The Bear Lives

Think U.S. markets are reasonably valued? Think again. Earnings are recovering, so the bear market must be on the run, right? Think again. Given the president's mandate, Social Security may be privatized and the era of tax cuts will surely continue. Isn't that good for Wall Street? Think again. So says Jeremy Grantham, the free-thinking chairman of Boston-based GMO, the $66 billion investment manager

Think U.S. markets are reasonably valued? Think again. Earnings are recovering, so the bear market must be on the run, right? Think again. Given the president's mandate, Social Security may be privatized and the era of tax cuts will surely continue. Isn't that good for Wall Street? Think again.

So says Jeremy Grantham, the free-thinking chairman of Boston-based GMO, the $66 billion investment manager that subadvises Evergreen's Asset Allocation fund. With 2005 upon us, Grantham's survey of historical trends makes him cautiously pessimistic — or maybe not so cautiously.

Registered Rep.: President Bush will begin his second term in January. You've done research on stock market performance as it relates to the four-year presidential cycle, and I wonder what it's telling you.

Jeremy Grantham: All markets tend to drop in the first two years of a presidential cycle. For 2005 and 2006, the average return we expect is minus-six for the S&P 500. The key for people to remember is that whoever is president has astonishingly little effect, whereas the cycle itself, the desire for every administration to get re-elected, is wonderfully obvious in the data. Had Kerry got in, he would have said, “My God, these nitwits, look what they've done.” Bush has to tighten the system in order to have some leeway to stimulate in year three for his party to get elected. The value of the market — which does not matter in year-three, where expensive markets go up anyway — matters a lot in years one and two.

If you are in the most expensive half of markets by normal value measures, you have a 33 percent chance of winning and your expected return is minus-six. If you want to embroider that with qualitative issues, I would say we're not in the most expensive half, we're in the most expensive 10 percent, point one, and point two, the presidential cycle is overwhelmingly a monetary event, and we're more stimulated than we've ever been. Since 1982, we have learned to live with lower rates and easy money and far more credit than ever before, all of which makes us more vulnerable.

RR: Ouch. I realize I'm talking to a man who believes that we're four-and-a-half years into a market decline slated to last about seven years — one that will bring the S&P 500 back to trend line 700. Also, you recently wrote that year-end 2004 might be a good time to “panic.” That is the word you used, isn't it?

JG: It's a way to underline how grim the situation is. Now is the time to armor-plate your portfolio — that is, to lower risk and survive to fight another day.

RR: What are some steps you recommend investors take?

JG: Buy some foreign and emerging equities, but be reconciled to periods of negative return. Diversify into commodities, such as forestry, and if you can stand the low returns, hold some cash. Going into 2005, the main thing is avoiding highly volatile stocks. That's more important than buying high quality or buying low beta. In the first and second year of a presidential cycle, they are, nearly 100 percent of the time, poisonous.

RR: In the past few weeks, the dollar has set lifetime lows against the euro; how are you protecting investors against dollar declines?

JG: If the dollar goes down, it's a win-win. We win because we've got foreign holdings, which have become worth more, and we win because U.S. companies get some benefit from a lower dollar, and perhaps on the margin, a little more earnings and dividends. We win locally a little bit, and we win overseas a lot.

RR: President Bush is expected to push for privatization of Social Security. Isn't that a good thing for Wall Street?

JG: The reality is that starting rapidly in four years, the population ages. The only way you fund that is with that year's GNP pie. Shuffling pension pools around does not change that. In the short term, if you have more people scrambling to buy equities with social security money and that causes the market to go up, it will mean that the imbedded return will drop, and the reward of getting a couple of good years will be more than offset by the fact that long before the 30 years [of the boomer bulge] are up, you will have crossed the point where cheaper prices, lower PEs and higher yields would have made you far richer than getting a couple of quick years upfront. What retirement is all about is compounding wealth. Quick fixes, represented by capital gains in the short term, are worse than irrelevant; they're detrimental.

RR: Asset allocation must be a heck of a lot harder today than it was in 2000, when almost all investors were in love with tech stocks.

JG: It is. Instead of living in a world with amazing overpricing and some reasonable pockets, we now live in a world of universal moderate overpricing, with the only equity exception being emerging equity. The nightmare for asset allocation is exactly the result of these five successful years. Small stocks and value stocks globally were brilliant and have used up either all their undervaluation, or even more than all. In March 2000, the market wasn't just overpriced; what was even more useful was the massive number of distortions, which gave us wonderful tilting up opportunities. In the U.S., small-cap was the second-most out of line to large-cap ever, and value vs. growth was actually more out of line than in 1972.

RR: What did you do then, and how have you done since?

JG: We moved money out of stocks into fixed income, switched from U.S. stocks into international small-cap and emerging and tilted U.S. monies hugely to REITs and smallcap value. In our standard asset-allocation accounts, we've outperformed our benchmark by 10 percent, 10 percent, 11 percent, 5 percent and 2.5 percent over the past five years.

RR: How does your approach to asset allocation differ from your competitors?

JG: We have observed at the institutional level that our competitors tend to be more benchmark-constrained than we are. We go all the way to the last stop in our hedge fund where we actually go short the S&P, long emerging equity and things like that. Other people have trouble moving away as far from the normally accepted numbers. In general, what we say is that the market is splendidly inefficient, except for a few seconds randomly dotted through history when asset classes flash through their fair price on their way from being overpriced to underpriced. So we try and move everything down to fair value. Comparing asset classes, if you're badly overpriced, like the S&P was in 2000, we march you down, and if you're very cheap, like REITs were then, we march you up.

RR: Your returns suggest you have mastered the bear quite nicely. But I wonder whether the bear case isn't getting tired. After all, the economy is getting better, earnings are improving nicely and interest rates aren't too troublesome. So, isn't now a pretty good time to be investing, even with the S&P valued at 18 PE?

JG: I concede it's reasonable sounding, and it feels plausible — it just happens to be completely wrong. You can't just say the market is valued at only an 18 PE, you have to say 18 times what! Earnings must be normalized. You cannot compare the total market when it's in an economic boom and profit margins are high, and margins today are very high — about 17 percent over normal — with 1982, where profit margins were 40 percent below normal. Remember, if high profits don't attract competition, something has gone tragically wrong with capitalism. By the way, I expect as much or more pain from profit margins coming down to trend than I do from PE's going to trend. When you couple normal profit margins with normal PE's, you get some extreme pain.

RR: You also worry about optimism creeping into the earnings forecast part of PE ratios.

JG: Absolutely. If you're using forward PE's, it's 14 percent higher than will actually occur. And there's more: even when they say, oh, it's only 18 times current earnings, in addition to not adjusting for profit margins, and not adjusting for forecast optimism, companies are also not adjusting for the fact that there are more write-downs than write-ups, which I call accounting weaseling, and that boosts earnings artificially, also by about 14 percent.

RR: So you have to make a few adjustments.

JG: To adjust for the weaseling, you take collective operating and knock it down by 14 percent, which is the average of the write-down level for the last 10 years, in addition to taking profit margins down to normal. If you're using next year's earnings, knock off another 14 percent for exaggerated estimates. Finally, even when everything is put to bed, you are not getting the return implied by the earnings yield [the inverse] of the PE. When the market says it averaged 16, you're getting the [lower] return compatible with a PE of 17.5. The likely reason is that due to occasional surges of technology assets go under-depreciated. Every five or 10 years there's some jump forward, which means equipment you thought was good for 15 years is obsolete by year nine. So depreciation expense, were it accurately stated, would be higher and earnings lower. Put it all together, and that's a lot of problems with PEs.

RR: Your critique of valuation seems to extend beyond puffed-up PEs; at times you imply investors are too optimistic in general.

JG: I don't know if you're aware, but the long-term growth of the S&P in sales and earnings is 1.8 percent. Compare that with the typical growth estimate. Remember back in 1999, if you weren't doing 10 percent, you were contemptible! And yet the record was 1.8 percent. When I used to say that, I had well-informed pension officers come up to me and say, “That can't be right!” To put it mildly, the biggest problem [investors face] is optimism. The reader should be aware that everything they read in round numbers, 90 percent plus, is advertently or inadvertently dripping with bullish bias. It sells stock. And for the record, it sells magazines.

RR: You argue with many different kinds of bulls. What do you say to the Alan Greenspan/Abby Joseph Cohen bull, when they claim that, since GDP and productivity and profit margins are all fine, the stock market will be fine as well.

JG: If you start with high profit margins, margins tend to go lower and so does the stock market. GNP growth has no easy relationship with stock market returns. The decades of the 1990s and 1970s — which felt like Heaven and Hell in the stock market — had almost identical GNP and productivity growth rates. And above-average GDP one year correlates with below-average market returns the next. It's simply a negative correlation. And that takes the standard bull case and just skewers it.

RR: At least you have a positive outlook on commodities.

JG: My view is that China and India will be seen as having kinked the price trend in commodities from drifting down at 1 percent to 1.5 percent per year to drifting up at 1 percent to 1.5 percent per year, a profound difference that I think will last for decades. Did the move of the last 18 months discount the next 30 years? Unfortunately, you can't see that in the data. But I would not play against oil as a theme.

RR: Can you explain the connection between GMO and Evergreen?

JG: We are subadvisors to Evergreen. We can mix and match the funds underlying Evergreen's Asset Allocation mutual fund to get the asset allocation we prefer. We don't let U.S. equity drop below 22 percent or so, or total equity below 50 percent. We can weasel and twist and turn quite a lot, and that's what we do. For Evergreen, all fund decisions are made by Ben Inker; he's our commander-in-chief.

RR: You manage hedge funds for those of us who live in mansions. Is this mutual fund appropriate for those of us living in split-levels?

JG: Absolutely. The Evergreen fund is designed to protect his assets, lower his risk and increase his returns.

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