Grantham on Cycles, Bargains, and the "Creative Tension" Facing Stock Investors

In an excellent interview with Steve Forbes, Jeremy Grantham — the bear who called both the 2000 market crash and the recent plunge — discusses how he’s avoided the bursting bubbles, talks about the areas of the market that intrigue him now, and reasserts his assertion that stocks are cheap, but likely to get cheaper

Grantham says his firm, GMO, has operated on the premise that the financial markets move in 10-year cycles. That is, over the course of a decade, profit margins and price/earnings ratios normalize, and the market should be at a normal price. Using that logic, his forecast for the S&P 500’s return from early October 1998 to early October 2008 was nearly perfect. Now, Grantham says his firm’s research has actually found that financial series revert to their means a bit quicker than every 10 years; they now base their evaluations on seven-year cycles.

Grantham said the decision on whether to buy stocks right now is one that’s full of conflict. On the one hand, stocks are cheaper than they’ve been in 20 years. But, he tells Steve Forbes, “[They’re] not dramatically cheap — not cheap like you and I have seen [in] a couple of markets. 1982, 1974 — that was very cheap indeed. This is merely ordinarily cheap.”

“And so now,” Grantham continues, “you have this terrible creative tension between, on one hand, they’re the cheapest they’ve been for 20 years. … And on the other hand, as historians, we all recognize that the great bubbles tend to overrun.”

Grantham says he sees real returns of about 7.5 percent per year for the S&P 500, and about 9.5 percent per year for emerging markets. But his firm is still underweighted in stocks, because he sees a two-in-three chance that the market will go to new lows in 2009 as it overshoots fair value.

Grantham offers some insightful thoughts on the psychology of deciding whether to buy stocks in the current climate. If he puts a client’s money in the market now and the market does go down further, he’ll be scolded for entering too soon, when he thought the market had further to fall. But if he waits on the sidelines and that one-in-three chance of the market taking off does happen, clients will complain that he didn’t buy at this time, even though he’d said the market was cheap.

How to deal with that tension? “There’s no way you can avoid [having] some regret,” he says. “You have to look at your own personal balance sheet. How much pain can you stand? If you absolutely can’t stand a 20 percent hit, you’d better carry quite a lot of cash, because you’re quite likely to get it. If, on the other hand, you’re made of steel, you can concentrate on the seven-year horizon and filter money in, and having a lot of cash here is probably a bit dangerous from the other point of view.” The worst situation: when an investor overestimates his or her “toughness”, and bails after the market plunges and never gets back in.

Other interesting topics Grantham touches on:

His bullishness on blue-chip U.S. stocks, certain emerging markets — and maybe even Japanese stocks;
The impact that “career risk” has on money managers’ decisions (i.e., managers who wisely sell out of overpriced markets risk getting fired because they miss out on what can be significant end-of-bull-market gains that others earn);
His decision to underweight emerging market stocks for the first time in 12 years late last June — just before they plummeted 40 percent — and his decision to overweight them again in October;