The Last Hurrah
One reason I am parting company with many of mybearish allies for a while is my familiarity with thePresidential Cycle and, critically, what it has taught usabout the power of stimulus and moral hazard to movethe stock market many multiples of their modest effectson the real economy. These lessons seem to me to beparticularly relevant today.This Presidential Cycle effect is dismissed as an artifactby the great majority of
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nancial academics, but theyhave a stalwart record of dismissing any data that implieseven modest market inef
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ciency, and this effect impliesgreat dollops of inef
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ciency. Simply summarized: since1932, in the third year of the Presidential Cycle, theaverage S&P 500 return (from October 1 to October 1)is 22 percentage points ahead of the average of yearsone and two! And this is statistical noise? Year threeis the time when, driven by politics,
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nancial stimulusand moral hazard are applied so that the economy –particularly increases in employment – can be a littlestronger in the run-up to the election in year four. Inyears one and two, in contrast, the system is tightened inorder to leave some room for re-stimulus in the next yearthree (except during Greenspan’s era, when he basicallycould never stop stimulating and so periodically upset theapplecart). It is all pretty understandable. All we haveto believe is that politicians like to be reelected and thatcompletely independent Fed chairmen like to play ballwith politicians. (Volcker of course, unlike the others,was never a ball player.) There have been no serious bearmarkets in year three, and many in years one and two.In our search for what actually caused this magni
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centlylarge effect, we have been unable to
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nd more than a verymodest tendency for rates or money supply to increaseabove trend in year three. From this historical lack of
GMO
Q
UARTERLY
L
ETTER
May 2009
The Loss of “Near Certainties” in Investing
First, let me lament the loss of near certainties in investing.The
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nancial and economic collapse that I described as “themost widely predicted surprise in the history of
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nance”about 18 months ago is behind us. More precisely, webelieved that bubbles had formed in global pro
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t margins,risk premiums, and U.S. and U.K. housing prices, andthat all three were “near certainties” to break, with severeconsequences for the economic and
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nancial system. Allhave thoroughly burst and are in their overcorrectionphase with the single exception of U.K. house prices,which I’m con
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dent will do their duty. Normally thereare, of course, no near certainties in investing. Life is notmeant to be that easy. Asset allocators have been blessedin the last 10 years with a large collection of extraordinaryoutliers. As my favorite quote by Mandelbrot (1983) says,“Even though economics is a very old subject, it has nottruly come to grips with the main dif
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culty, which is theinordinate practical importance of a few extreme events.”If this last 10 years did not prove him right, nothingwill. Since 1988, we have been offered 8 or 10 2-sigmaevents. (A 2-sigma event is our de
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nition of an importantbubble or bust.) All of these events were bubbles, and allbehaved themselves by bursting. Now, sadly, there areprobably none. Government bonds are the one seriouscandidate. In our opinion, they are badly overpriced butprobably not by enough to justify the bubble title. Globalequity markets are still cheap, but in major markets arenowhere near 2-sigma, 40-year bust levels. Some small-scale 2-sigma bargains may exist in the
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xed incomemarkets in rate differentials, but need skillful analysis andknowledge to disentangle from value traps. And, theyare a very far cry from, say, the opportunities offered bybuying credit default swaps at a handful of basis pointson overleveraged
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nancials in early 2007. So, all in all,welcome back to the age of guesswork.
The Last Hurrah and Seven Lean Years
Jeremy Grantham
2
GMO
Quarterly Letter – May 2009
rapid monetary expansion, we make two guesses. First,we assume that stock markets are far more sensitive to
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nancial stimulus than is the battleship GDP. The liquidityand other
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nancial encouragement required to move thebattleship a degree or two is apparently enough to have avery material effect on stocks. Stocks are simply muchmore sensitive to stimulus than the economy. The secondguess is that the Fed’s moral hazard is far more importantthan we realize, and is far more effective at movingmarkets than the modest
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nancial adjustments. Theimplied promise to bail out speculators in years three andfour if anything goes wrong, but to leave them hanging inyears one and two (again, Greenspan excepted), is whatdrives this. Never underestimate the power of the Fed(or the Fed’s willingness to deny its own in
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uence whenit suits). The best proof of this power has always beenthat the U.K. has shown a bigger year three jump on ourPresidential Cycle than the U.S. has since 1932! Europeand even distant Japan also show a pronounced sympathywith the U.S. cycle.Which brings us to this present case. Forget the traditionalPresidential Cycle effect for the time being: Greenspanruined it by overstimulating again in 2005 and 2006. Justbear our two principles in mind. If the stock market ismany times more sensitive to
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nancial stimulus in theshort term than the economy is, then we could easily geta prodigious response to the greatest monetary and
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scalstimulus by far in U.S. history. Second, if you don’t think there is a special, one-off, super colossal dose of moralhazard out there today, you are sadly uninformed. Themoral hazard in play today is of a massively larger orderthan any we have ever seen. (But given how strangelyselective the moral hazard or bailouts have been, it isenough to make those susceptible to conspiracy theoriesthink in terms of a
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nancial ma
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a led by You-Know-Who.Too much seems to depend on which friends you have.)So by analogy to the normal Presidential Cycle effect,driven by stimulus and moral hazard, we are likely to havea remarkable stock rally, far in excess of anything justi
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edby either long-term or short-term economic fundamentals.My guess is that the S&P 500 is quite likely to run for awhile, way beyond fair value (880 on our revised data),to the 1000-1100 level or so before the end of the year.(For the record, I presented this case six weeks ago inEurope at 725 on the S&P, but was sadly distracted in myquarterly letter writing by a trip to Bhutan. Poor thing.I won’t complain, though, since my “Reinvesting WhenTerri
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ed” was posted on the day the market hit its low.You win some and you lose some.)The market always anticipates an economic recoveryand, sometimes, it must be admitted, there are severalfalse moves (“suckers’ rallies”) before the recovery takesplace. The current stimulus is so extensive globally thatsurely it will kick up the economies of at least some of thelarger countries, including the U.S. and China, by late thisyear or early next year. (This seems about 80% probableto me, anyway.) Anticipating this, we should expect astock market recovery – which normally leads economicrecovery by six months, plus or minus two – sometimebetween two months ago and, say, August, which the astutereader will realize implies that this rally may already beit. This was part of the logic behind my March posting,“Reinvesting When Terri
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ed”: the uncertainties of theeconomy are so great that when the uncertainties of thestock market’s anticipation are laid on top of them, yousimply must have big ranges of outcomes and hedge yourbets. Unless you have extreme luck or divine guidance,you will never catch the low. Alternatively, there is stilltime – just – for another freefall leg, but time is runningout. Investor con
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dence is still fragile, and should weget a series of particularly shocking data points, which,in the unique position we
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nd ourselves is quite possible(say, one out of three), then con
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dence could crack onemore time and the market could go to a new low beforethe major anticipatory rally I’m describing. (This wouldmake the current rally a short-term head fake.) In a rallyto 1000 or so, the normal commercial bullish bias of themarket will of course reassert itself, and everyone and hisdog will be claiming it as the next major multi-year bullmarket. But such an event – a true lasting bull market – ismost unlikely. A large rally here is far more likely to provea last hurrah … a codicil on the great bullishness we havehad since the early 90s or, even in some respects, since theearly 80s. The rally, if it occurs, will set us up for a long,drawn-out disappointment not only in the economy, butalso in the stock markets of the developed world.
Bulls vs. Bears
Resolute bears will point out (as we have) that the lowof other major market breaks has been far lower thanthis one, and they would be correct. Compared to ourrevised fair value estimate of 880 for the S&P and itscurrent recent devilish low of 666, the bottoms of otherimportant comparative bear markets were much more
3
GMO
Quarterly Letter – May 2009
impressive. On a similar basis, the low in 1921 – the postWWI depression – was about 300; the U.K. in 1974 wasat the current S&P equivalent of about 300. In 1982 and1974, the lows in the U.S. were equal to about 450. Of oursix best comparable examples, only in Japan, three yearsinto the market crash, was the market still above 880equivalent. Admittedly, I don’t yet know enough about1921, but as for the others, I could offer good reasons whytheir lower levels might be understandable. One group(the U.K. and the U.S. in 1974 and the U.S. in 1982) hadvery high interest rates providing formidable short-termcompetition with stocks. (In the long term, the Fed Modellogic is simply false, but in the short term – up to a year –it does work for behavioral reasons.) These markets alsohad very high in
fl
ation, which in the short to intermediateterm has a compelling explanatory power for P/E ratios.To keep it simple, high in
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ation rates typically comewith lower than average P/Es and vice versa. A thirdfactor in all three cases was a crisis in oil supply and theaccompanying much higher oil prices. So without theseextra negative factors, the current market seems unlikelyto overcorrect below fair value quite as badly as theseprior bear markets have.The other two setbacks that we consider most useful forcomparison purposes – 1932 in the U.S. and Japan in1990 – were quite different. Both came with low ratesand de
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ationary pressures, and each had extremelyserious economic setbacks, with the wheels falling off the economic machine, a condition that certainly doesapply this time. On the other hand, in neither case didthey receive massive international stimulus. In Japan,the authorities delivered reluctant piecemeal stimulus.Interestingly, they now strongly warn against othercountries copying their strategy, which they now deeman expensive failure, both in terms of growth and time.In 1932 the stimulus in the U.S. was on-again/off-again,on a trial and error basis, and usually with some elementsoffsetting others so that the stimulus program is judgedto have been a partial or even substantial failure. Incomparison, the response to today’s crises is the
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rsttime that there has been even an attempt at a coordinatedglobal policy. In some cases, including that of the U.S.,the degree of stimulus far exceeds any previous efforts. Ithas also been initiated quite quickly despite the criticisms.So the effect of the stimulus might well kick up in time toclip off the last stage of the bear market, and this is whatI think will happen.(In this respect, George Soros’ re
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exivity can come intoplay: a false dawn can alter the eventual outcome as itchews up time. For example, in June 1932 market playerssaw illusory light at the end of the tunnel. In two months,the market rose almost vertically, climbing 110%! Forfour more months it held the gain and then, confrontedwith continued unrelieved bad news, sank steadily forsix months so that one year after the rally began it wasup only 35%. But this is the key: by then – a year later– there really was light at the end of the tunnel and themarket rose again, 130% in eight months. And this timeit did not give it back. If investors had jumped into atime machine back in June of 1932 and had been ableto see how bad things would look in 9 to 12 months, itseems nearly certain the market would have gone lower.In this way, one or two false hopes can protect againstlows that a more realistic view would cause. And I think it is likely to do so this time. Although the economy islikely to kick up in the next 12 months (although far froma near certainty) and be anticipated by the stock market,I believe it is likely that the longer-term health of theeconomy will be exaggerated. In time – perhaps a yearinto the recovery – the economy will slow once again andstay disappointingly below the standards to which wehave become accustomed over the last several decades.)But for this current market setback, it seems reasonablethat we would do less badly than all of these previousworst cases. We are not trying to be bullish and we haveno reputation as bulls, but – for a second ignoring thecurrent rally, which is so sharp as to bear out my warningsof March – three months ago we at GMO collectivelyconsidered that a range of 550-650 for the S&P was aboutright for the low this time.
Reinvesting When Not Quite Terri
fi
ed
My March note suggested that it is psychologically verydif
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cult to reinvest any cash once a crash in the market andthe economy has really frightened you. The antidote is tohave a simple battle plan of determining levels at whichto reinvest and to stick to it absolutely. We could call thatPlan A. It is ideal for dealing with a market meltdown,which should be any asset allocator’s dream: to be able tomake wonderfully cheap investments. Investors, though,also need a Plan B for investing if the market bouncesback up but stays either cheap – that is to say below fairvalue, currently at 880 on the S&P in our view – or closeenough that investors can still expect a decent return
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