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QUARTERLY LETTER
May 2009
First, let me lament the loss of near certainties in investing. One reason I am parting company with many of my
The financial and economic collapse that I described as “the bearish allies for a while is my familiarity with the
most widely predicted surprise in the history of finance” Presidential Cycle and, critically, what it has taught us
about 18 months ago is behind us. More precisely, we about the power of stimulus and moral hazard to move
believed that bubbles had formed in global profit margins, the stock market many multiples of their modest effects
risk premiums, and U.S. and U.K. housing prices, and on the real economy. These lessons seem to me to be
that all three were “near certainties” to break, with severe particularly relevant today.
consequences for the economic and financial system. All
This Presidential Cycle effect is dismissed as an artifact
have thoroughly burst and are in their overcorrection
by the great majority of financial academics, but they
phase with the single exception of U.K. house prices,
have a stalwart record of dismissing any data that implies
which I’m confident will do their duty. Normally there
even modest market inefficiency, and this effect implies
are, of course, no near certainties in investing. Life is not
great dollops of inefficiency. Simply summarized: since
meant to be that easy. Asset allocators have been blessed
1932, in the third year of the Presidential Cycle, the
in the last 10 years with a large collection of extraordinary
average S&P 500 return (from October 1 to October 1)
outliers. As my favorite quote by Mandelbrot (1983) says,
is 22 percentage points ahead of the average of years
“Even though economics is a very old subject, it has not
one and two! And this is statistical noise? Year three
truly come to grips with the main difficulty, which is the
is the time when, driven by politics, financial stimulus
inordinate practical importance of a few extreme events.”
and moral hazard are applied so that the economy –
If this last 10 years did not prove him right, nothing
particularly increases in employment – can be a little
will. Since 1988, we have been offered 8 or 10 2-sigma
stronger in the run-up to the election in year four. In
events. (A 2-sigma event is our definition of an important
years one and two, in contrast, the system is tightened in
bubble or bust.) All of these events were bubbles, and all
order to leave some room for re-stimulus in the next year
behaved themselves by bursting. Now, sadly, there are
three (except during Greenspan’s era, when he basically
probably none. Government bonds are the one serious
could never stop stimulating and so periodically upset the
candidate. In our opinion, they are badly overpriced but
applecart). It is all pretty understandable. All we have
probably not by enough to justify the bubble title. Global
to believe is that politicians like to be reelected and that
equity markets are still cheap, but in major markets are
completely independent Fed chairmen like to play ball
nowhere near 2-sigma, 40-year bust levels. Some small-
with politicians. (Volcker of course, unlike the others,
scale 2-sigma bargains may exist in the fixed income
was never a ball player.) There have been no serious bear
markets in rate differentials, but need skillful analysis and
markets in year three, and many in years one and two.
knowledge to disentangle from value traps. And, they
are a very far cry from, say, the opportunities offered by In our search for what actually caused this magnificently
buying credit default swaps at a handful of basis points large effect, we have been unable to find more than a very
on overleveraged financials in early 2007. So, all in all, modest tendency for rates or money supply to increase
welcome back to the age of guesswork. above trend in year three. From this historical lack of
rapid monetary expansion, we make two guesses. First, Terrified” was posted on the day the market hit its low.
we assume that stock markets are far more sensitive to You win some and you lose some.)
financial stimulus than is the battleship GDP. The liquidity
and other financial encouragement required to move the The market always anticipates an economic recovery
battleship a degree or two is apparently enough to have a and, sometimes, it must be admitted, there are several
very material effect on stocks. Stocks are simply much false moves (“suckers’ rallies”) before the recovery takes
more sensitive to stimulus than the economy. The second place. The current stimulus is so extensive globally that
guess is that the Fed’s moral hazard is far more important surely it will kick up the economies of at least some of the
than we realize, and is far more effective at moving larger countries, including the U.S. and China, by late this
markets than the modest financial adjustments. The year or early next year. (This seems about 80% probable
implied promise to bail out speculators in years three and to me, anyway.) Anticipating this, we should expect a
four if anything goes wrong, but to leave them hanging in stock market recovery – which normally leads economic
years one and two (again, Greenspan excepted), is what recovery by six months, plus or minus two – sometime
drives this. Never underestimate the power of the Fed between two months ago and, say, August, which the astute
(or the Fed’s willingness to deny its own influence when reader will realize implies that this rally may already be
it suits). The best proof of this power has always been it. This was part of the logic behind my March posting,
that the U.K. has shown a bigger year three jump on our “Reinvesting When Terrified”: the uncertainties of the
Presidential Cycle than the U.S. has since 1932! Europe economy are so great that when the uncertainties of the
and even distant Japan also show a pronounced sympathy stock market’s anticipation are laid on top of them, you
with the U.S. cycle. simply must have big ranges of outcomes and hedge your
bets. Unless you have extreme luck or divine guidance,
Which brings us to this present case. Forget the traditional you will never catch the low. Alternatively, there is still
Presidential Cycle effect for the time being: Greenspan time – just – for another freefall leg, but time is running
ruined it by overstimulating again in 2005 and 2006. Just out. Investor confidence is still fragile, and should we
bear our two principles in mind. If the stock market is get a series of particularly shocking data points, which,
many times more sensitive to financial stimulus in the in the unique position we find ourselves is quite possible
short term than the economy is, then we could easily get (say, one out of three), then confidence could crack one
a prodigious response to the greatest monetary and fiscal more time and the market could go to a new low before
stimulus by far in U.S. history. Second, if you don’t think the major anticipatory rally I’m describing. (This would
there is a special, one-off, super colossal dose of moral make the current rally a short-term head fake.) In a rally
hazard out there today, you are sadly uninformed. The to 1000 or so, the normal commercial bullish bias of the
moral hazard in play today is of a massively larger order market will of course reassert itself, and everyone and his
than any we have ever seen. (But given how strangely dog will be claiming it as the next major multi-year bull
selective the moral hazard or bailouts have been, it is market. But such an event – a true lasting bull market – is
enough to make those susceptible to conspiracy theories most unlikely. A large rally here is far more likely to prove
think in terms of a financial mafia led by You-Know-Who. a last hurrah … a codicil on the great bullishness we have
Too much seems to depend on which friends you have.) had since the early 90s or, even in some respects, since the
early 80s. The rally, if it occurs, will set us up for a long,
So by analogy to the normal Presidential Cycle effect,
drawn-out disappointment not only in the economy, but
driven by stimulus and moral hazard, we are likely to have
also in the stock markets of the developed world.
a remarkable stock rally, far in excess of anything justified
by either long-term or short-term economic fundamentals.
My guess is that the S&P 500 is quite likely to run for a Bulls vs. Bears
while, way beyond fair value (880 on our revised data), Resolute bears will point out (as we have) that the low
to the 1000-1100 level or so before the end of the year. of other major market breaks has been far lower than
(For the record, I presented this case six weeks ago in this one, and they would be correct. Compared to our
Europe at 725 on the S&P, but was sadly distracted in my revised fair value estimate of 880 for the S&P and its
quarterly letter writing by a trip to Bhutan. Poor thing. current recent devilish low of 666, the bottoms of other
I won’t complain, though, since my “Reinvesting When important comparative bear markets were much more
In which case:
Chances of a new low in the next three months .333 and rapidly declining
Branch #2:
The global economies prove to be so weak that they do not start
to recover until late next year after a series of disappointments .20
In which case:
Chances of a new low this year or next .80
Branches 1 and 2:
Chances that this is the start of a lasting bull market destined
to take us to new highs within three or four years (after inflation) .15!
Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending May 5, 2009, and are subject to change at any time based on mar-
ket 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.