Escolar Documentos
Profissional Documentos
Cultura Documentos
QUARTERLY LETTER
January 2009
Obama and the Teflon Men, and Other Short Stories. Part 1.
Jeremy Grantham
With economies and financial markets, it seems that if you 1. The Story So Far: Greed + Incompetence +
stare hard enough and long enough at the fog of battle, A Belief in Market Efficiency = Disaster
you occasionally get a glimpse of what may be going on Greed and reckless overconfidence on the part of almost
when a favorable wind blows. This, for me, is decidedly everyone caused us to ignore risk to a degree that is
not one of those occasions. It is obvious to all of us that probably unparalleled in breadth and depth in American
these are momentous days in which government actions history. Even more remarkable was the lack of insight
may well have make-or-break impact, but my confidence and basic competence of our leadership, which led them
in government and leadership is at a low ebb. (Although to ignore this development, or worse, to encourage it.
I must admit my confidence has increased enormously Ingenious new financial instruments certainly facilitated
in recent weeks in all areas outside of finance. Even in and exaggerated these weaknesses, but they were not the
finance it has increased a little.) Economic advice for most potent ingredient in our toxic stew. That honor goes
President Obama covers the waterfront, and even the near- to the economic establishment for building over many
consensus case for great stimulus is lacking in historical decades a belief in rational expectations: reasonable,
certainties or intellectual rigor. Everyone seems to be economically-induced behavior that would always
guessing at strategies and outcomes, knowing clearly that guarantee approximately efficient markets. In their desire
the best strategy would have been to have avoided getting for mathematical order and elegant models, the economic
into this pickle. The current disaster would have been easy establishment played down the inconveniently large role
to avoid by making a move against asset bubbles early in of bad behavior, career risk management, and flat-out
their lifecycle. It will, in contrast, be devilishly hard to bursts of irrationality. The dominant economic theorists so
get out of. But, we are deep in the pickle jar, and it seems valued orderliness and rationality that they actually grew
likely that, in terms of economic pain, 2009 will be the to believe it, and this false conviction became increasingly
worst year in the lives of the majority of Americans, Brits, dangerous. It was why Greenspan and Bernanke were not
and others. So break a leg, everyone! sure that bubbles – outbursts of serious irrationality – could
It would be helpful at a time like this to have a Quarterly even exist. It was why Bernanke, who had studied the
Letter that sounded convinced of something … anything. bubble of 1929, could still not see it as proof of irrationality
So I apologize for overtly tickling around the edges. and could still view the Depression (à la Milton Friedman)
I do not apologize, though, for pointing you to the best as a mere consequence of incredibly bad, easily avoidable
thing I have read in The New York Times in a very long policy measures. Of more recent importance, it was why
time: the article by Lewis and Einhorn1 does a great job Bernanke could dismiss a dangerous 100-year bubble in
of summarizing where we are and how we got here, as U.S. housing as being nonexistent. It was why Hyman
well as offering some helpful advice for the future. My Minsky was marginalized as an economist despite his
contribution is to address a few peripheral topics that have brilliant insight of the “near inevitability” of periodic
accumulated over recent quarters as more important topics financial crises. It was why the suggestion in academic
have dominated. Half of the mini topics are covered in this circles of stock market inefficiencies, let alone major
Letter, and the other half will be posted in a few weeks. dysfunctionality, was considered a heresy. It was why
Burton Malkiel could rationalize the 1987 crash as being
an efficient response to 12 or so triggers. These triggers,
1 Michael Lewis and David Einhorn, “The End of the Financial World as We
however, had a trivial weakness: seasoned portfolio
Know It,” The New York Times, January 4, 2009. This article is available
online at www.nytimes.com. managers at the time had never even heard of most of
them. Never underestimate the power of a dominant At times like this, animal spirits need nurturing. Obama’s
academic idea to choke off competing ideas, and never election will help, at least for a while; talking up the power
underestimate the unwillingness of academics to change of stimulus will help (whether or not the power is really
their views in the face of evidence. They have decades there), and avuncular, optimistic advice from influential
of their research and their academic standing to defend. figures will not go amiss.
The incredibly inaccurate efficient market theory was
But let us look for a minute at the extent of the loss in
believed in totality by many of our financial leaders, and
perceived wealth that is the main shock to our economic
believed in part by almost all. It left our economic and
system. If in real terms we assume write-downs of 50%
governmental establishment sitting by confidently, even
in U.S. equities, 35% in U.S. housing, and 35% to 40%
as a lethally dangerous combination of asset bubbles, lax
in commercial real estate, we will have had a total loss
controls, pernicious incentives, and wickedly complicated
of about $20 trillion of perceived wealth from a peak
instruments led to our current plight. “Surely none of this
total of about $50 trillion. This relates to a GDP of about
could happen in a rational, efficient world,” they seemed
$13 trillion, the annual value of all U.S. produced goods
to be thinking. And the absolutely worst aspect of this
and services. These write-downs not only mean that
belief set was that it led to a chronic underestimation of
we perceive ourselves as shockingly poorer, they also
the dangers of asset bubbles breaking – the very severe
dramatically increase our real debt ratios. Prudent debt
loss of perceived wealth and the stranded debt that comes
issuance is based on two factors: income and collateral.
with a savage write-down of assets. Well, it’s nice to get
Like a good old-fashioned mortgage issuer, we want the
that off my chest once again!
debt we issue to be no more than 80% of the conservative
asset value, and lower would be better. We also want
2. Lost Illusions: The Loss of Perceived Wealth and the income of the borrower to be sufficient to pay the
Stranded Debt interest with a safety margin and, ideally, to be enough to
During the market’s rise, I wrote about the fallacy of paper amortize the principal slowly. On this basis, the National
wealth, particularly as it applied to houses. At three times Private Asset Base (to coin a phrase) of $50 trillion
the price, they were obviously still the very same houses. supported about $25 trillion of private debt, corporate
How could we kid ourselves that we were suddenly rich and individual. Given that almost half of us have small
and didn’t need to save for our pensions when we were or no mortgages, this 50% ratio seems dangerously high.
sitting in the very same buildings we bought in 1974? But now the asset values have fallen back to $30 trillion,
With “wealth” built on such false premises, it is not whereas the debt remains at $25 trillion, give or take the
surprising that we come to grief from time to time. But miserly $1 trillion we have written down so far. If we
the good news is that, as we move back down to earlier would like the same asset coverage of 50% that we had a
prices, they are still the same houses. We have not lost year ago, we could support only $15 trillion or so of total
wealth, but just the illusion of wealth. Illusions tend not debt. The remaining $10 trillion of debt would have been
to have very long-lasting effects, but they obviously can stranded as the tide went out! What is worse is that credit
and do have very powerful short- and even intermediate- standards have of course tightened, so newly conservative
term effects. This particular illusion, which applied to lenders now assume the obvious: that 50% was too high,
stocks, real estate, art, and almost everything else, was and that 40% loan to collateral value or even less would
grand indeed, and it directly over-stimulated consumption be more appropriate. As always, now that it’s raining,
and indirectly over-stimulated imports. In the process, bankers want back the umbrellas they lent us. At 40% of
it suppressed both savings and investments of our own $30 trillion, ideal debt levels would be $12 trillion or so,
locally generated income. (Although there was plenty of almost exactly half of where they actually are today! It is
foreign investment into the U.S. to fill the gap, which has obvious that the scale of write-downs that we have been
its own long-term complications.) reading about in recent months of $1 trillion to $2 trillion
will not move our system anywhere near back to a healthy
Now the illusion of wealth has been lost, with formidably balance. To be successful, we really need to halve the
negative effects on animal spirits. My hero, Keynes, level of private debt as a fraction of the underlying asset
emphasized the importance of shifts in animal spirits in values. This implies that by hook or by crook, somewhere
economics, and explained how shifts in such spirits could between $10 trillion and $15 trillion of debt will have to
ruin the most carefully calculated investment decisions. disappear. Given where we are today, there are only three
Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending January 21, 2009, and are subject to change at any time based
on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to
specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell
such securities.
Copyright © 2009 by GMO LLC. All rights reserved.
Obama and the Teflon Men, and Other Short Stories. Part 2.
Jeremy Grantham
1. The Year of the Value Trap of over-discounting and handsome recovery has taken
Since time immemorial, the most successful value place dependably for several cycles in a row. It begins
investors have been the bravest. The greatest advantage to look like the natural, even inevitable, nature of things
of value investing has always been that when your cheap rather than merely the most usual outcome. The growth
stock goes down in price, it gets even cheaper and more in the number of quantitative investors exaggerated this
attractive. This is the complete opposite of momentum tendency because quants model the last 10 or 20 years (or
stocks, which lose their momentum rating as they decline even 40) without really requiring a full understanding of
and hence become unattractive. But averaging down the very long-term pattern and why it behaves the way
in value stocks can take lots of nerve and considerable that it does. And none of us modeled data that included
ability in convincing anxious clients of the soundness of the last great value trap: the Great Crash of 1929.
the strategy. For at least 60 years, those value investors In mild economic setbacks, even the wounded value
who managed these problems and bought more of the stocks recover fully. In substantial setbacks, a very small
stocks that had tumbled the most emerged with both the number fail, but not nearly enough to offset the large
strongest performance and the most business success. (Of discounts. Only in the really severe economic setbacks
course, analytical skills also help, but let’s assume that do enough casualties occur to bring home a truth: price-
these skills were distributed evenly between brave and to-book (P/B) and price-to-earnings (P/E) are risk factors.
nervous investors.) Major market declines in the past set Buying them and averaging down routinely has an element
up the best opportunities for brave value managers: the of picking up not nickels in front of the steamroller – that
50% declines of 1972-74 and 2000-02. Value investors would belittle the substantial returns – but, say, $1000
in 1972 and 2000 were also able to buy value stocks at bills in front of the steamroller. Because of the extra
their biggest discounts to the general market at least since discounts for career risk in the long run (at least for those
1945. In addition, averaging down in those value stocks who are not dead), the strategy will probably still pay off
that fell the most eventually added substantially to an even if the rare, severe fundamental crises are included.
already strong return. Those value managers with the But investors should be aware that the fundamental part
best analytical skills within this group became the few of the risk premium is justified by the pain of these outlier
handfuls of super-successful investors. events and is absolutely not a free lunch.
Outsiders could view this as a return to bravery, but it The value problems of the last two years were particularly
was also a return to risk. The cheapest price-to-book bad because of the outperformance that value stocks had
stocks are those deemed by the market to have the between 2002 and 2007. They won for five years in a row,
least desirable assets. And Mr. Market is not always so that by mid 2007 the value/growth spread was about
a complete ass. Because these companies are so often as unfavorable as possible for value stocks in the U.S.
obviously undesirable and are seen as such by clients, (see Exhibit 1). (We recognize that some value investors
they represent a career or business risk to the manager disagreed with this data when it was first presented. We
who owns them. This career risk is usually reflected in an were, and still are, puzzled by how they arrived at their
extra discount that will deliver an extra return for bearing more positive conclusion.)
the career risk. This “career risk” return is in addition
to the discount for buying lower quality companies with To put a measure on how awful the value trap was
more fundamental risk. Problems arise when this pattern during this time, please see the Fall 2007 edition of
Exhibit 1
Price to Book – Cheapest Quartile vs. Expensive Quartile
0.8
0.7
0.6
0.5
PB/PB
0.4
0.3
0.2
0.1
0.0
Dec-65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07
Source: GMO As of 1/31/09
the Outstanding Investor Digest. This publication answer clearly. On the one hand, value stocks are now at
concentrates on a dozen or so of the top value investors least much cheaper on a relative basis than they were a
and is readable, interesting, and chock-full of insight. year ago. On the other hand, they can get a lot cheaper,
However, that particular issue is a heartbreaker as one and they face the worst economy since 1938. I would give
after another of these superior investors put forward the them at best a 50/50 bet this year. (“Thank you very much
case that – down 30% to 50% – AIG, Lehman, Wachovia, for such useful advice!”)
Fannie Mae, etc., were ridiculously underpriced, and
represented enormous long-term franchise value that the 2. GMO’s Central Skill Set and Loss of Near
nervous market was missing. Certainties
It has long been my view that the pricing of value stocks That last point leads neatly into one of my principal
has a folk memory of the Great Depression when many regrets: in recent years we have been spoiled by the market
cheap companies went bust and the expensive Coca- in that we were presented with investment opportunities
Colas survived the best. Remember, you cannot regress that seemed to us to be near certainties, which we define
from bankruptcy. Using proprietary research data, we as probabilities over 0.9. Our principal skill has been
examined one fixed time slot: October 1929 to June 1932. to study major upside outliers or bubbles in all financial
With no rebalancing, the data showed a massive “value” series, trying to understand and recognize their patterns.
wipeout in which high P/E stocks declined far less than That’s it. Not a profound exercise. In fact, my hero
low P/E stocks. Keynes was quite disrespectful of this exercise. You are
probably familiar with his famous quote from 1923, “But
As we have pointed out before, one thing is certainly true: this long run is a misleading guide to current affairs. In
on fundamental measures of risk – level of profitability, the long run we are all dead.” What you may be unaware
volatility of profitability, and debt levels – stocks with low of is how it continues: “Economists set themselves too
P/B and P/E ratios have much lower “quality” and should easy, too useless a task if in tempestuous seasons they
be expected to be hurt badly in a very serious economic can only tell us that when the storm is long past the
setback such as the one we are now experiencing. And ocean is flat again.” Presumably, he would have been
so it was that many of the very best investors had their equally contemptuous of the reverse: the prediction that
very worst year in 2008, and were exceedingly happy to after a long calm, you had better be prepared for another
see the back of it. Whether 2009 will see a snapback for storm sooner or later. I believe it is a rare example of
value is an important question, and not one that we can Keynes simply being wrong in both cases. Ironically, for
Now, regrettably in some ways, the outliers and near 3. On Exiting a World of Bubbles and Entering a
certainties are ending. It is still nearly certain that World of Busts
global profit margins will decline a lot further. But it
Economic wipeouts and severe market over-corrections,
is no longer certain that this belief is not reflected fully
should they arrive, are second best for us. It is true that they
in stock prices. It is merely likely that it is not, and that
are outliers, but busts are not so dependable as bubbles.
stock prices will therefore decline to new lows. Perhaps
In contrast to Greenspan’s reluctance and vacillation in
the odds are 2 to 1, which is a very good bet, but far from
recognizing bubbles and Bernanke’s dismissal of their
the rare 9 to 1 odds of a near certainty. Similarly, U.S.
existence, bubbles do, of course, exist. More to the
house prices are very likely to decline their last 5% to
point, they always, always break, and their breaking
trendline and, since it was an extreme bubble, to overrun
is the most dangerous situation the Fed – or the whole
by, say, another 10%. But, again, this is at best a 2 to 1
economy, for that matter – ever faces. Similarly, strong
bet. Yes, a bet that U.K. house prices will continue to
economies and heroic profit margins always weaken. In
decline is a lay-up, but it has always been hard to play.
crunches, you must lower the odds of regression back to
Its main effect now will be to impose a lot more pain on
normal to “nearly always.” On rare occasions, you can
a system already so weakened that it makes it very likely
stay down for the duration. If, like Zimbabwe, you really
that more bailouts or the nationalization of U.K. financial
want to take your country back to the Stone Age, you can
companies will continue. Weakness in the pound was my
probably do it. (Thank goodness for term limits in the
favorite near certainty in the U.K., but that was at over $2
U.S.) Argentina, the fourth richest country in 1945, has
to the pound. It is now at under $1.50 and, like the other
taken its very best shot at resisting the tendency to revert
1 Danger: Steep Drop Ahead, Fortune, September 17, 2007. back upward to normal, and is still trying hard. If you
Exhibit 2
GMO 7-Year Asset Class Return Forecasts* as of December 31, 2007
7%
Stocks Bonds Other
5.0%
5%
Annual Real Return Over 7 Years
4%
3% 2.7%
1.9%
2%
1.4%
1.2%
0.9%
1% 0.6%
0.2% 0.0%
0%
-1%
-0.8%
-1.1%
-2% -1.6%
-3%
U.S. U.S. U.S. High Int'l. Int'l. Equities U.S. Bonds Int'l. Bonds Bonds Bonds U.S. Managed
equities equities Quality equities equities (emerging) (gov't.) (gov't.) (emerging) (inflation treasury Timber
2 2
(large cap) (small cap) (large cap) (small cap) indexed) (30 days to
2 yrs.)
Estimated Range of
7-Year Annualized Returns ±6.5 ±7.0 ±6.0 ±6.5 ±7.0 ±10.5 ±4.0 ±4.0 ±8.5 ±1.5 ±1.5 ±5.5
*The chart represents real return forecasts1 for several asset classes. These forecasts are forward-looking statements based upon the
reasonable beliefs of GMO and are not a guarantee of future performance. Actual results may differ materially from the forecasts above.
1 2
Long-term inflation assumption: 2.5% per year. Return forecasts for international equities are ex-Japan.
Source: GMO
Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending February 11, 2009, and are subject to change at any time based
on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to
specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell
such securities.
Copyright © 2009 by GMO LLC. All rights reserved.