The Rules of Investing

6 essential takeaways from my exclusive interview with Jeremy Grantham

Patrick Poke

Livewire Markets

It’s not every day you get the opportunity to speak with a legend like Jeremy Grantham. But I’ve been lucky enough to do so twice in recent weeks (the first time, unfortunately, cut short due to technical issues). Despite being at the end of a long day in Boston, the 82-year-old investment titan was happy to take two hours out of his evening to talk to me about bubbles, commodities, and the creation of index funds.

In our discussion, Jeremy drew many parallels between the bubbles in 1973, 2000, and today. He tells us about the behaviour, the economic drivers, and the valuations that are driving us to this precarious situation. He explains which assets are best and worst placed to weather the storm, and finally, he sets a timeframe and a framework for the culmination and unwind.

For those of you without 110 minutes to spare (or 55 minutes if you like to listen at double-speed), I’ll try to summarize some of the key points from our discussion in the wire below.

Six essential takeaways:

  1. Value outperforms growth when inflation rises
  2. Career risk prevents most financial professionals from acting on bubbles
  3. The 100-year downtrend in commodity prices is well and truly broken. Expect resources to be scarcer from here on
  4. This is not a simple case of overvaluation that can be easily dismissed. This is a bubble, and it's serious
  5. Inflation hedges and commodities look attractive, US equities and residential housing looks very risky
  6. Time is short, the end could be just months away. Read the full thing to see what to expect as we get closer to the 'pop'.

Alternatively, if you'd prefer to listen to the podcast, you can find that here:

Macro
Grantham: This is a bubble, this is serious

Lessons from the 70s

For those who don’t remember or weren’t around during the 1970s, it was a period defined by high inflation and rising commodity prices. Between 1965 and 1972, a small group of stocks known as the Nifty Fifty became market darlings, known as “one-decision stocks”. You only needed to make one decision to buy them, then you could hold them forever, regardless of price. It included blue-chip names such as The Coca Cola Company, Disney, and Walmart. But also, many now-defunct firms such as Kodak, Polaroid, and Xerox.

As OPEC’s oil embargo began to bite in 1973 and inflation really took off, ‘value’ stocks – those on low price-to-book or price-to-earnings ratios – were incredibly cheap. These high-priced growth stocks were sold down hard, and even those that survived and saw their underlying businesses thrive took many years to reach previous highs.

“The value factor was as cheap then as it is today, or as it was last November.”

Life was good for value managers in the years that followed. They’d outperform the index three years out of four, simply by buying cheap stocks.

“If you were a value manager, all you had to do was show up to work and win. “

It’s not just a coincidence that this period of big returns for value investors lined up with rising inflation. Grantham sees a direct causative link between the two.

“The higher the (interest) rate, the more the dividend counts. The lower the (interest) rate, the more the growth counts. So in an era where rates drop lower and lower, two things happen. There’s a bigger and bigger premium for high quality – part of the discount rate structure. And there is a bigger and bigger premium for growth. And value underperforms. When interest rates rise, it flips.”

If you’ve been paying attention, you might notice the similarities between that period and today. So perhaps value investors are about to enjoy their time in the sun again?

Why fund managers don’t act on bubbles

Bubbles are not difficult to spot, says Grantham. The hard part is acting on them.

“They’re all completely obvious. Anyone with a brain could see that all three of those (the Japanese equity bubble, the tech bubble, and the US housing bubble) were extravagant bubbles. The trick is, you don’t know when the bubble will end. Therefore it comes with incredible business risk.”

Most investment professionals are unwilling to take the kind of career risk required to ride out these bubbles from the sideline. The uncertainty of timing, and the power of FOMO, prove too powerful a combination.

To give an idea of the true seriousness of this career risk, he explained what happened to his firm in the late stages of the tech bubble.

“If you think it wasn’t big and painful, you would be wrong. In 2000, we knew what the highest PE in history was, from 1929 – 21 times earnings. It got there at the end of ’97… Then as the PE rose from 21 to 27, we fairly quickly became as defensive as anybody. Then as it went to 35 in the early part of 2000, we became utterly defensive. In many cases, we hit the legal boundary of our conservatism that we were allowed in a relationship with a client. In some cases we went and asked to change the relationship so we could be even more conservative.

"Some of them allowed it, and some of them shot us. They were getting fed up. The market nearly doubled, it went up 70% and we were defensive. So we underperformed handsomely in ’98, ’99, and the first quarter of 2000. Before we were doing fine, but now we had two and a quarter years of bad performance and these blue-chip clients fired us left, right, and centre. They started firing us after 18 months. That’s when the home truth came.

"You don’t get fired for doing badly in a bear market – they become catatonic … But in a bull market, they’re playing golf with their fellas from the club who are telling them about the brilliant manager they have who’s stacked full of growth stocks and is knocking it out of the park. They get incredibly upset and impatient.”

During this period, GMO lost at least 60% of their asset allocation business. The market did turn though, and the funds came flowing back in. However, Grantham says that not one of the clients who left in this period ever returned to GMO, despite the accuracy of their calls.

The outlook for commodities is bright

Grantham says he only has two of his notes go truly viral over the years. One of them, called “Waiting for the last dance”, was written in early January this year and culminated in an interview on Bloomberg (and his appearance on The Rules of Investing, of course) that has received nearly 4 million views to date.

The other was a paper published in April 2011 titled, “Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever.” While he managed to time it as poorly as possible, publishing right at the top of a major cyclical peak in resources, the paper was looking at long term trends that had been ignored up to that point.

“For 100 years, from 1900 to 2000, the price (of commodities) had fallen 70 percent (adjusted for inflation).”

They looked at 33 important commodities – excluding oil, which he says is a special case – and created an equal-weighted basket of them. Over the 20th century, this basket of commodities had fallen steadily – with a couple of temporary spikes due to the World Wars. By 2000, commodity prices were down to 30% of the 1900 level.

But over the next eight years, all that reversed, and 100 years of price falls were retraced. What changed? China. Over 30 years, China had risen from 4% of the global iron ore market to 50%. Similar gains were seen in coal, cement, and many other critical commodities.

Of course, China’s desire for commodities dampened in the early part of the last decade, and after decades of demand growth, it ground to a halt. Meanwhile, many of the world’s commodity producers had huge expansions in process or coming online. As anyone who was investing in Australia at the time could tell you, a deep bear market followed. But the old trendline of the 20th century was never restored, and today, many commodities are approaching old highs, or setting new ones.

“China has given us warning that the easy supplies have gone. We have no big safety margin like the good old days. Whether it’s this crisis or the next crisis or the one after, we have entered a new era where some commodities will always be going up, some sideways, some going down. It looks this year, indeed today, as if in 2000 we started on a wild up and down… different world.”

He points to industrial metals in particular, such as lithium, copper, nickel, and cobalt. Prices are being driven up by rising demand for use in electric cars, solar panels, wind turbines, and tech application. While these metals will be subject to the usual boom and bust cycles, rising demand and scarce supply should ensure old trends are not resumed.

Why the looming threat is not like 2011

On the back of his very public and accurate calls at both the top and the bottom of the financial crisis, Grantham was often quoted in the media in the years following. It’s not hard to find articles from this period with headlines about overvalued markets. 

However, Grantham stresses that these comments were simply “routine comments” is his job as a “colour commentator”, discussing overvaluation.

Markets have been increasingly overvalued since 2011, but this alone is not enough to form – or pop – a bubble.

“You asked me about the fact that I had been bearish. I was trying to separate what I call a serious moment, when I’m saying, “look, this is a bubble, this is serious.” 80 percent of the time, things are more or less okay. You go to work, you keep your nose clean. Ho bloody hum. 10 or 20 percent of the time, you’re either forming or breaking a bubble. That’s important – how you treat it. You have an opportunity to be a hero, or an opportunity to get out of the way and let people go over the cliff together.

“When I wrote ‘Reinvesting while terrified’, that is serious. Seriousness is flagged by the language you use. I said, “Get your ass back into the market.”

“In the housing bust I said, “I have a problem. I have been bearish about these prices for years. In general, the market has been overpriced. Big deal. This is different. This is serious”…“This is, today, a really impressive bubble in the US equity market"

But the situation in the world is very different today from what it’s been like in the last decade or two. Labour is becoming scarcer as populations age, birth rates drop, and the flow of workers from “the farm to the factory” has greatly reduced. Interest rates have fallen to zero and beyond in most developed economies, and asset prices have increased substantially.

“If you have high-priced assets, you are seriously reducing the rate at which society can compound its wealth. That is simple arithmetic. 

"The only people who benefit from super high-priced assets are old fogies like me, liquidating their portfolio and selling their houses. The people who really suffer from high prices are the newbies, who are disgruntled because they can’t afford a house like their grandparents.”

So where do you invest in a period like this?

Grantham says that investing through the period ahead will be challenging as assets reprice for a new environment. Once that repricing has occurred, returns will be much easier to come by, but for now, navigating asset markets is like trying to avoid stepping on mines in a minefield.

“In the transition, everything is dangerous.”

But there are some areas that look better than others. He points to inflation hedges, raw materials, and mining companies, saying they “look pretty good.” He separates oil though, saying that it’s “super scary” as “no one knows what the hell is going on.” So he does not recommend oil.

Though he confesses to owning gold himself, however he says he’s uneasy with his gold investment.

“If you try to explain what gold is, other than being partly useful as an industrial metal, you end up in a pickle. All I can say though is Bitcoin is harder to explain.”

However, he points to gold’s 4000-year history of use, having stood the test of time, unlike cryptos.

US equities and residential housing look particularly risky, with high prices and erratic behaviour. And this is accompanied by low bond rates and low premiums for risky bonds.

The current bubble: What to look for, and what to expect

The developed world is coming back to life, thanks to the unexpectedly effective vaccine. Grantham says this has gone much better than he had expected. Meanwhile, the amount of stimulus injected into economies by both governments and central banks has been far greater than expected.

“We have an almost incomprehensibly large stimulus program, which, added together with previous ones, will total more than the Great Depression, as a percentage of GDP… It’s off the scale.”

We know from the first stimulus, that some of the money that flows into people’s pockets ends up being used for speculation. Grantham expects the second round of US stimulus to be no different. He thought before that a good time for the bubble to pop would be when the last major group of investors get vaccinated, but the stimulus appears to have pushed that date back a bit.

At the end of each bubble, there’s always a phase where blue-chip, low-beta stocks begin to outperform the exciting growth stocks. He observed this during the latter stages of the tech bubble, and history shows the same thing occurred at the end of the 1929 bubble.

“That’s eerily similar to 2000."

In the current bubble, it’s been Tesla and the SPACs at the centre of the storm. Both peaked in January, and both are down over 30% since then. Bitcoin is having “wobbles” here too (it’s down 42% from its high). It appears these “mini-bubbles” are starting to pop, he says.

“Based on comparison to other bubbles, and pushed, you would say maybe another few months. Three or four months. When I think about the pleasant surprise of the size of the stimulus program, the pleasant surprise of the vaccination, I would say, three or four months. They both line up for a decline that is a few months in the future. It could go tomorrow…

“The definition of a bubble is pretty easy. We say 2-sigma. You have a price series, you can work out when it’s 2-sigma, and if you want to dress it up more than just numbers, you then insist on it having behavioural features, like crazy behaviour, and that’s more a sign of the end. And this one has done its duty on every front. It’s entertaining, spectacular. And I have participated in one of these, back in the midst of time, in a little but spectacular bubble of micro stocks in 1968-1969. 

"It was thoroughly exciting. I have no doubt that I cannot persuade anybody not to speculate, it is far too gripping, thrilling, and everyone in it together. It’s irresistible. All I can do it point out, like a historian really, this is what it feels like, it feels wonderful, they go up like this, they deviate at the end, then they crash, and they go all the way back to what is a fair price. That’s what will happen this time.”

Hear more from Jeremy Grantham

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Patrick was one of Livewire’s first employees, joining in 2015 after nearly a decade working in insurance, superannuation, and retail banking. He is passionate about investing, with a particular interest in Australian small-caps.

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