Brace Yourself

Interview with Jeremy Grantham, Chief Investment Strategist, GMO

By SANDRA WARD

ONE OF THE GRANDEST OF THINKERS AND MOST ELOQUENT
of oracles, Jeremy Grantham has long been the voice of reason in an
industry prone to excesses and embellishment. By taking the long view,
blending quantitative strategies and technical analysis with sound and
experienced judgment, Grantham, chairman of Boston-based GMO,
consistently uncovers with his team the best values among a wide range
of global asset classes.

The payoff is outstanding
performance and risk management. In return, clients have entrusted the
firm with about $150 billion. As the man who warned early of a
worldwide bubble forming, we turned to him as that bubble has started
bursting.

"It was late '06 when [Fed Chairman Benjamin] Bernanke said he thought the high prices of homes in the U.S. merely reflected a strong U.S. economy. Was he not looking at the data?" -- Jeremy Grantham

Barron's: You, along with George Soros, have called this the worst financial crisis we've had in the post-war era.

Grantham: This is
much more global than, say, the savings-and-loan crisis was. The world
is obviously much more globalized than at any time since the late 19th
century and much more interrelated in almost every way, certainly
financially. To have the leading economy and the reserve currency
having a major-league credit crisis would by itself make it more
important than earlier ones.

Secondly, this occurred at a
time of what I believe is the first global bubble in pretty well all
asset prices, so there is a much greater degree of broad-based
vulnerability. Then it is a question of degree, and how carried away
the sloppy lending was: It was very carried away. Not just in the
design of needlessly complicated instruments, but in the enthusiasm --
recklessness one might say -- with which they were sold.

Can these bubbles burst if the Fed is easing the way they are?

Well, this is an amazing
little tidbit. People think the Federal Reserve can stop a bear market
because they can throw money at it and lower interest rates. It is even
more certain we can collectively stop a bear market if some fiscal
stimulus is thrown in. To which I say, 'Oh, you mean like 2000 and
2002?' -- when they threw what I call the greatest stimulus in American
history, an unparalleled series of interest-rate cuts, cumulating in
two, almost three, years of negative real returns, real interest rates
coupled with a really substantial tax cut, which would never have
happened without 9/11.

The combination would have
gotten the dead to walk, and it stopped the bear market eventually. But
the Standard & Poor's 500 was down 50% and the Nasdaq -- which was
all anyone talked about back then -- went down 78%. And a puny five to
six years later, people are saying there is not going to be a bear
market because the Fed is going to lower rates and because the
government is going to have a stimulus package. But we have just been
there, done that, and we had a nice bear market.

What about places to hide?

That isn't something we can
laugh off. Last time, there were plenty of opportunities: Bonds were
cheap and TIPS (Treasury-inflation protective securities) were
brilliant; real estate was cheap and REITs were brilliant. Even within
equities, emerging markets were much cheaper than U.S. equities, and
within U.S. equities, value stocks were only a little expensive and
small-caps were only a little expensive and small-cap value was
actually a little bit cheap. So you could really hide and could
reasonably expect to make money, which we did in each of the three
years of the bear market.

Since then, all those areas
appear to have read the book on mean-reversion. Ten years would be a
perfectly normal period of time to go from a peak of a great bubble
[like the one in 2000], based on the history of bubbles and their
aftermath, to the low. I have long thought that 2010 would be when we
hit the biggest discount to fair value. Trend-line value on the
S&P, by the way, in 2010 is 1100. (The S&P 500 traded at 1334
late last week.)

What should we expect from the market between now and 2010?

In the fourth year of a
presidential cycle, where you have a lame-duck president, the typical
pattern of S&P 500 performance has been something like 10% below
the normal long-term average (a 5.2% gain, inflation-adjusted), and
worse if it is an overpriced market. A first year is never very
pleasant: They average about 3% below normal. If they are overpriced,
they do four points worse than that.

But if the party in power
changes, first years tend to be eight points below normal. The
following year is ugly, too. The average year two, since 1932, has been
10 points below normal and, if the market is overpriced, 15 points
below normal. This is unpleasant. By a nice coincidence, those averages
suggest the market will decline to 1100 in 2010, which is exactly the
number we get to from a completely different technique -- building it
from the grass roots through fundamental value. We do that by taking
average corporate-profit margins, actually a generous average,
assigning a normal market price/earnings ratio, and that gives you 1100
in 2010. This year, next year and the year after will all be
uncomfortable years. One of them might be up, but my guess is it won't
be up by much.

What exactly will make them more uncomfortable?

Profit margins, the great
prop to the market, surprisingly defied the laws of gravity for three
years in the developed world and, particularly, in the emerging world
and even in Japan. That was because the global economy was stronger
than any corporation counted on and, in the U.S., consumption was
always higher and our savings rate was always lower than any corporate
economist would have suggested, going into negative territory. But
there are a few near certainties in this business -- not many, but a
few -- and one of them is that abnormally high profit margins will go
back to normal. The timing is unfortunately shrouded in fog. The other
near certainty is that house prices will go back to a normal multiple
of family income. In the end, we, the people, have to be able to afford
the houses and they are affordable at something around 2.8 times family
income. When they peak in Boston at 6 times and nationally at 3.9
times, you know you are in for tough times.

Incidentally, it was late in
'06 when [Fed Chairman Benjamin] Bernanke said he thought the high
prices of homes in the U.S. merely reflected a strong U.S. economy. Was
he not looking at the data? Did he not measure long-term house prices?
Had he not seen how they ebbed and flowed as a multiple of family
income, which they do here and in the U.K. and everywhere else? And
with it being so obviously a bubble, how could he have said that?

He was taking his cue from Alan Greenspan, who said we should all be taking out adjustable-rate mortgages.

Greenspan and Bernanke have
taken a hands-off approach for two consecutive great bubbles, first in
TMT -- telecommunications, media and technology -- and second, in
housing. A hands-off approach is a polite way of saying they
facilitated this. And what is the point of a 125-basis-point rate
reduction, other than to provide reinforcement for the people who
borrow short and lend long? From bankers who have committed every crime
you could possibly accuse a banker of, to hedge funds who borrow short,
leverage, and invest long in the stock market -- that's who really
benefits from the interest-rate reduction. The economy, broadly
defined, does not.

I have an exhibit that shows
the 30 years prior to 1982 when the debt-to-gross domestic product
ratio was completely flat at 1.2 times. Total debt is defined as
government debt, personal debt, corporate debt and financial debt. Then
in the 25 years after 1982, the flat line goes up at a 45 degrees angle
from 1.2 times to 3.1 times GDP. Massive. In the first 30 years, when
debt is flat, annual GDP growth is its usual battleship, growing at
3.5% and hardly twitching. After the massive increase in debt, GDP, far
from accelerating, grew at 3%. So debt in the aggregate does not drive
the economy. The economy is driven by education, man-hours worked,
capital investment and technology. It is not driven by what I owe you
and you owe me.

So the Fed's actions won't stave off a slowdown?

Since when did the thought
of an economic slowdown induce such hysteria? That was a response to
the decline in global markets. It was aimed at the stock market. It was
aimed at banking disorder and banking profits. It doesn't have that
much of a powerful effect on the economy. If it had any more profound
effect, there would be a positive relationship between debt increasing
and GDP growth, and there is none.

But it is driving down the dollar.

It drives down the dollar, which is inflationary, and, eventually, it could be seriously inflationary.

I understand you are most concerned with further fallout in the private-equity arena?

Yes. I have yet to meet a
private-equity firm that put into its spreadsheet the assumption that
system-wide profit margins could decline by 20% to 30%. They have taken
the current, abnormally high profit margins as a given and then
determined to improve them by, let's say, 15% and assume everything
works out pretty well.

But if the base declines by
20%, even if they end up improving margins by 15%, they are going
backwards. And if they pay the 25% premium up front, which was normal,
and if they leverage 4-to-1, which was normal, then they almost
precisely wipe out all of the clients' money, all of the 20% in equity
and if, perish the thought, they don't add 15%, but add perhaps zero to
5%, then they do more than wipe out the equity, they leave the
underlying debt in ragged disarray. That is the next shoe to drop on
the credit side.

Where else does this housing crisis lead us?

It has a lot to go. It still
has to drop 20% to 25% to reach more normal levels, or if you prefer,
it could wait five years for income to catch up, barring no big
recessions. With the housing market gone, people turned to credit cards
and with economic times slowing down -- whether there's a recession or
not -- consumers are going to slow down a lot, are slowing down or have
slowed down a lot.

What about the dollar?

Currency is a real problem,
I've got to admit. There was a time not that many years ago when we had
a huge high-confidence bet against the dollar. It was technically
overpriced, and we were running a huge trade deficit. Now, it is
technically substantially cheap. But we are running an even bigger
deficit. It is a conundrum. I don't think it should be a major, major
bet. We are reasonably happy owning emerging currencies as a packet
against the dollar for a several-year time horizon. I'm not
particularly happy owning a packet of other developed currencies
against the dollar.

Personally, I'm long the
yen, the Singapore dollar and the Swiss franc. I'm certainly not long
the pound: shorting the pound is a better bet than shorting the dollar.

What other bets would you take here?

My favorite bet on Jan. 1
and today, for that matter, is going long very-high-quality U.S. blue
chips with 50% of my dough, and long emerging markets for 50%, and
shorting the Russell 2000 for 100%, or a complete hedge. In that bet,
I'm long value because both of those components are cheaper than the
Russell 2000. I'm long liquidity on average. I'm long momentum on
average.

What about growth stocks? Isn't there value there?

Growth stocks are expensive,
but not quite as expensive as value stocks or low-growth stocks.
Quality stocks are expensive but substantially less so than anything
else. Emerging is expensive, but less so than anything less, and the
fundamentals are so much superior to the rest of the world. Everything
is expensive. All we are trying to do is extract some relative money,
or by going short, actually make some real money.

But how do you define quality these days?

We always defined
high-quality companies as those with high and stable returns and low
debt. Recently, we had to override, and exclude several banks from that
list. Whether you like it or not, you have got to treat banks
separately.

What about the deal market, will that provide any lift to stocks? Microsoft's bid for Yahoo! hasn't done much for the market.

You might say that is a
company in serious trouble being acquired by a company that is worried,
maybe desperate. And that doesn't sound like a very strong deal to
anybody.

Fascinating as always, Jeremy. Thank you.