Jeremy Grantham January 2009 Quarterly Letter

Thanks to Todd Sullivan's ValuePlays for bringing Jeremy Grantham's 4Q letter to my attention. It's a good read. Grantham is considered by some to be a value investor but, unlike most value investors, he is a top-down, macro-focused, strategist. At least that's my impression of him. I recommend this letter to anyone, including non-macro-oriented investors since it gives an overview of the size of the problem.

Jeremy Grantham has been critical of many policymakers and so-called leaders and he is critical of Obama's Treasury team as well. In any case, the most valuable thing for me is his quantification of potential losses in America, and how they compare to Japan. I had been trying to figure out how the US situation compares to Japan and Grantham finally provides his estimate. The bad news is that there will be huge losses; the good news is that it looks better than Japan. I personally felt before that the losses would be better than Japan since Japanese real estate and stocks were wildy overvalued like nothing I have ever seen or heard of in my limited reading (people always keep referring to the South Sea bubble and the Mississippi bubbles but the Japan one looks much larger--I still need to do read up more though.) Jeremy Grantham doesn't cover it, but my feeling is that the picture in some parts of Europe will be ugly--far worse than what America is facing.


Scope of American Losses

But let us look for a minute at the extent of the loss in perceived wealth that is the main shock to our economic system. If in real terms we assume write-downs of 50% in U.S. equities, 35% in U.S. housing, and 35% to 40% in commercial real estate, we will have had a total loss of about $20 trillion of perceived wealth from a peak total of about $50 trillion. This relates to a GDP of about $13 trillion, the annual value of all U.S. produced goods and services. These write-downs not only mean that we perceive ourselves as shockingly poorer, they also dramatically increase our real debt ratios.

...If we would like the same asset coverage of 50% that we had a year ago, we could support only $15 trillion or so of total debt. The remaining $10 trillion of debt would have been stranded as the tide went out! ... As always, now that it’s raining, bankers want back the umbrellas they lent us. At 40% of $30 trillion, ideal debt levels would be $12 trillion or so, almost exactly half of where they actually are today! It is obvious that the scale of write-downs that we have been reading about in recent months of $1 trillion to $2 trillion will not move our system anywhere near back to a healthy balance. To be successful, we really need to halve the level of private debt as a fraction of the underlying asset values. This implies that by hook or by crook, somewhere between $10 trillion and $15 trillion of debt will have to disappear.

I haven't published my macro outlook--I'll do it soon--but this humongous loss, some $10 trillion to $15 trillion, is what makes me dismiss all the rosy forecasts. The consensus seems to be that assets, most importantly stocks and real estate, will somehow start a bull market later in the year. A day doesn't go by without some analyst expecting oil to rally to $80, for housing to show strong recovery, and for consumer discretionary technology stocks to rally. I'm not sure how that is possible given that a big chunk of losses still haven't been absorbed. A short term rally, call it an Obama rally if you will, is possible; so is skilled stockpicking. But long-term bullish macro bets seem risky.

Given where we are today, there are only three ways to restore a balance between current private debt levels and our reduced, but much more realistic, asset values: we can bite the bullet and drastically write down debt (which, so far, seems unappealing to the authorities); we can, like Japan did, let the very long passage of time wear down debt levels as we save more and restore our consumer balance sheets; or we can inflate the heck out of our debt and reduce its real value. (In the interest of completeness I should mention that there can sometimes be a fourth possible way: to somehow re-inflate aggregate asset prices way above fair value again. After the tech bubble of 2000 Greenspan found a second major asset class ready and waiting – real estate – on which to work his wicked ways. This time there is no new major asset class available and, although Homo sapiens may not be very quick learners, we do not appear eager to burn our fingers twice on the very same stove. As a society, we apparently need 15 to 20 years to forget our last burn. With so many financial and economic problems reverberating around the world and with animal spirits so crushed, re-inflating equity or real estate prices way above fair value again in the next few years seems a forlorn hope if indeed it is possible at all.)

I concur with Grantham and think the fourth choice is unlikely, even though it must be said that a big chunk of market participants are expecting another bubble to be created soon, as if bubbles are the norm and possible after such a big credit bust. Grantham comments that he thinks that a bit of each of the three choices will be used. He seems to be in the inflation camp and expects the possibility of high inflation (I'm in the mild-deflation/disinflation camp and think high inflation is only likely if the authorities want it to occur.)

The Humongous Bubble In Japan

The Japanese had an even bigger problem in write-downs of “wealth” than we have now. They had to write down perceived wealth by an amount equal to a stunning three times GDP! Even in 1929, we had to write off amounts equal to only three quarters of a year’s GDP as the stock markets then were less developed and housing was decidedly pre-McMansion. This time in the U.S., however, we must write down perceived wealth or capital by almost precisely one and a half times GDP, worse than the Depression but happily much less than Japan.

...At about 4 to 1, the Japanese corporate sector went into the 1989 crunch with much higher leverage than the U.S. had ever seen. Remember too that their stock market, at 65 times earnings, was over three times our market’s recent highs and their land was at several multiples of ours. In 1989, Tokyo’s land per square foot was around ten times the value of Manhattan’s! So they had higher write-offs confl icting with much higher corporate leverage. If they had rapidly marked their assets to market, the entire corporate Japan Inc. would have been under water. And since we know that around a quarter of Japan’s market – their Sonys and Toyotas – was solvent, we can deduce that the remaining three-quarters was shockingly under water, using the types of rules we are attempting to apply to ourselves now... Somehow or other, Japan absorbed the greatest deleveraging in human history without incurring a severe depression.

I knew that Japan had higher P/Es on stocks and wildly overvalued real estate; but, until I read this, I never knew that they had greater corporate leverage than America ever did. I wonder if part of the high leverage was due to commercial real estate holdings of corporations (real estate, commercial or not, tends to involve higher leverage.) My understanding is that it was popular for some Japanese corporations to speculate on real estate--sort of like how we heard stories a few years ago of Chinese companies speculating on the stock market--since they were making more money off that than in their operations.

Grantham is correct to point out that Japan actually managed to avoid a depression. They ran up their debt to some ridiculously high level in order to save themselves--but this is their World War (USA ran up the debt during WWII.) I see a lot of investors criticizing Japanese policymakers for taking their time but, as Grantham speculates, 2/3 of Japanese corporations may have been insolvent if they took a quick pill, as some liquidationists desire.

Having said that, I do feel that Japanese culture and government policies make things worse. They need to diversify their economy and make it more dynamic.

Although Japanese corporations were in much worse credit shape than ours are now, the reverse is true for consumers. Japanese individuals went into the 1989 event with a very high savings rate and very high accumulated savings. In contrast, our households go into our crunch borrowed to the hilt (or beyond) and painfully under-saved. So our job is to nurture our average people in the street and somehow restore the quality of their balance sheets, just as Japan (admittedly taking 15 uncomfortable years) did for its corporations.

This is something that the liquidationists and libertarian-type individuals such as Jim Grant and Jim Rogers never seem to address. Calling for a quick liquidation is all fine and dandy but given how 70% of the US economy is driven by the consumer, have any of them considered what would happen to the economy? The economy will completely implode if a big chunk of the consumers declare bankruptcy in a short period of time. A lot of extreme free market supporters never realize that politics and economics are intertwined. In fact, the concept of 'political economy' was quite common a hundread years ago. Perhaps this is probably why they never get elected to power in any country.

Investment Suggestions

For many years, we used a 10-year forecast for asset class returns. In January 2002, we made our first 7-year forecast, dated December 31, 2001. We moved from 10 to 7 years because research proved that it was closer to the average time for financial series to mean revert.

I wondered why he uses 7 year forecasts rather than the convention 10-year ones but now I know...

Even with hindsight, if you value the market in 1974 using our current methodology it was very much cheaper than it is today at 950, which is what we calculate as almost precisely fair value.

...we suspect that cheaper prices are not just possible but probable, although admittedly far from certain...

Slowly and carefully invest your cash reserves into global equities, preferring high quality U.S. blue chips and emerging market equities. Imputed 7-year returns are moderately above normal and much above the average of the last 15 years. But be prepared for a decline to new lows this year or next, for that would be the most likely historical pattern, as markets love to overcorrect on the downside after major bubbles. 600 or below on the S&P 500 would be a more typical low than the 750 we reached for one day.

In fixed income, risk finally seems to be attractively priced, in that most risk spreads seem attractively wide. Long government bond rates, though, seem much too low.

So, he thinks the market is currently close to fair value; but he thinks it can overshoot on the downside. This is similar to my view. Valuations are attractive but not exceptionally so (You can get the breakdown of his forecast from last year here.)

For the long term, research should be directed into portfolios that would resist both inflationary problems and potential dollar weakness. These are the two serious problems that we may have to face as a consequence of flooding the global
financial system with government bailouts and government debt.

This is completely opposite my view. I don't feel that high inflation will be a problem. Admittedly it's a possibility but I'm not willing to build my portfolio based on that. I will change my bias towards inflation if China gets through this without any major implosion and we avoid major trade disputes.

Under the shock of massive deleveraging caused by the equally massive write-down of perceived global wealth, we expect the growth rate of GDP for the whole developed world to continue the slowing trend of the last 12 years as we outlined in April 2008. Since this recent shock overlaps with slowing population growth, it will soon be widely recognized that 2% real growth would be a realistic target for the G7, even after we recover from the current negative growth period. Emerging countries are, of course, a different story. They will probably recover more quickly, and will continue to grow at double (or better) the growth rate of developed countries.

I think it's fairly safe to assume that GDP growth will be much lower over the next 20 years than the last 20. Without the same leverage, developed countries like USA, Britain, et al, will slow down. Similarly, I doubt that China can grow at 10%+ in the future, or that Brazil can grow at the same high rates without a commodity bubble.