Wednesday, May 6, 2009

GMO: Jeremy Grantham's 1Q 2009 letter

The Loss of “Near Certainties” in Investing

First, let me lament the loss of near certainties in investing. The financial and economic collapse that I described as “the most widely predicted surprise in the history of finance” about 18 months ago is behind us. More precisely, we believed that bubbles had formed in global profit margins, risk premiums, and U.S. and U.K. housing prices, and that all three were “near certainties” to break, with severe consequences for the economic and financial system. All have thoroughly burst and are in their overcorrection phase with the single exception of U.K. house prices, which I’m confident will do their duty. Normally there are, of course, no near certainties in investing. Life is not meant to be that easy. Asset allocators have been blessed in the last 10 years with a large collection of extraordinary outliers. As my favorite quote by Mandelbrot (1983) says, “Even though economics is a very old subject, it has not truly come to grips with the main difficulty, which is the inordinate practical importance of a few extreme events.” If this last 10 years did not prove him right, nothing will. Since 1988, we have been offered 8 or 10 2-sigma events. (A 2-sigma event is our definition of an important bubble or bust.) All of these events were bubbles, and all behaved themselves by bursting. Now, sadly, there are probably none. Government bonds are the one serious candidate. In our opinion, they are badly overpriced but probably not by enough to justify the bubble title. Global equity markets are still cheap, but in major markets are nowhere near 2-sigma, 40-year bust levels. Some small-scale 2-sigma bargains may exist in the fixed income markets in rate differentials, but need skillful analysis and knowledge to disentangle from value traps. And, they are a very far cry from, say, the opportunities offered by buying credit default swaps at a handful of basis points on overleveraged financials in early 2007. So, all in all, welcome back to the age of guesswork.