Some thoughts from Jeremy Grantham's Fourth-quarter Letter

(Not sure what's wrong my blog template; it seems to be messed up. Oh well...)

Most of you probably already read this but if not, here are some interesting points Jeremy Grantham made in his GMO 4Q 2011 Letter (if you have never heard of Jeremy Grantham and are macro-oriented, you should definitely put his quarterly letters on your reading list):

Well, 15 years ago, Ben Inker and I designed a model to explain (not predict) the ebbs and fl ows of the P/E ratio. It had a surprisingly high explanatory power. We found that everything that made investors feel comfortable worked. That is to say, it was a behavioral model. Fundamentals like growth rates did not work. The two (out of three) most important drivers were profit margins and inflation.

The seemingly unsustainable profit margins is what keeps some who are bearish, like me, on the sidelines. Graham (elsewhere in the letter) feels that normal weight in equities is ok but I'm not so sure.

The long-term behaviour of stocks is so out-of-whack, compared to the past that one may want to be really cautious.

Historians would notice that all major equity bubbles (like those in the U.S. in 1929 and 1965 and in Japan in 1989) broke way below trend line values and stayed there for years. Greenspan, neurotic about slight economic declines while at the same time coasting on Volcker’s good work, introduced an era of effective overstimulation of markets that resulted in 20 years of overpriced markets and abnormally high profi t margins. In this, Greenspan has been aided by Bernanke, his acolyte, who has continued his dangerous policy. The first of the two great bubbles that broke on their watch did not reach trend at all in 2002, and the second, in 2009 – known by us as the first truly global bubble – took only three months to recover to trend. This pattern is unique. Now, with wounded balance sheets, perhaps the arsenal is empty and the next bust may well be like the old days. GMO has looked at the 10 biggest bubbles of the pre-2000 era and has calculated that it Quarterly Letter – Shortest Quarterly Letter – December 2011 3 GMO typically takes 14 years to recover to the old trend. An important point here is that almost no current investors have experienced this more typical 1970’s-type market setback. When one of these old fashioned but typical declines occurs, professional investors, conditioned by our more recent ephemeral bear markets, will have a permanent built-in expectation of an imminent recovery that will not come.

 The risk with overvalued markets is not that a real threat will harm equity prices; rather, it will give an excuse for the market to sell off. Most people who own assets probably know they are overvalued and then will just head for the exits at any sign of smoke.

I have a horrible record so don't listen to me blindly but I think we are vulnerable to a correction similar to the 1966-1974 period. By this, I'm not referring the size of any decline or the type of stocks that are vulnerable; instead, I'm referring to market declines without any serious problems. The economy may not have been ideal but it was fine during that period; inflation was high but nothing like what was in store later in the decade; yet the market kept weakening.

As Grantham and others have pointed out many times, major bear markets always over-shoot for a sizeable period of time. I have a hard time imagining that the bear market that started in 2000 (in my view) will end without overshooting on the downside.