GMO’s Grantham licking his lips over hot bargains in the markets

BOSTON — Jeremy Grantham, chairman of Boston-based GMO LLC and a renowned wet blanket in the face of irrational exuberance, is sounding uncharacteristically giddy these days.

Asked what advice he’d give to chief financial officers overseeing corporate retirement plans, Mr. Grantham said they should recognize that there are bargains to be had now in almost every corner of global equity markets — even mouthwatering bargains.

While that might seem like a schizophrenic shift for a man who for years has dismissed most mainstream investment opportunities as wildly overpriced, it’s the capital markets that have been manic — and now depressive. In the space of just over a year, the Dow Jones industrial average has fallen 41% from its record close of 14,164.53 on Oct. 9, 2007. That plunge simultaneously revived Mr. Grantham’s reputation as a seer, while turning him into a bull — albeit, a cautious one.

On the seer side, the market’s plunge in the past month left annualized returns for the Standard & Poor’s 500 benchmark index over the past decade below the -1.1% forecast GMO made on Sept. 30, 1998, at a time when competitors were largely predicting healthy returns for U.S. stocks.

In an interview, Mr. Grantham said until the more than 20% plunge of U.S. equity markets in the past month, the surge in equity valuations that began from the mid-1990s had been the only market bubble of 28 tracked by GMO that had not “broken all the way back to pre-existing trend lines.” The idea that volatile market valuations inevitably revert to historic means has been a mantra of Mr. Grantham’s over the decades.

“Previous bubbles had always overcorrected,” but the retreat from the technology bubble between 2000 and 2002 fell well short of the average retrenchment, said Mr. Grantham, calling the market’s upturn between 2003 and 2007 “the greatest sucker rally in history.”

The latest bubble was unique in both its geographic reach, and the range of assets with bloated valuations, the market veteran said. “For the first time, this was a truly global bubble,” sweeping up everything from equities and real estate to fine art. If a global price/earnings ratio could be constituted, it would have been the highest in history, he said.

But suddenly equity markets are “below trend lines” for the first time since 1994, and even at the market levels that prevailed at the end of September, investors can expect to earn real annualized returns of more than 5% a year in U.S. equities over the next seven years.

“U.S. pension funds are crying in their soup now, but they can at least find some solace in the fact that, for the first time in 20 years, we’re looking at all global equities being modestly cheap,” said Mr. Grantham. Some are substantially cheap, which has left GMO looking to add to its holdings, he said. “Catching a falling knife is never without pain, (but) the prime directive is to buy cheap assets.”

There’s no need to rush, however. CFOs should phase back into equities “with all deliberate slowness, as opposed to all deliberate speed,” Mr. Grantham warned. Even though the S&P 500 is trading below GMO’s fair value estimate for that index of 975, markets typically overshoot on the downside by 20% or more, he noted. If the market panics, that bottom could be reached in days or weeks. If it’s a more orderly affair, it could take until 2010, as investors digest a likely stream of wretched economic news, he said.

This time around, GMO, with $126 billion in assets under management as of June 30, might take longer to profit from correctly reading an overheated market than it did after March 2000, when the technology bubble collapsed, Mr. Grantham said.

Making money between 2000 and 2002 by taking hefty positions in severely undervalued market segments — including bonds and Treasury inflation-protected securities, small-cap and value stocks — was like shooting fish in a barrel, Mr. Grantham said. This time around, with everything overvalued, there was “no place to hide,” and the only option was to tilt more to the least overpriced sectors.

At GMO, “we have not covered ourselves in glory,” said Mr. Grantham, noting that “this is the first year we will have lost money in 15 years.” The fact that GMO has a value tilt at a moment in market history when many value managers have been eviscerated hasn’t helped. Still, some of the firm’s balanced strategies and asset allocation strategies have managed to fall eight or nine points less than their benchmarks over the past year, he noted.

Going forward, Mr. Grantham said GMO will be “steady buyers as the market goes down.” The firm risks being too early, but will be in position “to make a ton of dough” when the inevitable recovery comes, he said.

Mr. Grantham predicted the scars from the current market downturn will be long lasting, and the effect on the money management industry profound. While GMO now believes equities can be had at attractive prices, “a very substantial fraction of a generation of investors” is likely to be leery of stocks, just as they were in the 1930s, ’40s and ’50s, and as they were again for most of the ’70s, he said.

This is “truly the end of an era, and almost everything will be re-evaluated,” from interest in leverage-dependent hedge fund and private equity strategies, to asset allocation, to how institutional investors handle their liquidity needs, Mr. Grantham said.

At the end of the day, people will have a different view of risk — “a much more realistic view of how hard it is to generate alpha,” he said.

As part of that review, the idea that “everyone and his dog” would end up with a portfolio like Yale University’s endowment, highly diversified with allocations to a number of illiquid asset classes, will give way to the realization that many of those investment targets don’t have the liquidity to accommodate a wave of assets, Mr. Grantham said.

Contact Douglas Appell at [email protected]