历史上最大的傻瓜反弹？

GMO Quarterly Letter October 2003 Jeremy Grantham, Chairman The Greatest Sucker Rally in History?

The Third Quarter and ‘Bear Market Rallies’ How do the prior three great bubbles and busts score on The third quarter was right back into classic ‘bear market this front? (They are: U.S. from 1929 to 1932; U.S. from rally’ mode: a huge rally in last year’s crushed stocks, and 1965 to 1974 (or 1982); and Japan from 1990 to 2002 (?). leadership by growth, low quality, and small cap. This of a. Value course was not GMO’s type of market, unlike the second quarter where we had an unexpected broad value rally, All three were scrap iron value or barely half long-term which I reluctantly conceded felt like a serious bull trend. FAIL market. b. Leadership Even small cap, usually at least a modest GMO bias in The changes in the market leadership in Japan and the recent years, was not extraordinarily helpful as we had U.S. in 1932 and 1974 were dramatic, as everything scored small cap as fully valued relative to large by the changed; in the U.S. in 1982 they were merely very beginning of the year, and only our deliberate inertia (a substantial as energy and commodities declined and value slow 18-month cycle of slicing out of old investments) and all small cap rallied. FAIL left us modestly overweight small in the U.S. and substantially overweight in foreign quant, although less c. Sharp, speculative rally than half of our peak bet. After 1982 there was some speculation otherwise, FAIL I concede that bear market rallies are a fairly nebulous d. Heart-broken concept because you cannot be sure what they were until All three pass the test and stock ownership halved. VERY later – the only proof of a bear market rally is that you go FAIL to a new low in the not too distant future. But despite this reservation, I cannot resist noodling with the concept. How does this current rally in the aftermath of the fourth great bubble stack up?

The characteristics usually attached to a bear market rally are: a. Value September 2002 low was barely lower than the prior two a. the prior low was not particularly cheap; great bubble highs (19 times to their 21 times). b. the leadership reverts back to that of the prior bull Spectacular PASS market; b. Leadership c. the rally is sharp, unusually persistent while it lasts, and Classic reversal to prior bull market leadership, has a speculative tone, perhaps because investors are especially growth and tech. Spectacular PASS. trying to make up lost ground; c. Sharp, speculative rally d. investors’ hearts were only half broken by the previous This rally has shown substantial outperformance of low low in the market, allowing confidence and speculation to quality and rapid build-up of speculation in which recover rapidly. Nasdaq margin debt has risen to new highs!

Handsome PASS d. Heart-broken methodology. The Financial Times a month ago had a Investor confidence has quickly bounced into top quartile tidbit that characterized our U.S. problems: the 25% of levels and newsletter confidence has rebounded to 1999 stocks that were down the worst last year were up 44% levels! Cash holdings in funds are also way below this year; the almost 25% of the companies that had no normal! PASS earnings at all were up 41%, but the cheapest 25% on p/e were up only 9.4%! Given this, the underperformance of The minor rallies in 2001 to 2003 also pass the tests, not some of our U.S. funds seems reasonable. In surprisingly. Each time we had very strong rallies in the international and emerging, value continued to work heroes of the prior bubble – tech, growth, and the real through most of the quarter, although the U.S. low quality internet flakes of the prior cycle.

Pumatech remember, infection spread rapidly. By the end, I was relieved to see doubled three separate times last year and was still down two of our funds that are important to asset allocation – for the year! Well, as Crocodile Dundee would say, “You international small cap and emerging – have a good third call that a rally?” Since its low last October, Pumatech quarter. Asset allocation, with its huge bear market bias climbed 40 times. Yes, 40 times! From 18 cents (down historically, continued to walk on water with a 5.7% YTD from $100) to $7.21. Pumatech, for the record, has been gain on its benchmark as I write (October 20), and ahead my selection of the quintessential stock ‘flake’ for 4 of the S&P 500’s +20% despite holding 35% fixed years. This is nothing personal. The company may be a income. (But I apologized for our good fortune last fine, tiny company on its way to break-even, but the stock quarter so I won’t again.) is flakey.

Accompanying Pumatech this year were a substantial percentage of the survivors of the tech IPO The Presidential Cycle and the Greatest Sucker frenzy of the late 90s, led in size by Amazon (+211% Rally in History YTD) and Ebay (+58% YTD). As in 1998 to 1999, This topic will be addressed at our Fall Conference and growth beat value and tech trounced everything. will be written up as a separate piece and sent next But, you may answer, this bear market rally is bigger in quarter. So please bear with me, as many clients do not some ways (the Nasdaq is up over 50%, for example) come to the conference. The argument very briefly is: than any previous bear market rally and certainly longer: • The third year of the Presidential Cycle is used by the no other bear market rally after the three great bubbles administration to attempt to stimulate the economy for broke in 1929, 1965, and Japan in 1980 came close to this year four to create a favorable re-election environment. performance.

And this is true! But it is also true that more stimulus and moral hazard has been offered to this • This President, perhaps learning from his father’s error, rally than any previous one, by a wide margin. It is succeeded in having truly record stimulus. reasonable, therefore, to expect a big response and we are certainly getting it. • This stimulus has a moderate effect on the economy in years three and four, but has an extravagant effect on But Ben Inker, more cold blooded than I and less the stock market. interested in semantics says, “Who cares what you call it, it’s going to end badly eventually because it’s This is partly the traditional effect of lower rates, but is overpriced.” largely psychological; consumer confidence rises, which is coincident with higher p/e’s, and we hypothesize that Third Quarter Performance investors generally feel some substantial underwriting of Both the quarter and the year so far have had mixed their risks, or moral hazard, by the Fed and the performance for GMO funds, certainly by the standards Administration, who imply that they will keep money of the last 3 years, but with two mitigating circumstances. available and rates low for a chunk of time so that First, all the equity markets are up a lot, and, in the investors can speculate at low risk. average up month, all our funds tend to lose a little to the The net effect on the U.S. market is remarkable: since benchmark (happily more than offset by downside 1932, years one and two have been 4.5 points below outperformance in the past).

Second, in the U.S., growth average, year three 8 points over average, and year four, has beaten value, ‘low quality’ has beaten ‘high quality’, 1 point over. and momentum has failed as last year’s wiped out stocks have come surging back. Value, high quality, and Also remarkable is that this U.S. Presidential Cycle effect positive momentum simply work better with our has been stronger in the UK than in the U.S. since 1932!

GMO Quarterly Letter – October 2003 2 (Gallingly, there is absolutely no Prime Ministerial Effect gave in a previous quarterly letter, begin to look for the Brits!) Since 1970, when good data starts, the vulnerable for several reasons. First, our new research effect of the U.S. Presidential Cycle has even been one shows, to my surprise, that the Presidential Cycle is third as strong in continental Europe and two thirds as largely played out by year four. Second, the fourth year’s strong in Japan. Yes, Japan! Where everything is always performance is normally sensitive to the market’s considered independent. aggregate value (unlike year three), and the current market has been rising in an accelerating fashion, which Notably, in year three, other normally important is characteristic of mini (or maxi) bubbles, but more influences seem to be swamped by this Presidential critically has already carried the market to 24x trailing Effect and either disappear or are muted.

For example: normalized earnings and at this rate, would be in the 25x the value of the market (in price/earnings or price/book to 30x range by year end! terms), which is usually moderately indicative of next year’s performance, appears to have no effect. In round So it would be prudent to revise the odds of a continued numbers, all third years are up and 1999, by far the most rally next year to below 50%, though given the expensive year ever recorded then, kept going straight up exceptional stimulus, the odds of a continued rally should like a good third year. Similarly, the substantially still be reasonable, say 40%. If this year’s rally continues powerful January effect (the strong tendency for January at current rates, the odds should fall considerably further performance to predict the balance of the year) also from there.

So this is a significant and relatively rapid bounces off year three: witness this year with its slightly change in my view on next year. I had really hoped for a down January. very slow market advance deep into next year during which we would very slowly and reluctantly increase our Interestingly, the sector effects in year three are defensiveness until later in the year, when we would completely compatible with increased confidence and an batten down the hatches and try to be heroes in any increased willingness to speculate under the protective ensuing decline. umbrella of the Administration and the Fed. Growth, small cap, and low quality all do well in year three just as they are doing this year. Growth stocks beat their average Outlook for 2005 and 2006 performance relative to value by 5% in year three, small The outlook for 2005 and 2006 unfortunately still looks beat large by 6.5% over normal, and low quality beat high like a black hole however one massages the data for next quality by 2% over normal. year.

That would be a very likely time to take this market down to fair value (16x) or below. For as mentioned in Outlook for 2004 earlier quarterly letters, in the first two Presidential Cycle years all the house cleaning – like moving against Yet year four, in complete contrast to year three, is a excessive debt – gets to be done, and debt levels are the reasonably normal year. The fourth year outperforms by highest ever and still growing. This time the chances that a statistically insignificant 1% over normal, and small cap small cap or value stocks will materially buck the trend is also near normal. What is interesting and surprising to seem slim or none, since they are both fully valued us, however, is that low quality has a poor year and value against the market, although in a major decline value has its best year.

So, if 2004 is an up year, we may do should help a little. Foreign developed also seems very better (or at least less badly) than we would have vulnerable to a sympathetic decline if the U.S. market expected otherwise. falls, although given the record relative cheapness of The exceptional fiscal and monetary stimulus program foreign developed, the decline should be substantially appears to have worked quite well this time, and we less and probably further helped by a continued weak expect a continued decent economic recovery and quite dollar. Emerging market equities, despite their huge good profits for a while longer into next year. These move, is now the only cheap equity subset, and only conditions would typically cause a rising market and a slightly cheap at that. But its economics look stronger growth and speculative tone at least until next year. than in developed countries and there is enormous institutional interest.

We have said for years that the Next year, though, anything can happen. The stimulus reasons to own emerging are that it’s different, and that in program will still be having a beneficial lagged effect, one 12-month period someday it would double. If the but the 50%+ odds for a continued rally next year, that I U.S. market hangs in next year, we are probably in 3 Quarterly Letter – October 2003 GMO that year. If the U.S. falls (and a faltering economy short-term reprieve or rather a ‘stay of execution’. In the would still be the most likely catalyst) then emerging longer run, boring old value is extremely predictive and might still hang in or at least fight a tough rearguard at 24x trailing earnings, the 7-year forecast is below -1% action. a year real return for the S&P 500, to be followed after our assumed 7-year decline by a normal 5.7% a year Summary return.

Of course, if the S&P reaches its normal p/e of Today we have substantially the worst prospects for long- 16x faster than 7 years, then the short-term pain will be term global investment returns of my 35-year career commensurately greater. when all asset classes are considered, particularly for Welcome to the unexpectedly large number of new U.S. centric investors. The asset classes collectively are clients; I hope my comments are not too shockingly simply the most overpriced they have been. There are no gloomy. The good news is that my letters are not usually large categories that are good hiding places, unlike March this long, at least not when the attachment is included. 2000, which offered real estate, REITs, all bonds (especially TIPS), small cap value everywhere, and The attachment is an opening salvo on the effect on emerging country equities.

Only the huge, politically performance of asset size and how GMO is trying to cope driven stimulus gives cause for hope, and that is for a with it.

GMO Quarterly Letter – October 2003 4 GMO Special Topic October 2003 Jeremy Grantham, Chairman The Size of Assets and its Effect on Performance Two of our best performing strategies closed to new assets, you will halve your alpha if you prefer. Fifteen accounts on September 30 – Emerging Market Equity and years later, it still seems like as well informed a guess as Emerging Country Debt – both candidates since their I can come up with. inception for the best performance in their respective categories. Size of assets in any style is the ultimate There has been a considerable amount of nonsense barrier to adding value, and is the perfect example of the written on this topic. I believe that every professional Peter Principle: do well with 2 billion and they’ll give investor knows that it is an ironclad law that size reduces you 4 and keep on giving until your good performance outperformance, but I also understand the investment has gone. guild’s vested financial interest in muddying the water.

The basic truth is that as you add assets, you have three The appeal of extra marginal business in any business is disagreeable alternatives. You can either add more stocks enormous because some costs are fixed, but in the or buy more of the original list, or both. As you extend investment management business, the ‘cost of goods’ can your list, you dilute the one or two brilliant stock ideas be small and there can be a strong illusion that there is no that many good professionals have every now and then, material marginal cost at all so that an extra dollar of and you dilute the dozen or so good ideas. You are revenue becomes a dollar of profit. Because of the quickly into your “B-team” stocks, and eventually you extreme profitability of the next dollar of revenue, it is are forced to buy anything that is merely acceptable. If desperately hard for a very commercial enterprise to the ‘merely acceptable’ beat or even equal your highest refuse it, and a public company can argue that unlimited confidence bets, then you have a very eccentric talent. growth is justified by its fiduciary responsibility to its stockholders to maximize the firm’s profits. In any case, It is even easier to understand the point that buying more they overwhelmingly act as if this is indeed a guiding of the same idea increases the true transaction costs, principle and few funds are closed. The exception of which eats into your outperformance. Instead of buying course is the hedge fund business, and this is interesting 10% of the daily volume for 5 trading days to complete a for it reflects its different incentives. Hedge fund position, you are in there for 20 days or, finally, months managers’ incentives are not perfect from a client’s on end buying every day. Alternatively, you can pull perspective; they are not paid to maximize the client’s back for a while to let the stock cool down, but with a performance, but, second best, they are paid to maximize strong alpha, time is money and as you wait, other people the total dollar outperformance and to do so with absolute get the same good idea. With more money, you are not performance that at least compares well with competitors. only pushing the stock more yourself, but allowing more (For example, they are likely to prefer producing 20% time for others to push with you and share the benefits. I performance with $300 million over 25% performance suppose there is yet another alternative and that is to buy with $100 million.) Institutional long only managers, in more of the daily volume. This is severely bounded at the complete contrast, are paid to maximize their assets under top as it’s hard to buy over 100% of a day’s volume, but management, so it should not be a major surprise that this even at 40% to 50% you are fairly obviously courting is apparently what they try to do. disaster.

Fifteen years ago or so I proposed at one of our client This problem is not confined to individual stocks, but conferences a rule for relating size of assets to value applies also to larger ideas. In international investing, for added, or alpha: every time you double your assets, you example, if a central idea is that Austria is cheaper than lower a positive alpha by 30%, or if you quadruple your other countries, the relative illiquidity of that whole market will impose severe size or cost limitations; buy product line, doing everything we thought we could do less of your best idea or pay more. that did not compete with our other products, and to close each product down at an appropriate size.

There are few unarguable first principles in investing, but I believe larger size equals smaller outperformance to be GMO’s history at least suggests that our heart is in the one. So why have the academics, free of the commercial right place: vested interest, not proven it? Because it’s very difficult to prove without a long-term controlled experiment. The 1. Dick Mayo and I, along with Chris Darnell, closed our time that has been wasted comparing large mutual funds first product, U.S. Active, at $250 million in 1981 and with small ones is impressive. Large funds, of course, get closed it about as ‘hard’ as could be done, taking no to be large primarily because they are good, and many money from anyone. (There were plenty of small funds stay small because they are not. How can one temptations, for our first 9 years we were ahead of the prove that a firm with, say $50 billion in emerging market S&P 500 by an average of 8% a year.) Eventually we equities (there is no such firm) would have done even did take a few clients, but only to partially replace better than they did had they had one tenth of the money. those who had left.

It cannot be done.

2. Foreign active closed to new accounts after its first 3 Perhaps the best try would be to take the largest 10 funds years at $550 million. (Even though its hit rate for in, say 1960 and see how they did for 5 or 10 years new business presentations was running over 90%. against funds sized 90 to 100 in 1960. And repeat every Honest!) After a few years, we decided that the great 5 years. It doesn’t feel like scientific proof, but it might increase in global liquidity meant that we could be indicative. When we have time, we will try it and keep manage more money, and we entered an unusual you informed, but since we completely believe this whole phase of moderate growth, limiting our growth to a issue to be self-evident on first principles, it is not at the maximum of 10%. Today’s $8 billion seems a top of our agenda. reasonable and manageable number given the past performance and the size of the market, and carefully The best counter argument is that by adding more and limited growth remains the policy. more good people, you can pick more and more good stocks.

The trouble with this is that, like diamond or gold 3. The closing of the two emerging products (equities mining, there are only a few great strikes to be had. In a and debt) continues this tradition and introduces the platonic sense, if everything were known to a person of topic of the best way to close down or limit growth. ultimate wisdom, there are at most 50 truly underpriced There are two relatively different obstructions to stocks in the largest 1000. Two or three good old pros steady outperformance. First, there is the steady might get 25 of these and ten more pros might get 20 maintenance of a more or less fixed book of business, more, leaving the last five good ideas to the next 50 pros and second, there is the incremental impact of new you might hire or, indeed, the next 500 old pros!

The inflow, which all has to be invested fairly quickly lest Law of Diminishing Returns exists in almost everything, the manager be debited for poor relative performance and in few areas more than investment management. if the market rises. These two distinctly different factors suggest at least a two-stage closing. First, at So for now, let us assume that the point is proven – size an asset level substantially below the estimated total hurts. What is GMO to do about it? For at least 25 years that the manager feels he can handle well, the manger I have had some apparently contradictory beliefs. First, I must limit the inflow of new money, expressed either believed it was an exciting challenge to help build a large as dollars or as a percentage increase in assets. This and profitable firm. Second, I believed the main controls the impact of new money to a small fraction characteristic of a good money manager was reasonably of the maintenance impact.

Second, as assets steady outperformance. Third, I knew that my partners carefully grow, the manager can better estimate the and I wanted above all to be seen as good money level at which no new assets should be accepted. managers, for to repeat my own axiom, “There is nothing more supremely useless than a mediocre money At GMO, we have tried several approaches, but not until manager.” But fourth, my partners and I shared the belief now have we had to face an asset class becoming as hot that size impacts performance. The way to reconcile or in a few months as emerging country equity has become compromise with the conflicts was to have a very broad this year. Last year we set a time target for closing to new GMO 2 Size of Assets and its Effect on Performance, October 2003 accounts in our Emerging Markets Fund – September investment management.

I for one will be delighted to 30th of this year. At that time, there was very little money hammer at this issue and with any luck seriously flowing into the asset class and we wanted to give clients embarrass some of our competitors. Given our policy, as long a lead time to invest as we could. In the interim, this issue is gloriously self-serving, but all the best issues as emerging heated up, we ended up with more assets are, and this one at least has the virtue of being than intended, raising the question of what to do. Our undeniably correct in general principle. current proposal is to gain experience with the size impact of this new larger amount without any inflow. If One question this topic is bound to bring up is which with experience, the manager feels the size has pushed us GMO products will be next to close if assets continue to past a desired level of long-term outperformance (this is flow in.

All our hedge funds are very sensitive to size and not necessarily about 1 or even 2 years, which are always one big year could close any of them. In long only buffeted by many other factors than size) then we will at investing, GMO International Small Cap is a likely least not replace any business that leaves. At most, we candidate. (This is our quant version. The active version might reluctantly decide to give money back, a battle plan – Foreign Small – is already closed.) Similarly, we are that should always be considered in any product if market already thinking about managing future growth in assets conditions change, say by liquidity drying up. in our flagship Australian equity strategy. Having learned some lessons from emerging markets, we are very likely There are so many factors to be considered in size to close in two stages, and I would expect that we would limitation that we might as well admit it is nearly announce before the end of next year a limited growth impossible to be simon pure.

No doubt from time to time phase starting when our assets, currently $1.5 billion, hit we will take more money in a given product than we a maximum $2.5 billion (at today’s market level), and should. But we can and do undertake to go after “the probably less. A more complete close would come at a spirit of the exercise”. We have designed many of our later date when we have more experience. products quantitatively to handle considerable assets, but we will in every product be conscious of the size effect, This topic, we admit, is full of compromises and GMO’s and we are prepared to close every product at an main compromise concerns asset allocation. All of our appropriate size. otherwise ‘closed’ products will be available for broad asset allocation products for some considerable time, We would like GMO, in fact, to be the first broad-based including our Multi-Strategy Hedge Fund.

We believe, firm who both announces this intention years in advance not surprisingly, that the broader funds are the highest and and lives up to it. Because we have 55 products and still best use of GMO’s competence, our best diversification, a few more to add, we expect to be able eventually to and importantly, they are contrarian fund buyers: they handle $100 billion or so in today’s market terms and still have been big buyers of GMO funds when the asset class do a good job. It should also be mentioned here that over is out of favor – a debt crisis for emerging debt, for 90% of our products are quantitative, which is a example – when client money is leaving. As asset substantial advantage in building extra liquidity into each allocation at GMO grows, this will increasingly help fund. We expect (or at least hope) that given favorable stabilize the funds. circumstances, most of our products will be closed in 10 years.

Indeed, I look forward to tottering into work one Where component funds are otherwise ‘closed’ to the day when all our products are closed to new clients. extent that they do take asset allocation money, they will not otherwise replace departing clients. Typically, it We believe the industry worries far too little about the should also be mentioned, the funds that close earlier will consequences of unrestricted growth, and our side of the be in the illiquid markets that are usually a small business listens too much to the Goldman Sachs percentage of the allocation funds. Where this is not argument that any manager with less than $150 billion is always the case, notably in the absolute return funds, then a piker and likely to be squeezed out or absorbed by these allocation funds will have to be the first allocation larger competitors with greater economies of scale. funds to close.

There are two economies in our business. There is a substantial economy of scale in marketing and brand We would really welcome client feedback on this issue. building, and there is a great diseconomy of scale in (I think.)

Size of Assets and its Effect on Performance, October 2003 3 GMO