper than normal.”
“Q: Then the worst for those stocks is not behind us?
A: The Internet-telecom-tech bubble was the biggest by far in American history. Bigger than the railroads, bigger than anything. To put it in perspective, the S&P peaked at 21 times earnings in 1929. In 1965, in the other great cycle, the post-war cycle, it again peaked at 21 times earnings. Both cycles were built on incredibly strong earnings and productivity gains. In this cycle the index peaked at 33 times earnings, and as we sit here the S&P’s P/E is at 26 times earnings. [As we will see in later chapters, P/E ratios are now between 30-35. P/E ratios have actually gotten worse, even as the market has dropped.]
“So, how can you believe that there is going to be a permanent low at a P/E higher than the previous highs? There isn’t much hope. My colleague Ben Inker has looked at every bubble for which we have data. His research goes back years and years and includes stocks, bonds, commodities and currencies. We found 28 bubbles. We define a bubble as a 40-year event in which statistics went well beyond the norm, a two-standard- deviation event. Every one of the 28 went back to trend, no exceptions, no new eras, not a single one that we can find in history. The broad U.S. market today is still in bubble territory at 26 times earnings.”
[Let me repeat for emphasis: with no exceptions, bubbles and markets will come back to trend.]
“Q: What P/E represents the old trend-line for the S&P?
A: The long-term average is 14. I believe the P/E will come back to 17 1/2 sometime in the next 10 years. A level of 17 1/2 recognizes the world is a better, safer place and therefore we can pay more for it. [This is pre-9/11.] We think the P/E will trend down gracefully. If it happens more quickly, it will be a lot more painful. If it happens in 10 years, there will only be a modest negative return.”
[If the P/E trends down gracefully, as Grantham asserts, then that means the market will essentially be where it is today ten years from now. There are clear historical precedents for this.
In fact, that is exactly what Professor Robert Shiller said in his book, Irrational Exuberance. He points out that no stock market at the P/E levels we have seen for the past few years has ever returned anything to buy and hold index investors after ten years. Period.]
“Q: You say we’re still in a bubble. Everyone else thinks this is a bear market.
A: The peak was March 2000 and the market has come down a lot, but it has a whole lot further to fall. Great bear markets take their time. In 1929, we started a 17-year bear market, succeeded by a 20-year bull market, followed in 1965 by a 17-year bear market, then an 18-year bull. Now we are going to have a one-year bear market? It doesn’t sound very symmetrical. It is going to take years. We think the 10-year return from this point is negative 50 basis points [a basis point is one one-hundredth of a percentage point] after inflation. We take inflation out to make everything consistent.”
Q: Your outlook is not pretty. Yet, investors appear to be hanging tough. Do you expect that to continue?
A: When a cycle or bubble breaks it so crushes people’s euphoria that they become absolutely prudent for the balance of their careers. I’ve been talking to older people who went through a wipeout and my best guess is about 95% of the people who have been through a bubble breaking never speculate in that asset class again.”
(Ben Stein, actor, lawyer and money maven, tells it another way: “Philip DeMuth, the noted investment psychologist, puts it in a thought-provoking way. As DeMuth sees it, investors who lost big in the tech debacle often cannot bring themselves to sell because that would mean final recognition of their folly in getting in on the wrong side of that bubble. Not only that, but if they sold after colossal losses and the stocks did by some miracle rebound, they would be suicidal. Thus, they refrain from selling because of a combination of fear that they will be wrong again and denial of the finality of the end of the bubble. Through the prisms of fear or just plain self-delusion, investors see hope and keep on buying — a hold is the same as a buy, as Roy Ash taught me long ago — and the market stays at startlingly high levels relative to historic norms. Unless the law of reversion to the mean has been repealed — always a risky bet — these investors, myself included, are likely to feel more pain.”)
A: “….The capital spending cycle is very important to profits, and it is in full-scale retreat. However low interest rates go, who is going to build a plant that they don’t need? No one. So capital spending continues down and corporate earnings are still under pressure.
“….The economic recovery will be quite short, two or three quarters, and weak. And then people will get a whiff of the fact that GNP is going to settle back down into a 1.5% range again, because of the capital-spending bust. Finally the negative savings rate will begin to move up, and that will impact top-line growth. The market is no longer in its old game. But this will not destroy the economy. I am not a big bear on the economy at all.”
“Q: But what about all the talk of productivity gains?
A: People say productivity justified higher P/Es through higher profits. But I’ll give you a simple thought experiment because thought experiments are incredibly useful. Say you come out with a seed corn that is twice as productive — that is, for every dollar of seed it will grow twice as much corn in an acre. Give it to everybody at the same price as the old seed. Productivity will double. But what will happen to the price of corn and what will happen to the profits of the farmers in the following year? I think it is fairly obvious to everybody that they will be drowning in red ink and there will be corn coming out of every silo. Productivity does not necessarily equate with profit.
However, let us give it only to a farmer in Illinois. What will happen to his profits? They will go through the roof. He will grow twice as much corn per cost as everyone else and he will get rich and famous. Productivity gains are fine if there is a monopoly. If productivity is shared by everybody it flows right through to the consumer. We get fat and happy because the price of semiconductors comes crashing down, the power of the machines goes up, everybody has it, it flows through. It is not a competitive advantage and profits are completely unaffected by it. The whole productivity argument was interesting but it has no relevance to how much money the system makes and how high a P/E you should pay for it.”
[For those interested, he believes that there are good opportunities available. He likes bonds, REITS, timber, hedge funds, value stocks and emerging markets.]
The above is consistent with another study by Hussman Econometrics. They calculated that S&P earnings have grown at an average of 5.7% [including inflation] over the last 40 years. Even if the New Era hallucinations were reality – that is, even if the virtual productivity gains became real ones – they suggest there is no reason to think that competition would allow higher rates of profit growth in the future.
What happens next? Rather than another decade of 15% per year growth in stock prices, “a more probable outlook,” says Hussman, “is that earnings will grow at a long-term rate of 5.7% annually and that at the end of 10-20 years the price/record earnings multiple of stocks will be about 15…stocks will be about 13% below current levels a decade from now. Add in dividends and you’re looking at zero total return over a decade.”
It could be worse, they point out. The total return from 1965 to 1982 was minus 20%. “If you are interested in long-term returns,” continue the Hussman team, “it is madness to try to squeeze 9% out of a market which is priced to deliver zero.”
For the last two years, I have been invited to speak at the National Endowments and Foundations Symposium on the prospects for the economy and the markets for the coming year. Interestingly, when I spoke at this conference in early 2002, I was soundly taken to task by some pension/investment consultants for suggesting that the stock market would drop for a third straight year, even as the economy would Muddle Through.
“You must,” I remember one speaker who came after me saying, “have a 22% exposure to large cap growth stocks.” I was dismissed as some kind of troglodyte bear brought in to amuse the locals, as this person noted the long list of large clients and solid pedigree of their firm. How could such a company with so many analysts and Ph.Ds be wrong? I note that I was asked back in 2003 and they were not. Perhaps it was that his advice cost his clients another 20%.
As a recognized expert and leader on investment issues, Millennium Wave Investments president John Mauldin is primarily involved in private money management, financial services, and investments. Visit http://www.JohnMauldin.com for investment advice that works.
