On Jeremy Grantham's Latest

Brave Talk
GMO's irrepressible Jeremy Grantham is at it again. In his third-quarter 2013 letter to shareholders, reprinted on Morningstar.com, Grantham takes aim at, among other things, economists, the Nobel Committee, Eugene Fama, the Efficient Market Hypothesis, and the condition of today's stock market.

It's entertaining stuff, made more entertaining by Grantham's delivery, which suggests that he has received his word directly from the Lord. Grantham knows what his audience wants. Investment managers comfort their shareholders when they are direct and confident. It's unbecoming for a guru to show uncertainty.

For me, Grantham overestimates his abilities in the first part of the letter, when he attacks economists and the Nobel Committee. He's on much firmer ground later on when assessing the stock market.

No Bells for Nobels
Grantham isn't fond of economists, who practice a "soft science" that is guilty of "physics envy." As "economics has been more or less threadbare for 50 years," the Nobel Committee should stop handing out so many economics prizes. Instead of three awards per year, as has been the recent fashion, the Committee should instead make the award once every three years.

That's a fun section, but not credible. The number of people who understand physics, literature, medicine, chemistry, and economics (I'm setting peace aside--not sure what to do there) well enough to judge the amount of excellence exhibited by each field must surely be very small. It's unlikely that one of those people would be an investment manager who is paid to evaluate asset prices, not to measure, say, the quality of contributions from modern physicists.

Grantham isn't much more convincing with his criticism of one of this year's Nobel Laureates, Gene Fama. Grantham demolishes the Efficient Market Hypothesis, which Fama helped to develop, by pointing to various market bubbles. In 1991, Grantham writes, the land underneath the Japanese Emperor's Palace was worth more than the value of the land in the entire state of California. The boom in U.S. stock prices during the New Era of the 1990s, and then the growth in housing prices in the 2000s, also strike Grantham as being indefensible.

With this section, I fully agree with Grantham, down to his mocking of the "12 reasons that were given as to why the 22% drop in one day" of Monday, Oct. 19, 1987, was a "rational economic response." I recall an editorial in The Wall Street Journal claiming that news that arrived over the weekend of Oct. 17 and 18 justified a change in the discount rate used for valuing stocks, and therefore justified the 22% daily loss in stock prices. I also remember believing that couldn't possibly be right. It was not. But it was a required line of thought for those who felt the need to defend the EMH. 

That said, the EMH has been useful.(1) Defending the extreme form of EMH is a losing proposition--a proposition, admittedly, that Fama himself has sometimes made the mistake of supporting--but in its milder form the thesis has been accurate. It has served as a useful guide for understanding the performance of mutual fund managers, few of whom have been able to beat a static benchmark consistently. Indeed, of GMO's three large-company stock funds with 15-year records (U.S. Core Equity ,  U.S. Equity Allocation , and U.S. Growth ), two trail the Wilshire 5000 for the time period.

(1) Also, Professor Fama generated other insightful research, most notably his paper co-authored with Ken French that demonstrated the failure of beta as a stock-market predictor.

The reason being, as discussed previously in this column, it's a lot easier to identify a market bubble than to profit from it. It's easiest, of course, to identify a market bubble after the fact, as Grantham did in this letter (and as I frequently do). It's harder to identify a bubble as it is forming, a feat that to his credit Grantham has sometimes managed. It's hardest of all to know when to exit a bubble. Leaving early can have a high opportunity cost, leaving late will have an actual cost.

Today's Stock Market: Be Careful
Which leads us to the conclusion of Grantham's letter: current market conditions. Now we're talking. If there is one thing Jeremy Grantham does well, it's gauging the level of asset prices, using both quantitative measures and judgment based from experience. He might not be suited for a Nobel Committee, but he'd outdo anybody on that Committee--and, aside from Robert Shiller, all the Laureates as well--for practical insights into current market valuations.

For U.S. stocks, Grantham says, it's time to be worried but not panicked. "In equities there are few signs yet of a traditional bubble." As he notes, the popular press has yet to hop aboard the equity rally; for example, people aren't tuning out of NFL games so that they can catch stock-market tips. There's no equivalent of the New Era best-seller Dow 36,000 attempting to explain why the tree will grow all the way to the sky. Cash flows into stock mutual funds, usually a contrarian indicator, have only recently become positive. (What's more, stock-fund cash positions have been inching higher, per a Reuters report. Normally in a bubble, cash positions decline.)

With that I will not quarrel. My view, expressed previously this month, is essentially identical. The early warning signs have appeared. However, the stock market rarely falls after the early warning signs. Typically, the plummet occurs later, after repeated indications, when it seems that this time will be different and the downturn will not occur. The bear is at its most dangerous when its existence is doubted.

If trouble lies on the horizon, should investors continue to hold stocks? On this matter Grantham is conflicted. The bad news is that the market is "badly overpriced," such that it will deliver "negative real returns over seven years." However, writes Grantham, because the bubble does not yet appear to be fully formed, U.S. stock prices will likely rise before they fall. He expects stocks to appreciate by 20%-30% over the next 12-24 months.

How investors implement this good news/bad news depends upon their risk tolerance. "Be prudent and you'll probably forgo gains. Be risky and you'll probably make more money, but you may be bushwacked and, if you are, your excuses will look thin. Your call."

I have no quarrel with that either. Being a risk-taker (with stocks, not with other things, as a general rule), as well as being skeptical of tactical asset allocation, I am remaining in. I can, however, understand those who opt for the prudent path.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.