Jeremy Grantham Speaks

He's not a household name like Jim Cramer but his company, GMO, does have $107B in assets under management, so the self-described "perma-bear" Jeremy Grantham probably has some idea what's going on in the financial world. He started telling investors in 2006 to avoid risk because things were going to get ugly. Jeremy's 3Q'08 newsletter is available here. I had the opportunity to hear him speak recently, along with another GMO portfolio manager, and wanted to capture some of their thoughts in a very disorganized fashion here:

• A dim view of future prospects for humankind, very Malthusian. Basically, there will be too many people and resources will not increase fast enough, so standards of living will drop.
• We're going to write off wealth equal to 1.5 times GDP ($20T) with a 60% peak-to-trough decline for the stock market.
• If you looked at the entire world's balance sheet, we had leveraged $50T of assets with $42T of debt (80% leverage!). Now those assets are only worth $30T, but the amount of debt hasn't declined and remains stranded out there. How are we going to get rid of it? Inflate it away or offload it to the government.
• 2003-2007 was one of the biggest suckers' rallies of all time.
• The ratio of median house price to median family income was more than 3-sigma above its long term average when Ben Bernanke said that the housing market has never declined. Now it's going to overcorrect on the downside. A housing bubble is much worse for the country than a stock bubble, because it's easier to get leverage and the majority of people who own houses will be affected by it.
• The UK housing market is in a similar situation, but UK banks have yet to take a single writeoff for loans there.
• Fair value for crude oil is about $75, but it will trade between $32 and $150.
• What we have seen is the result of a "risk bubble." As investors' perceived risk decreased due to low volatility, they decided to increase risk back to their tolerance level by increasing leverage.
• In 1981, debt was about 125% of US GDP. Now it is 300% of GDP. Increase credit will probably lead to more frequent credit bubbles.
• In the 1970s, the price of treasuries implied 11% inflation for 30 years. We know how that turned out. Today, the price of treasuries implies 2% inflation for 30 years. Is that any more likely?
• The efficient market camp couldn't be more wrong. Buy and hold investing is a joke. Every asset bubble over corrects by 50% below the long term trend. We're not there yet. If you had a 3-sigma increase in asset prices based on a random walk model, you'd never get a similar 3-sigma decrease directly following it on the way down. Yet this is what every bubble looks like.
• Things can get so beaten down that even on bad news, they recover. Example: June of 1932 had terrible news every month, yet the market went up 100%.
• Japan's great recession in the 1990s was remarkable because unemployment never became a big problem.
• Most interesting was his prediction in September 1998 that the S&P 500 would have a real return of -1.1% over the next ten years. It turned out to be +0.1%, but that is still pretty close. His 1998 forecast also correctly tagged emerging markets and REITs as the biggest winners over the decade. Here's his forecast going forward. He likes high quality US stocks (low volatility, low debt), emerging markets, and commodities.

His associate also spoke about some of the unintended consequences we're seeing in the fixed income markets right now.

• In 1997 when LTCM blew up, the spread between on the run and off teh run treasuries had increased from 5 bp to 15 bp. In October of 2008, that spread had widened to 100 bp. There were basically $20 bills available to be picked up by any arbitrageur.
• Earlier this year there was a rally in Fannie Mae's bonds and some assumed it was because their financial health was improving. What actually happened was that the fed started accepting FNM bonds as collateral, so traders were buying the debt at $0.80 on the dollar and then using it to borrow $0.96 from the discount window.
• AIG's first bailout was at LIBOR+800 bp, a punitive interest rate. A few weeks later when the government opened their commercial paper facility, AIG said "can we use that?" and then proceeded to pay off several billion of L+800 debt with much cheaper government backed CP. The government was arbitraged against itself.
• The federal reserve now has $3T on its balance sheet. So far, this hasn't contributed to inflation. Most of that $3T is short term. However, there is talk of the fed buying longer term assets. This presents a problem once the economy recovers, if they are stuck holding longer term assets that may have gone bad, they will not be able to easily sell them and take money out of circulation. This could lead to problems controlling inflation down the road.