Friday, February 24, 2012

Jeremy Grantham's 4Q Letter: "The Longest Quarterly Letter Ever"

Jeremy Grantham's 4Q Letter is comprised of three sections: Investment Advice from Your Uncle Polonius, Your Grandchildren Have No Value (And Other Deficiencies of Capitalism), and Investment Observations for the New Year.



Inflation Hedges

The 800-pound gorilla (the one that prefers bond holders to bamboo) is not in the room yet, but you can hear him thumping his chest up in the hills. He will come eventually, and before he does, you should remember that stocks are underrated inflation hedges. The underlying corporations have real assets, employ real people, and sometime even make real things, although a good idea embedded in a small thing (like an iPad) or a service is just as good. Equities have been tested over and over again in different places and in different decades and they have always been found to be very effective hedges. Serious resources – oil and copper in the ground and forestry and farmland – will almost certainly also be good and very probably much better than broad stocks in the short run. Gold may be good too. Who knows? But for stocks to work dependably as inflation hedges one has to have a several-year time horizon: in the short term, rising inflation can hurt stocks badly, for as mentioned last quarter, inflation is usually a powerful negative behavioral input. Investors hate jumps in inflation because they sharply raise the levels of uncertainty. Fairly quickly, though, earnings always catch up, and after multi-year surges in inflation (as in Brazil in the ’80s) we end up with the total market value in its normal range as a percentage of GDP while regular bonds if they exist, get destroyed.

Exhibit 2 shows the co-incident 5-year relationship between the return for stocks, bonds, and gold, respectively, against the CPI since 1919 in the U.S. As inflation picks up, the real price of gold goes up, the real price of bonds declines a lot, and equities decline also, but significantly less. Exhibit 3 looks at exactly the same inflation data but adds the next 5 years of real returns for the three assets. Now, over 10 years, there is only a very slight relationship between either gold or equities with the original 5 years of change in the CPI. In the case of bonds however, there is still a strong tendency for bonds to continue to lose ground. The conclusion from that time period is that surges in inflation have been a very slight issue for holders of equities (and gold) on a 10-year basis, but a very serious one for bond holders. We must also remember that previous inflationary periods in the U.S have mostly followed a pattern of rising several years to a single peak and then falling. The next one may be different. It may move up and then fall back several times, creating more of a range of hills than a single Himalayan peak like 1981. In such a bumpy ride, stocks are likely to adjust more quickly each time while long bonds will see their values steadily eroded.

The short-term correlations between stocks and inflation in the past have been quite high, but short-term correlations are for traders, not investors. I’d advise not getting too carried away with them. In general, I also much prefer to have stocks and other real assets in a longer-term approach than to have complicated hedges and options. Murphy’s Law of complexity is powerful: things will go badly if they can and when you least need them to, but complex things will go bad first, and worst given half a chance, as we saw in the mortgage market a few years ago. Keep it simple when you can. And owning stocks is very simple indeed.


Summary of Recommendations (with apologies for the lack of changes)

  • Heavily underweight U.S equities, but not the high quality quartile, which is almost fair price. Non-quality equities, in contrast, have a negative imputed 7-year return after their handsome rally in the last 3 months through to mid-February.
  • Slightly overweight other global equities, which are almost fair price, down from a little cheap at year end.
  • In total, be about neutral in global equities. Yes, there is more than our normal fair share of potential negatives lurking around, but on our data: a) most of the negatives are reflected in stock prices; and b) all fixed income duration is dangerously overpriced. This last situation is, of course, engineered by the Fed, which hopes to drive us all into taking more risk, notably by buying more equities. I hate to oblige, but at current equity prices it just makes sense to do what they want. As mentioned earlier, equities are also good long-term hedges against inflation.
  • Underweight as much as you dare long-term bonds, especially higher-grade sovereign bonds.
  • In the long term, resources in the ground, forestry, and agricultural land are attractive, but come with the usual caveats of the risk of short-term over pricing, so average in.