Risk Latte - On Grantham and Mount Fuji!

On Grantham and Mount Fuji!

Aditya Rana
May 01, 2010

We have yet another great quarterly from Jeremy Grantham who runs the well-known money manager GMO prompted me to write a brief note. To summarise:

  • The market has had a record rally, being up 80% for the year which is second only to the recovery rally in 1932. despite being hammered twice in the last 10 years, investors are furiously back in the game and it seems likely that the rally has more to go.

  • The Fed, by maintaining a long period of artificial low rates and easy financial borrowing, is “helping us up and then lead us down the cliff again”.

  • The sharp market recovery is despite the backdrop of an economy limping back into action and facing tough structural headwinds in terms of rising housing mortgage defaults, continued repayment of consumer debt, refinancing risk in commercial real estate and private equity and stubbornly high unemployment levels.

  • The Fed will certainly keep rates low for an extended period of time if the economic recovery is slow, likely leading to more speculation and higher stock prices from already very overpriced levels.

  • However, if we get a strong, broad based economic recovery, interest rates are likely to rise leading to a reasonable (but not disastrous) correction in the stock market (30% probability).

  • The real risk is that if markets go up by another 30-40% over the next 18 months or so, thereby creating a third bubble that would cause an even bigger shock to the economic and financial system as governments would not have the resources to deal with the aftermath (49% probability).

  • However, if we continue with a weak economic recovery, we should hope that we get an event which breaks the speculative spirit before a bubble is created – and the event could come from a variety of sources – a down leg in housing prices, refinancing issues in commercial real estate or private equity, a sovereign crisis in europe, a surge in commodity prices, trade wars, a serious setback in china...(21% probability).

  • An important factor supporting a further rally into 2011 is that , since 1932, markets have not had a serious decline in the 3rd year of a presidential cycle – even when they have got seriously overpriced.

  • In this environment the U.S. high quality stocks provide a relatively attractive expected real returns of 5% over the next 7 years; emerging markets provide the potential to participate in a bubble as they could end-up trading at a 25-50% premium to developed markets in a few years.

Grantham has also attached a copy of an interesting speech he made to the benjamin graham and david dodd investment club – some insightful nuggets:

  • “The only things that really matter in the investing business are the bubbles and busts”..the rest of time “just keep your nose clean and you will be fine”!

  • “The only things that really matter in the investing business are the bubbles and busts”..the rest of time “just keep your nose clean and you will be fine”!

  • A bubble is defined as a 2-sigma event divergence from the trend line – i.e. an event which would occur every 40 years under normal conditions, and there have been 34 of them in history. every single one of them have broken back towards the trend line (an average decline of 40%) and there are no exceptions.

  • The two existing bubbles out of the 34 to date are the U.K. and the Australian housing bubbles – and if they do not deflate then that would be the first time in history that such an event has taken place.

  • The ”reversion to mean” principle of financial markets is most predictable for asset classes (rather than countries, sectors or individual stocks)- and when a bubble appears in an asset class it is almost certainly going to burst.

  • High quality stocks (i.e. stocks with high profitability, low profit volatility and minimal use of leverage – like Coca-Cola, Johnson & Johnson, Microsoft) have outperformed by 40% over the last 50 years. this is a “free lunch” when compared to other yardsticks of value investing-low p/b ratios or small caps.

Grantham is always thought provoking reading – and the three scenarios he has outlined are spot on. however, in terms of probability, i would put a higher probability (say 40%)to the scenario where we get a shock from one of the multiple sources he describes (i would add a gdp shock to the list as well) , leading to a 30% to 40% correction in the market later this year or in early 2011. while there is a decent probability (30%) we inflate a new bubble into 2011 – the aftermath would be an unmitigated disaster and i think policy makers would do their utmost to try and prevent a third bubble from forming (a view expressed by andrew smithers and summarised in an earlier blog).

On mount Fuji

A great chart (though not quite as symmetrical as fuji!) from economist & financial commentator Mish Shedlock which depicts the rise and fall of land prices in japan – together with typical views which were expressed about the market at the relevant times of the cycle. the dates in red highlight the progress of the u.s. housing market which follows an eerily similar pattern. others to follow - U.K., Australia, Hong Kong, China?

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