Jeremy Grantham has released the second half of his fourth-quarter 2008 letter on GMO’s website, and in it he offers several intriguing points about why value investors got hit hard in 2008, where the economy is headed, and whether a buy-and-hold approach to stock investing makes sense.
Calling 2008 “The Year of The Value Trap”, Grantham notes that the decades-long pattern of big market declines leading to great stock bargains and big recoveries did not occur. “Problems arise when this pattern of over-discounting and handsome recovery has taken place dependably for several cycles in a row,” he writes. “It begins to look like the natural, even inevitable, nature of things rather than merely the most usual outcome.”
What value investors lost sight of, Grantham says, is that during extreme negative economic events — like those we’ve experienced — value stocks can do the opposite of providing downside safety. “Only in the really severe economic setbacks do enough casualties occur to bring home a truth: price-to-book (P/B) and price-to-earnings (P/E) are risk factors,” he says. Buying low P/B and low P/E stocks “and averaging down routinely has an element of picking up … $1,000 bills in front of the steamroller,” he explains. Such a strategy will still probably pay off in long run, Grantham says, “but investors should be aware that the fundamental part of the risk premium is justified by the pain of these outlier events and is absolutely not a free lunch.”
During the Great Depression — which followed the Crash of 1929, the “last great value trap”, according to Grantham — many of the cheapest companies folded and more expensive firms, like Coca-Cola, survived the best, Grantham says. From October 1929 to June 1932, there was a “massive ‘value’ wipeout in which high P/E stocks declined far less than low P/E stocks,” he notes.
Grantham also says the future is now much less clear than it was back when he foresaw the housing and asset bubble bursts as “near-certainties”. He and GMO now expect average annual returns for the S&P of about 6-7%, after inflation, over the next seven years. But while the market is cheap, he says, “do not think for a second that this is as low as markets can get”; back in 1974 and 1982, valuations were still much cheaper than they are today. He also says, however, not to rule out another “sucker rally”, like the 2002-2007 surge that was fueled by Federal Reserve policy and post-9/11 tax cuts. But, he says, “I think it’s unlikely.”
With stocks cheap but having the potential to get a lot cheaper, Grantham says GMO is trying to the line between buying cheap and buying too soon. The firm has been upping its Global Balanced Asset Allocation Strategy’s exposure to stocks since October, for example, and could keep doing do if stocks get cheaper, he says.
Grantham also hits on another controversial topic: buy-and-hold investing. Buying and holding a fixed portfolio mix with an annual rebalancing is “okay” for those intimidated by the idea of making changes, he says. “But for institutions with access to professional advice and with long investment horizons, surely a fixed mix is aiming too low. … If the last 15 years has taught us anything, hasn’t it taught us that asset classes can be incredibly mispriced, along the lines of the 35 times inflated earnings for the S&P in 2000? …When very large mispricings occur, should we not reasonably move away from extremely overpriced assets toward more attractive ones?”
The best way to bolster returns, Grantham concludes, is through asset allocation — not by trying to add alpha, and his reasoning is particularly interesting. Asset classes, he says, are priced more inefficiently than stocks. “There is a large and relatively efficient arbitrage between stocks, and the career risk of picking one stock versus another is quite modest. In contrast, when picking one asset class against another, it is painfully clear when mistakes have been made.”
The career risk involved for managers in going against the current asset allocation grain will likely always be high, Grantham says, and for that reason, mispricings across different asset classes will likely always exist. “Consequently, there is great advantage to be had in getting out of the way of the freight train, rather than attempting to prove your discipline by facing it down,” he says of avoiding expensive asset classes. Those advantages include both higher returns and lower risk, he says.