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Tuesday, June 26, 2012

Jeremy Grantham On The Markets - Keeping The Powder Dry

[Grantham's] GMO regularly publishes its forecast for market returns, which it projects over a seven-year time horizon. It “ruthlessly normalizes” earnings, Grantham said, assuming they will return to their historical averages by the time seven years have passed.

Abnormally high earnings will lead to disappointing US equity returns, Grantham said.

“The great majority think US equities are reasonably cheap,” he said, “but we don’t, because we want them to be priced to normal earnings.”

...Grantham conceded that high profit margins in the context of high unemployment is “truly weird” and has never occurred before. But he also said that GMO’s research has revealed that rising government debt is often accompanied by higher profit margins (although he did not say whether this was globally or just for the US, or over what time period)...

[Are] central banks and government fiscal policies are working to slow or stop the regression to the mean upon which GMO’s investment philosophy relies? He said those factors contributed to poor results from many noted and talented value managers, including some who had exemplary track records for over a decade. He acknowledged that the Fed policy has allowed “changes to the laws of nature” and wasn’t sure whether those changes are temporary or permanent...

Among US equities, Grantham said the best returns are likely to come from high-quality blue-chip stocks, for which GMO forecasts an inflation-adjusted annual return of 4.8%. But, he said, “you would lose a ton in US small-cap.” International large- and small-cap stocks and emerging equities are at fair price, he said.

Grantham said that investors face short-term risks in emerging markets, and that China’s economy may slow down. But globally diversified investors should expect “pretty decent” returns equal to their historical averages over a seven-year horizon, according to Grantham.

The “real problem” among asset classes is bonds, Grantham said. Their overvaluation is the result of Fed policies that have artificially depressed real interest rates. “They do it to encourage you to get so fed up with parking your money at minus one that you will move it into the equity market,” he said. “The more you do it, the more seductive it becomes.”

GMO has refused to be seduced. “It makes it so expensive to have the dry powder that you know you should have in the face of the euro, China, and the debt overhang, which are pretty big problems,” Grantham said.

GMO is the uncontested expert on bubbles, having studied and mathematically analyzed over 330 of them. Although bonds are horribly priced, Grantham said they are not in a bubble. To earn that distinction, he said there would need to be “wildness,” with IPOs and exuberant, excited investors. Indeed, he said the bond market is in an “anti-bubble,” marked by fear and nervousness. (Vitus emphasis)
---Reported by Robert Huebscher, Advisor Perspectives

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