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Grantham Sees Huge Opportunity in "Anti-Risk"

Will a financial bubble crush small caps and hedge funds?

Russel Kinnel, 07/31/2007

Jeremy Grantham says he's spotted the third great investing opportunity of his career.

The first was small caps in the 1970s. The second was real estate, Treasury Inflation-Protected Securities, and value stocks during the tech bubble in 2000.

Before you get too excited, I should make clear that the main opportunity today, in Grantham's view, is getting out of the way and watching the markets plummet in what he calls a slow-motion train wreck. Grantham made this call in a report published July 25--a day before the Dow got 300 points sliced off the top (talk about instant gratification!).

Grantham's firm, GMO, runs mostly institutional mutual funds but also runs half of Vanguard U.S. Value VUVLX and all of Evergreen Asset Allocation EAAFX. Grantham has always had a bearish tilt, so I typically take his warnings with a grain of salt. Still, he has been very much on the money with his warnings about the S&P 500 in 2000 and recommendations of foreign small caps, emerging markets, and timber.

In Grantham's view, we are in a financial-debt-soaked bubble that he's labeled the Blackstone Peak. Real estate and bonds are wobbly, and equities may weaken in October 2008. Grantham is a big believer in election cycles, which essentially means that the government floods the economy with money to get itself re-elected and then the market has a big hangover the following year when the bill comes due.

Grantham says that the excesses of private equity, hedge funds, and subprime debt mean lots of the economy and markets are leveraged to the gills and the end won't be pretty. He posits that in five years half the hedge funds will be out of business and one major bank will go belly up. The first call isn't really that bold when you consider the survivorship rates of hedge funds, but the second is a whopper.

I asked him about that, and he explained that he expects big banks to get burned by loaning money to private equity for a low return. He figures they'll get stuck with a few of those loans and take a bath. Moreover, he points out that most financial crises take down at least one big player.

Grantham calls this new opportunity "anti-risk." He says the opportunity lies more in bonds than stocks. "The ideal way of playing this third great opportunity is perhaps to create a basket of a dozen or more different anti-risk bets, for to speak the truth, none of us can know how this unprecedented risk bubble with its new levels of leverage and new instruments will precisely deflate. Some components, like subprime and junk bonds, may go early, and some equity risk spreads may go later."

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