The bubble in growth stocks, which burst in 2000, transformed pension fund investment committees from prudent investors into ‘gunslingers’ according to Jeremy Grantham, chairman of GMO, the Boston-based investment management group.
Grantham told an audience of pension fund managers and consultants in the City of London that he had been shocked by the transformation. “For 30 years foundations, endowments and pension funds, 65% of our business, were absolute models of prudence. But between 1995 and 2000 they metamorphosed into a bunch of gunslingers. The pension fund market in general were concerned suddenly not with protecting capital but with keeping up with the competition – making more money than the other guy.”
What turned out to be “the greatest bubble in American history” should have been easy to predict, he said. “The market in 1929 reached 21 times earnings. The next great bull market in 1966 also reached 21 times earnings But in early 2000 it reached 33 times claimed earnings, and 36 times revised earnings. This is enormously higher than 1929. So if you didn’t see it coming you weren’t looking. And if you didn’t act on it you were chicken.
“The growth bubbles are not difficult to spot, but what you do about them may be dangerous to your career. The risks are high, and not for the chicken-hearted. Managers like Gary Brinson of UBS Brinson and Tony Dye of Phillips & Drew both had all the right bets out and hung on as long as they could.” But it is impossible to get the timing of a bubble right, he suggests. “You will never know much about timing and what you do know will be unplayable. You know that the market will eventually go down, but you don’t know when.”
The danger to the market now is over-correction, he suggested. “There aren’t many great bubbles, so you don’t have a lot of confidence in the data, but every great sector bubble has over-corrected by an average of 50%. That’s the phase we’re in at the moment. There is no reason for it to over-correct by this much, but what we can sure of is that it will do so.”
However, Grantham said that there were still opportunities for institutional investors to make money in the market; in particular there were arbitrage opportunities in international, non-US equities. “There is one terrific bet left and that the US equities market versus non US equities. Non-US markets are simply much less expensive. So the highest quality bet has got to be the spread between them.”
He suggested that the US markets would probably rally this year, and possibly beat the performance of the non-US markets. “But on a seven year horizon the probabilities of non-US equities not winning are very slim indeed. The kind of magnitude by which they can win is very significant – 30 or 40 percentage points. So you can expect to make a decent seven year return in real terms relative the real risk.”
GMO’s seven year forecast of global equity returns predicts an annual return of 8.7% for international (non-US) large caps and 8.8% for international (non-US) small caps. Emerging markets is expected to return 9.2% annually over seven years. “This is currently a very nice market for us to be in. Emerging countries are hugely volatile. In the same nine month period you can have Russia down 40% and Turkey up 70% – a wonderful arbitrage opportunity for a quantitative investor.”
GMO also forecasts a real return of 9.5% annually over seven years for timber “This is the only quality low risk, high return asset class in existence. That’s because the investment world is behaviourally driven. It hates illiquidity and it hates things it doesn’t know. Timber scores brilliantly on both of these.”
He said institutional investors do not have to lose money when a bubble bursts. “In March 2000 there were wonderful opportunities to invest money and make money if you could think outside the box. Had investors been prepared to think this way and say we know the volatility, we know the real return, so let’s build an efficient portfolio, they could have put asset classes together that would have easily given them a positive return in a bear market.
“I was screaming at clients to do that. So what did they do? They took their US equity allocation down from 46% to 45%.”
Grantham warned that although asset managers did not need to lose money they should be prepared to lose clients. He said that GMO lost 35% of its business in the two years before the bubble burst in March 2000. But that is a necessary occupational hazard of a contrarian investor, he concluded. “If you’re not swinging hard enough to take it on the chin every 20 years you’re not swinging hard enough to make money in between.”