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By | 06-22-2012 01:00 PM

Grantham Keynote: Investing in a Slower-Growth World

The GMO chief strategist highlights the factors behind the market's bullish bias, abnormally high corporate earnings, current valuation levels, a slowdown in productivity, and the great paradigm shift in natural resources.

Scott Burns: We are all here, so bright and shiny, and it’s early. We must be really excited about our first speaker. I think that goes without saying.

So we've got Jeremy Grantham here. I think Jeremy Grantham gets typecast a lot as a bear, rather unfairly, because a bear is just hunkered down and holding cash, and not buying anything. But Jeremy has been investing in quite a few things over the years. He's just been a little bearish on U.S. equities, and if you are a bear, I guess even if we do want to wear that typecast label, I guess it's OK to be a bear when you're right as often as Jeremy is, right?

So Jeremy and I talked about education quite a bit. We’ve had so many people in the back, while we were getting ready, come up to Jeremy and thank him for his quarterly insights and the education role that he's played in helping investors understand what's happening in the markets, what's happening in their own investment behavior, what's happening with valuations. And so it's with great pleasure that I introduce GMO's Jeremy Grantham.

Jeremy Grantham: Thank you, nice to be here.

I suppose I should start by saying that I don't feel I really do know much about what is going on right now. It's a very strange time, and I get this Groundhog Day effect, as if the news is just replaying and replaying.

I just visited, a year later, the other day, a client, and I read my notes of the year before, and holy cow, nothing has changed at all. Greece was about to collapse, no it wasn't. Bernanke was thinking about QE 23, and China for two years, according to several of my very smart colleagues, was about to stumble big time into kind of zero growth, and it still looks like that today, that it might. It still claims to be growing at 8%, but it looks like it might be stumbling big time. And people have a wonderful story: look at the electric output and so on. And Bernanke still identically talking the same game, and the EU just goes round and round in torturous circles, and the market just goes up and down, going nowhere in particular. I actually think that the Financial Times is recycling its old articles. They seem so desperately familiar and, of course, by definition, incredibly boring.

I've got three things to talk about, but I wanted to just share, first of all, kind of Friday morning thoughts. In general, everybody is automatically a little optimistic. If given half a chance, people will assume things will work out. I believe it's programmed into our species. I think back in the days when we were hanging on by our fingernails, if you were a pessimist, you just gave up.

So, we're the survivors, we're the optimists. And I think it's evident when you look at the history of the stock market. Give it half a chance, and it will spin a terrific story. And it will always be reinforced by the financial industry. The financial industry has a huge investment in being bullish, and being bearish is bad for business, and therefore, nobody in round numbers ever is. So, that's kind of theme one. Be prepared to see a bullish bias in normal situations.

Secondly, quite separately, people like to stay in the pack, and sometimes the pack wants to go hurtling downwards, so you can have bear markets OK. You have a bullish bias, and then quite separately, a bias to create a herding effect, driving stocks or markets, commodities, everything up and down, far away from anything sensible, but still with an overall bullish bias.

Another breakfast thought is that the earnings level is abnormally high. And GMO is pretty academic, sometimes to its cost, and so we ruthlessly normalize earnings to very long-term averages. And that's what separates us from most of the data. People think the American market is very cheap, in general. A great majority think it's reasonably cheap, and we don't, because we want it to be priced to the normal earnings. And the bulls say, well, of course, there's been a paradigm shift. Profit margins are higher and always will be higher, because that's what bulls like to say. And we say, other things being equal, we'll always bet on the average--profit margins will come down.

And think how weird profit margins are. We have high unemployment. We have lots of things going wrong. We have, I think, a justifiably scary world, and yet we have world-record profit margins. It is truly weird. It has never occurred before.

According to my colleague, Ben Inker, and some economists over the years, there is a relationship between rising government debt and profit margins. As government debt rises, other things being equal, underlined three times, profit margins tend to go up. And when they start to pay down the debt, other things being even, profit margins come down, and that seems pretty plausible in today's situation, but it gives you this artifact, and it's a prop to the market: world-record earnings. And they are believed by most people, but not GMO. And so they look at the P/E on these astronomical earnings, and they say, oh boy, the market is really cheap, so that even though I'm nervous, I don't necessarily have to sell my stocks at such a bargain price. And, in fact, American stocks are a little expensive, and as earnings turn over, which they are doing now, I was worrying over breakfast that people would see that, oh my, earnings are not what we thought they were. And that would give a nervous marketplace a pretty good excuse to come down. So it's kind of offsetting errors. The market wants to be nervous, thinks it's being nervous, and thinks it's priced the market accordingly, but only because it quite incorrectly gives full credit to today's earnings. So I think that is food for thought.

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