Jeremy Grantham: With Great Depression II Nowhere in Sight, Look to the "Emerging Markets Bubble" for Maximum Profits

[Editor's Note: This market-outlook commentary appeared as part of the most recent GMO LLC Quarterly Letter, and was excerpted with permission. To view the full newsletter on the GMO Web Site, please click here.]

The good news is that we have not fallen off into another Great Depression. With the degree of stimulus there seemed little chance of that, and we have consistently expected a global economic recovery by late this year or early next year.

The operating ratio for industrial production reached its lowest level in decades. It should bounce back and, if it moves up from 68 to 80 over three to five years, will provide a good kicker to that part of the economy. Inventories, I believe, will also recover.

In short, the normal tendency of an economy to recover is nearly irresistible and needs coordinated incompetence to offset it – like the 1930 Smoot-Hawley Tariff Act, which helped to precipitate a global trade war. But this does not mean that everything is fine longer term.

It still seems a safe bet that seven lean years await us.

Corporate profit margins [excluding financials] remain above average and, if I am right about the coming seven lean years, we will soon enough look back nostalgically at such high profits. Price/Earnings (P/E) ratios, adjusted for even normal margins, are also significantly above fair value after the rally.

Fair value on the Standard & Poor's 500 Index is now about 860 (fair value has declined steadily as the accounting smoke clears from the wreckage and there are still, perhaps, some smoldering embers). This places [the] market [as of Oct. 19, when the S&P 500 closed at 1,097.91] at almost 25% overpriced, and on a seven-year horizon would move our normal forecast of 5.7% down by more than 3% a year. [Editor's Note: The S&P 500 closed yesterday (Tuesday) at 1,093.01 - essentially in the same neighborhood as the Oct. 19 close that Grantham referenced].

Doesn't it seem odd that we would be measurably overpriced once again, given that we face a seven-year future that almost everyone agrees will be tougher than normal? Major imbalances are unlikely to be quick or easy to work through. For example, we must eventually consume less, pay down debt, and realign our lives to being less capital-rich.

Global trade imbalances must also readjust. To repeat my earlier forecast, I expect developed markets to grow moderately less fast – about 2.25% – for the next chunk of time, and to look pretty anemic compared to emerging countries growing at twice that rate. We are nervous about the possibility of a major shock to Chinese growth.

(My personal view of a major China stumble in the next three years or so is that it is maybe only a one-in-three chance, but is still the most likely important unpleasant surprise of the fundamental economic variety).

Notwithstanding this concern, I believe we are well on the way to my "emerging bubble" described 18 months ago (in the First Quarter 2008 Quarterly Letter). I would recommend to institutional investors, including my colleagues, to give emerging equities the benefit of value doubts when you can.

For once in my life, I would like to participate in a bubble – if only for a little piece of it, instead of getting out two years too soon. Riding a bubble up is a guilty pleasure totally denied to value managers who typically pay a high price to the God of Investment Discipline (Thor?) for being so painfully early. I think the first 15 percentage points over fair value would satisfy me. If I'm right, the first 15% will be a small fraction of the eventual bubble premium.

So in a sense, we would be early once again.

We believed from the start that this market rally and any outperformance of risk would have very little to do with any dividend-discount-model concept of value, so it is pointless to "ooh and ah" too much at how far and how fast the market has traveled. The lessons, if any, are that low rates and generous liquidity are a little more powerful than we thought, which is a high hurdle because we have respected their power for years. And what we thought were powerful and painful investment lessons on the dangers of taking risk too casually turned out to be less memorable than we expected.

Risk-taking has come roaring back. Value, it must be admitted, is seldom a powerful force in the short term. The U.S. Federal Reserve weapons of low rates, plenty of money, and the promise of future help if necessary seem stronger than value over a few quarters. And the forces of herding and momentum are also helping to push prices up, with the market apparently quite unrepentant of recent crimes and willing to be silly once again.

We said in July that we would sit and wait for the market to be silly again. This has been a very quick response, although, as real silliness goes, I suppose it is not really trying yet. In soccer terminology, for the last six months it is Voting Machine 10, Weighing Machine nil!

Price, however, does matter eventually, and what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors.

First, the disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems, particularly pressure on profit margins as the quick fix of short-term labor cuts fades away.

Second, the slow gravitational pull of value as U.S. stocks reach +30% to +35% overpricing in the face of an extended difficult environment.

On a longer horizon of two to 10 years, I believe that resource limitations will also have a negative effect (see GMO's Second Quarter 2009 Quarterly Letter). I argued that increasingly scarce resources will give us tougher times, but that we are collectively in denial.

The response to this startling revelation, for the first time since I started writing, was nil. It disappeared into an absolutely black hole. No one even bothered to say it was idiotic, which they quite often do. Given my thesis of a world in denial, though, I must say it's a delicious irony.

So, back to timing.

It is hard for me to see what will stop the charge to risk-taking this year. With the near universality of the feeling of being left behind in reinvesting, it is nerve-wracking for us prudent investors to contemplate the odds of the market rushing past my earlier prediction of an 1,100 S&P 500. It certainly can happen.

Conversely, I have some modest hopes for a collective sensible resistance to the current Fed plot to have us all borrow and speculate again. I would still guess (a well-informed guess, I hope) that before next year is out, the market will drop painfully from current levels. "Painfully" is arbitrarily deemed by me to start at minus 15%. My guess, though, is that the U.S. market will drop below fair value, which is a 22% decline (from the Oct. 19 S&P 500 level of 1,098).

Unlike the really tough bears, though, I see no need for a new low. I think the history books will be happy enough with the 666 of last February.

Of course, they would probably be slightly happier with, say, 550. The point is that this is not a situation like 2005, 2006, and 2007 when, for the first time, a great bubble – 2000 – had not yet broken back through its trend. I described that reversal as a near-certainty.

I love historical consistency, and with 32 bubbles completely broken, the single one outstanding- the S&P 500 – was a source of nagging pain. But that was all comfortably resolved by a substantial new low for the S&P 500 last year.

This cycle, in contrast, has already established a perfectly respectable S&P low at 666, well below trend, and can officially please itself from here. A new low (or not) will look compatible with history, which makes the prediction business less easy.

[Editor's Note: Talk about market calls … In its May issue, in an article titled "Why Jeremy Grantham Changed his Mind," SmartMoney magazine detailed how the veteran investment strategist warned investors of the dangers of a global investing bubble ahead of the global financial crisis that lead to a near-collapse of the world's securities markets. And that's not all. In March, Grantham exhorted investors to buy back in - ahead of one of the strongest market rebounds in market history.

Grantham co-founded GMO in 1977. Prior to that, Grantham was co-founder of Batterymarch Financial Management, where he recommended commercial indexing in 1971, one of several claims to being first. He began his investment career as an economist with Royal Dutch Shell. Grantham is GMO's chief investment strategist and is an active member of GMO's asset allocation division. He is a member of the GMO board of directors and has also served on investment boards of several non-profit organizations.

Grantham has been featured in Forbes, Barron's and BusinessWeek and is routinely quoted by the financial press. He earned his undergraduate degree from the University of Sheffield and an MBA from Harvard Business School. To learn more about GMO, please visit the company's Web site by clicking here.]

News and Related Story Links:

• GMO LLC Quarterly Letter (October 2009):
  Just Desserts and Markets Being Silly Again.
• GMO LLC:
  Official Web Site.
• Jeremy Grantham:
  GMO Company Bio.
• SmartMoney.com:
  Why Jeremy Grantham Changed His Mind.
• The New York Times:
  Emerging markets bubble is worth riding.
• Money Morning News:
  Fed: Recession "Very Likely Over," but Threats Remain.
• Wikipedia:
  Industrial Production.
• U.S. Department of State:
  Smoot-Hawley Tariff Act.
• Money Morning Week Ahead Column:
  Investors Needn't Fear a Double-Dip Recession.
• Wikipedia:
  Herd Behavior.
• Mythical Realm:
  Thor – The Norse God of Thunder.
• Investopedia:
  Dividend Discount Model.
• Money Morning Week Ahead Column:
  A Year After the Crisis, the Global Economy is Firing on All Cylinders.
• Hubblesite.org:
  Black Hole.
• Wikipedia:
  Value Investing.
• Money Morning News:
  Money Morning's Hutchinson Makes the National News – Again.
• Investopedia:
  Price/Earnings Ratio.
• EzineArticles.com:
  Investment Bubbles Past and Present.
• Investopedia:
  Fair Value.
• CreditWritedowns.com:
  Jeremy Grantham: Overheating in China, speculative rallies and fair value.
• Estockwise:
  Bull and Bear Markets.
• Wikipedia:
  Momentum Investing.
• BullRider:
  Technical Analysis Indicators.
• YourDictionary.com:
  New High/New Low List.
• Money Morning Special Report:
  Five Ways to Ride the Commodities Bull.

Tags: Emerging Markets, Global Investing, Jeremy Grantham