最后的欢呼与七个荒年

GMO QUARTERLY LETTER May 2009 The Last Hurrah and Seven Lean Years Jeremy Grantham The Loss of “Near Certainties” in Investing The Last Hurrah First, let me lament the loss of near certainties in investing. One reason I am parting company with many of my The financial and economic collapse that I described as “the bearish allies for a while is my familiarity with the most widely predicted surprise in the history of finance” Presidential Cycle and, critically, what it has taught us about 18 months ago is behind us. More precisely, we about the power of stimulus and moral hazard to move believed that bubbles had formed in global profit margins, the stock market many multiples of their modest effects risk premiums, and U.S. and U.K. housing prices, and on the real economy. These lessons seem to me to be that all three were “near certainties” to break, with severe particularly relevant today. consequences for the economic and financial system.

All This Presidential Cycle effect is dismissed as an artifact have thoroughly burst and are in their overcorrection by the great majority of financial academics, but they phase with the single exception of U.K. house prices, have a stalwart record of dismissing any data that implies which I’m confident will do their duty. Normally there even modest market inefficiency, and this effect implies are, of course, no near certainties in investing. Life is not great dollops of inefficiency. Simply summarized: since meant to be that easy. Asset allocators have been blessed 1932, in the third year of the Presidential Cycle, the in the last 10 years with a large collection of extraordinary average S&P 500 return (from October 1 to October 1) outliers. As my favorite quote by Mandelbrot (1983) says, is 22 percentage points ahead of the average of years “Even though economics is a very old subject, it has not one and two!

And this is statistical noise? Year three truly come to grips with the main difficulty, which is the is the time when, driven by politics, financial stimulus inordinate practical importance of a few extreme events.” and moral hazard are applied so that the economy – If this last 10 years did not prove him right, nothing particularly increases in employment – can be a little will. Since 1988, we have been offered 8 or 10 2-sigma stronger in the run-up to the election in year four. In events. (A 2-sigma event is our definition of an important years one and two, in contrast, the system is tightened in bubble or bust.) All of these events were bubbles, and all order to leave some room for re-stimulus in the next year behaved themselves by bursting. Now, sadly, there are three (except during Greenspan’s era, when he basically probably none.

Government bonds are the one serious could never stop stimulating and so periodically upset the candidate. In our opinion, they are badly overpriced but applecart). It is all pretty understandable. All we have probably not by enough to justify the bubble title. Global to believe is that politicians like to be reelected and that equity markets are still cheap, but in major markets are completely independent Fed chairmen like to play ball nowhere near 2-sigma, 40-year bust levels. Some small-with politicians. (Volcker of course, unlike the others, scale 2-sigma bargains may exist in the fixed income was never a ball player.) There have been no serious bear markets in rate differentials, but need skillful analysis and markets in year three, and many in years one and two. knowledge to disentangle from value traps. And, they are a very far cry from, say, the opportunities offered by In our search for what actually caused this magnificently buying credit default swaps at a handful of basis points large effect, we have been unable to find more than a very on overleveraged financials in early 2007.

So, all in all, modest tendency for rates or money supply to increase welcome back to the age of guesswork. above trend in year three. From this historical lack of rapid monetary expansion, we make two guesses. First, Terrified” was posted on the day the market hit its low. we assume that stock markets are far more sensitive to You win some and you lose some.) financial stimulus than is the battleship GDP. The liquidity and other financial encouragement required to move the The market always anticipates an economic recovery battleship a degree or two is apparently enough to have a and, sometimes, it must be admitted, there are several very material effect on stocks. Stocks are simply much false moves (“suckers’ rallies”) before the recovery takes more sensitive to stimulus than the economy. The second place. The current stimulus is so extensive globally that guess is that the Fed’s moral hazard is far more important surely it will kick up the economies of at least some of the than we realize, and is far more effective at moving larger countries, including the U.S. and China, by late this markets than the modest financial adjustments.

The year or early next year. (This seems about 80% probable implied promise to bail out speculators in years three and to me, anyway.) Anticipating this, we should expect a four if anything goes wrong, but to leave them hanging in stock market recovery – which normally leads economic years one and two (again, Greenspan excepted), is what recovery by six months, plus or minus two – sometime drives this. Never underestimate the power of the Fed between two months ago and, say, August, which the astute (or the Fed’s willingness to deny its own influence when reader will realize implies that this rally may already be it suits). The best proof of this power has always been it. This was part of the logic behind my March posting, that the U.K. has shown a bigger year three jump on our “Reinvesting When Terrified”: the uncertainties of the Presidential Cycle than the U.S. has since 1932!

Europe economy are so great that when the uncertainties of the and even distant Japan also show a pronounced sympathy stock market’s anticipation are laid on top of them, you with the U.S. cycle. simply must have big ranges of outcomes and hedge your bets. Unless you have extreme luck or divine guidance, Which brings us to this present case. Forget the traditional you will never catch the low. Alternatively, there is still Presidential Cycle effect for the time being: Greenspan time – just – for another freefall leg, but time is running ruined it by overstimulating again in 2005 and 2006. Just out. Investor confidence is still fragile, and should we bear our two principles in mind. If the stock market is get a series of particularly shocking data points, which, many times more sensitive to financial stimulus in the in the unique position we find ourselves is quite possible short term than the economy is, then we could easily get (say, one out of three), then confidence could crack one a prodigious response to the greatest monetary and fiscal more time and the market could go to a new low before stimulus by far in U.S. history.

Second, if you don’t think the major anticipatory rally I’m describing. (This would there is a special, one-off, super colossal dose of moral make the current rally a short-term head fake.) In a rally hazard out there today, you are sadly uninformed. The to 1000 or so, the normal commercial bullish bias of the moral hazard in play today is of a massively larger order market will of course reassert itself, and everyone and his than any we have ever seen. (But given how strangely dog will be claiming it as the next major multi-year bull selective the moral hazard or bailouts have been, it is market. But such an event – a true lasting bull market – is enough to make those susceptible to conspiracy theories most unlikely. A large rally here is far more likely to prove think in terms of a financial mafia led by You-Know-Who. a last hurrah … a codicil on the great bullishness we have Too much seems to depend on which friends you have.) had since the early 90s or, even in some respects, since the early 80s.

The rally, if it occurs, will set us up for a long, So by analogy to the normal Presidential Cycle effect, drawn-out disappointment not only in the economy, but driven by stimulus and moral hazard, we are likely to have also in the stock markets of the developed world. a remarkable stock rally, far in excess of anything justified by either long-term or short-term economic fundamentals.

My guess is that the S&P 500 is quite likely to run for a Bulls vs. Bears while, way beyond fair value (880 on our revised data), Resolute bears will point out (as we have) that the low to the 1000-1100 level or so before the end of the year. of other major market breaks has been far lower than (For the record, I presented this case six weeks ago in this one, and they would be correct. Compared to our Europe at 725 on the S&P, but was sadly distracted in my revised fair value estimate of 880 for the S&P and its quarterly letter writing by a trip to Bhutan. Poor thing. current recent devilish low of 666, the bottoms of other I won’t complain, though, since my “Reinvesting When important comparative bear markets were much more GMO 2 Quarterly Letter – May 2009 impressive.

On a similar basis, the low in 1921 – the post (In this respect, George Soros’ reflexivity can come into WWI depression – was about 300; the U.K. in 1974 was play: a false dawn can alter the eventual outcome as it at the current S&P equivalent of about 300. In 1982 and chews up time. For example, in June 1932 market players 1974, the lows in the U.S. were equal to about 450. Of our saw illusory light at the end of the tunnel. In two months, six best comparable examples, only in Japan, three years the market rose almost vertically, climbing 110%! For into the market crash, was the market still above 880 four more months it held the gain and then, confronted equivalent. Admittedly, I don’t yet know enough about with continued unrelieved bad news, sank steadily for 1921, but as for the others, I could offer good reasons why six months so that one year after the rally began it was their lower levels might be understandable.

One group up only 35%. But this is the key: by then – a year later (the U.K. and the U.S. in 1974 and the U.S. in 1982) had – there really was light at the end of the tunnel and the very high interest rates providing formidable short-term market rose again, 130% in eight months. And this time competition with stocks. (In the long term, the Fed Model it did not give it back. If investors had jumped into a logic is simply false, but in the short term – up to a year – time machine back in June of 1932 and had been able it does work for behavioral reasons.) These markets also to see how bad things would look in 9 to 12 months, it had very high inflation, which in the short to intermediate seems nearly certain the market would have gone lower. term has a compelling explanatory power for P/E ratios.

In this way, one or two false hopes can protect against To keep it simple, high inflation rates typically come lows that a more realistic view would cause. And I think with lower than average P/Es and vice versa. A third it is likely to do so this time. Although the economy is factor in all three cases was a crisis in oil supply and the likely to kick up in the next 12 months (although far from accompanying much higher oil prices. So without these a near certainty) and be anticipated by the stock market, extra negative factors, the current market seems unlikely I believe it is likely that the longer-term health of the to overcorrect below fair value quite as badly as these economy will be exaggerated. In time – perhaps a year prior bear markets have. into the recovery – the economy will slow once again and stay disappointingly below the standards to which we The other two setbacks that we consider most useful for have become accustomed over the last several decades.) comparison purposes – 1932 in the U.S. and Japan in 1990 – were quite different.

Both came with low rates But for this current market setback, it seems reasonable and deflationary pressures, and each had extremely that we would do less badly than all of these previous serious economic setbacks, with the wheels falling off worst cases. We are not trying to be bullish and we have the economic machine, a condition that certainly does no reputation as bulls, but – for a second ignoring the apply this time. On the other hand, in neither case did current rally, which is so sharp as to bear out my warnings they receive massive international stimulus. In Japan, of March – three months ago we at GMO collectively the authorities delivered reluctant piecemeal stimulus. considered that a range of 550-650 for the S&P was about Interestingly, they now strongly warn against other right for the low this time. countries copying their strategy, which they now deem an expensive failure, both in terms of growth and time.

Reinvesting When Not Quite Terrified In 1932 the stimulus in the U.S. was on-again/off-again, My March note suggested that it is psychologically very on a trial and error basis, and usually with some elements difficult to reinvest any cash once a crash in the market and offsetting others so that the stimulus program is judged the economy has really frightened you. The antidote is to to have been a partial or even substantial failure. In have a simple battle plan of determining levels at which comparison, the response to today’s crises is the first to reinvest and to stick to it absolutely. We could call that time that there has been even an attempt at a coordinated Plan A. It is ideal for dealing with a market meltdown, global policy. In some cases, including that of the U.S., which should be any asset allocator’s dream: to be able to the degree of stimulus far exceeds any previous efforts.

It make wonderfully cheap investments. Investors, though, has also been initiated quite quickly despite the criticisms. also need a Plan B for investing if the market bounces So the effect of the stimulus might well kick up in time to back up but stays either cheap – that is to say below fair clip off the last stage of the bear market, and this is what value, currently at 880 on the S&P in our view – or close I think will happen. enough that investors can still expect a decent return Quarterly Letter – May 2009 3 GMO that is far in excess of cash. Our Plan B is to move our to be wrong! For sensible long-term investors, what can equity investments up to neutral weight steadily over 9 possibly be better than investing at great prices? Every to 12 months. Since we were fortunate enough to trigger percent of our 23% invested so far has been done at 7-year a second major investment at 740 on the S&P eight forecasted returns of over 10% real.

We would just like to weeks ago (executed six weeks ago) we are now only 2% do some more. So should you. underweight. So for us, that requires investing only a fraction of one percent a month. But for those formerly Seven Lean Years in rigor mortis who were left behind and are now praying For the biblical record, Joseph, consigliere to the Pharaoh, for a pull-back, this steady investing process is critical. advised him that seven lean years were sure to follow You have missed some great investment opportunities, the string of bountiful years that Egypt was then having. and now you have a psychological commitment to another This shows an admirable belief in mean reversion, but major fall to add to any intellectual reasons you may unfortunately the weather does not work that way. It, have had. The market may well oblige by coming down unlike markets, really is random, so Joseph’s forecast sharply again in the near future, and I for one continue was like predicting that after hitting seven reds on to believe there is still about a 1 in 3 chance it will do so. a roulette wheel, you are likely to get a run of blacks.

There is also perhaps a 1 in 5 chance that the market will This is absolutely how not to make predictions unless, come down much further in the future to a new low, but if like Joseph, you have divine assistance, which, frankly, it does not and it continues to rise, extended praying may in the prediction business is considered cheating. Now, not make you as much money as you would like. however, and definitely without divine help but with Plan C gets to be a particularly speculative prospect, and masses of help from incompetent leadership, we probably that is what to do if the market, fueled by liquidity and do face a period that will look and feel painfully like seven hopes from the stimulus program and the usual morally lean years, and they will indeed be following about seven hazardous promises from the Fed, soars way over fair overstimulated very fat ones. value, say to the 1000 to 1100 range, which I begin to think Probably the single biggest drag on the economy over is quite likely by the end of the year, whether or not there is the next several years will be the massive write-down in another near-term fall. But to keep things simple, we will perceived wealth that I described briefly last quarter. In discuss what to do for Plan C if and when we get there. the U.S., the total market value of housing, commercial real estate, and stocks was about $50 trillion at the peak Where GMO’s Asset Allocation Stands in All This and fell below $30 trillion at the low. This loss of $20-$23 In traditional asset allocation accounts, we hit an all-time trillion of perceived wealth in the U.S. alone (although low of 39% global equities against a theoretical minimum it is not a drop in real wealth, which is comprised of a of 45% due to the speed of the decline last October. In stock of educated workers and modern plants, etc.) is still October and November we invested a double tranche enough to deliver a life-changing shock for hundreds of of 16%, and at 740, as already mentioned, we invested millions of people. No longer as rich as we thought – another 7.5%, leaving us then 4% underweight equities under-saved, under-pensioned, and realizing it – we will with two more 7% tranches lined up to go at lower prices. enter a less indulgent world, if a more realistic one, in We would have preferred a lower low to trigger at least which life is to be lived more frugally. Collectively, we one more trade, and we would much prefer a new low will save more, spend less, and waste less. It may not even going forward, especially one in the next two or three be a less pleasant world when we get used to it, but for months. We prefer it so intensely that we hope it is several years it will cause a lot of readjustment problems. not impacting our assessment of the future odds. Our Not the least of these will be downward pressure on profit second choice is for a new low, say, late next year after margins that for 20 years had benefited from rising asset our longer-term head fake to over 1000 has been washed prices sneaking through into margins. away by the longer-term economic and financial problems.

Strangely, therefore, if a lot of the thinking in this letter Closely related to the direct wealth effect is the stranded is simply wrong and far too bullish, we will be in a good debt effect. The original $50 trillion of perceived wealth position to benefit by reinvesting the rest of our reserves supported $25 trillion of debt. Now, with the reduced at wonderfully cheap prices. It is seldom that one wants and more realistic perception of wealth at $30 trillion GMO 4 Quarterly Letter – May 2009 combined with more prudent banking, this debt should be new inflation-adjusted high on the S&P. cut in half. This unwinding of $10-$12 trillion of debt is not, in my opinion, as important as the loss of the direct If we are looking for any further drawn-out negatives, wealth effect on consumer behavior, but it is certainly more I suspect we could add the more touchy-feely factor of confidence. We have all lost some confidence in the quality important to the financial community. Critically, we will of our economic and financial leadership, the efficiency almost certainly need several years of economic growth, of our institutions, and perhaps even in the effectiveness which will be used to pay down debt. In addition, we of capitalism itself, and with plenty of reason. This lack will need several years of moderately increased inflation of confidence will not make it easier for animal spirits to to erode the value of debt, plus $4-$6 trillion of eventual recover. This does not mean necessarily that we haven’t debt write-offs in order to limp back to even a normal 50% already seen the low, for, in my opinion, it is almost 50/50 ratio of debt to collateral. Seven years just might do it. that we have. It is more likely to mean a long, boring Another factor contending for worst long-term impact is period where making fortunes is harder and investors the severe imbalance between overconsuming countries, value safety and steady gains more than razzle dazzle. largely the U.S. and the U.K., and the overproducing (The flaky, speculative nature of the current rally thus countries, notably China, Germany, and Japan. The bears none of the characteristics that I would expect from magnitudes of the imbalances and the degree to which a longer-term market recovery.) they have become embedded over many years in their economies do not suggest an early or rapid cure. It will The VL Recovery be hard enough to get Americans to save again; it will So we’re used to the idea of a preferred V recovery and the be harder still to convince the Chinese, and indeed the dreaded L-shaped recovery that we associate with Japan. Germans and the Japanese too, that they really don’t have We’re also familiar with a U-shaped recovery, and even to save as much. In China in particular they must first be a double-dip like 1980 and 1982, the W recovery. Well, convinced that there are some social safety nets. what I’m proposing could be known as a VL recovery (or very long), in which the stimulus causes a fairly quick A lesser factor will be digesting the much shrunken but superficial recovery, followed by a second decline, financial and housing sectors. Their growth had artificially followed in turn by a long, drawn-out period of sub-normal and temporarily fattened profit margins as had the general growth as the basic underlying economic and financial growth in total debt of all kinds, which rose from 1.25x problems are corrected.

GDP to 3.1x in 25 years. The world we are now entering will therefore tend to have lower (more realistic) profit An Amateur’s Assessment of the Stimulus Program margins and lower GDP growth. I expect that, at least for the On the confidence topic, it would be a start if we could all seven lean years and perhaps longer, the developed world believe in the effectiveness of our stimulus program, but it will have to settle for about 2% real GDP growth (perhaps is not easy. The situation today is that an unprecedented 2.25%) down from the 3.5% to which we used to aspire amount of stimulus is being thrown at our problems and it is in the last 30 years. Together with all the readjustment being thrown on a global basis. Some hurlers, like the U.S., problems and quite possibly with some accompanying are more prodigal than others, and some, like the Germans, higher inflation, this is likely to lead to an extended period whose only imaginative stimulus – a scrapping bonus, not of below average P/Es.

As I have often written, extended surprisingly reserved for their beloved cars – are more frugal. periods of above average P/Es, particularly those ending But in total, the effort is unrivaled in history. The bad news in bubbles, are usually followed by extended periods of comes in two bits: first, no one really knows if generous below average P/Es. This is likely to be just such a period bailouts are a good idea in the long run; and second, no one and as such historically quite normal. But normal or not, really knows, if they are indeed a good idea, whether this it makes it very unlikely with P/Es, profit margins, and current stimulus is enough. What most of us, including me, GDP growth all lower than average that we will get back agree on is that the problems we face are unprecedented to the old highs in the stock market in real terms anytime both in global reach and in the breadth of financial assets soon – at least not for the seven lean years – and perhaps that are affected, which is to say everything. considerably longer.

To be honest, I believe that most of you readers are likely to be grandparents before you see a My own personal and speculative take on this is that Quarterly Letter – May 2009 5 GMO the stimulus program will have a positive effect on all of short-term economic forces. We know we are perfectly countries, and in some cases this will be enough to kick capable of doing this since as recently as last November GDP growth back into positive territory quite soon for the the “authorities” like the IMF estimated a +0.5% GDP for most fortunate, in which group I include the U.S. the developed world in 2009 and it is now at –4%! Not bad … a 1% reduction per month where a 0.1% change It is ironic, by the way, that the U.S. would be less hurt per month for four months would normally be considered than most given that Pied Piper Greenspan led all of us a landslide. global rats off the cliff.

And, yes, in this case the Maestro (well named) had an orchestra pit filled with Treasury and But to get back to the point: the stimulus program is not Fed officials (especially the NY Fed), and such a large based on either persuasive economic theory (if that is not an supporting cast of dancing CEOs of financial firms and oxymoron these days) or on solid historical studies: there their reckless board chums that even Cecil B. DeMille are simply too few examples and absolutely no controlled would have found them sufficient. So we in the U.S. experiments, so we are reduced to guesswork. Almost developed almost single-handedly the tech bubble of the everyone has had the thought that if overconsumption late 1990s, and then engineered a U.S. housing bubble and excessive debt have caused our problems in the U.S., and a flood of excess dollars that almost guaranteed that then pushing rates so low that they practically beg us to global assets would follow suit.

Yet, unfairly or not, the borrow and consume some more seems an odd cure. We U.S. has some considerable advantages in this mess we acknowledge that a stiff whiskey can get the drunk to created. First, we have an unusually low percentage of stagger to his feet and make it a few blocks, but it doesn’t our labor force in manufacturing and export-oriented seem like a probable long-term answer. Yet we all override companies that will be the most immediately affected this thought by saying that because a great majority of by the global downturn, unlike Germany and China, to dignified economists, although they all disagree on the name two. Second, the dollar plays an important role that details, seem to think stimulus is necessary, surely they may cushion U.S. pain by allowing U.S. authorities the must collectively have it right.

However, we in the flexibility to make their own rules where other countries investment business are blessed by an example that allows such as Spain and Ireland have most decisions heavily us to keep an open mind. The widespread acceptance of constrained. More profoundly, the U.S. is in a position rational expectations and the efficient market hypothesis where necessary sacrifices will simply be less painful. We has taught us never to underestimate the ability of the in the U.S. will have to buy two fewer teddy bears for economics establishment to get an idea brutally and expensively wrong. So they may have done this time. It our already spoiled four-year-olds. The third television may indeed be a better long-term solution to accept a more set will be postponed as will the second or third car.

We punishing decline and let foolish overleveraged banks will have to settle for a slimmed down financial industry go under together with weak players in other industries. and fewer deal-oriented lawyers. Woe is us. China, on Surely assets would flow to stronger hands with beneficial the other hand, will close teddy bear factories, and send long-term effects. Indeed, the quick 1922 recovery from its workers back to marginal or sub-marginal jobs in the the precipitous decline of 1919-21 was so profound that countryside. That is the real world, and it delivers real the “Roaring Twenties” suppressed the memory of that pain. Even worse, in some ways the Germans (and to a earlier depression. lesser extent the Japanese) make and sell the equipment that builds the teddy bear factories, no more of which will So what do we really know about the merits of stimulus be needed for a long while.

That, too, is real pain. To add programs? We do know that National Socialist Germany to these advantages – at least in the short term – the U.S. had full employment by 1935 when we – Americans and is pouring on more stimulus than anyone else. Brits – still had 15% unemployment. They did this as far as one can tell by direct government expenditures: So for the U.S. at least I have considerable confidence by building autobahns, “people’s cars” (VWs), and the that the GDP will kick back into positive territory (+0.8) odd battleship. We also know that wartime preparations by late this year or early next year. This, I concede, is finally and absolutely cured the recalcitrant depression in a consensus view, but one that comes with a significant the U.S. caveat. I believe that there is a decent chance, say 20%, that we still badly underestimate the downward momentum Germany and Japan sprang back from the ashes after GMO 6 Quarterly Letter – May 2009 World War II, but are we sure that this doesn’t say it seems nearly certain that such a government will never more about remarkable economic resilience than it does have to regret it.

Keeping banks, bankers, or even extra about stimulus? On the stimulus side it certainly had auto workers in business seems, in comparison, far more the Marshall Plan, the very high point of enlightened questionable. So questionable in fact that it must be justified and generous American foreign aid. On the other hand, by politics, not economics. We should particularly not surprisingly, the U.K. received more Marshall aid than the allow ourselves to be intimidated by the financial mafia Germans, who had far more damage to their infrastructure. into believing that all of the failing financial companies So, perhaps it is indeed more about resilience and work – or very nearly all – had to be defended at all costs. To ethic than stimulus. We know that in 15 years, with a take the equivalent dough that was spent on propping semi-flattened industrial sector, the Germans had flashed up, say, Goldman or related entities like AIG (that were past the Brits and even the neutral Swedes for that matter. necessary to Goldman’s well being), as well as the many The U.S. economy was also back on its long-term growth other incompetent banks and spending it instead on really trend in 1945 as if the depression and the war had never useful, high return infrastructure and energy conservation occurred.

So, we know a lot about the powerful resilience and oil and coal replacement projects would seem like a of economies. They are not such delicate flowers that real bargain for society. Yes, we would certainly have had we need to protect every foolish bank or be faced with a very painful temporary economic hit from financial and wrack and ruin. Current stimulus seems to be more about other bankruptcies if we had decided to let them go, but timing. We are unwilling to take a very sharp economic given the proven resilience of economies, it would still downturn even if such a downturn makes a quick, healthy have seemed a better long-term bet. But, as I said, this recovery more likely. Rather, we seem to be making a is all just speculative theory and I don’t have to deal with desperate attempt to make the setback shallower, perhaps Congress. at the expense of a longer recovery period.

What is likely Let me end this section by emphasizing once again the to happen in the near term always has far more political difference between real wealth and the real economy on influence than what may happen in the longer term. So one hand, and illusionary wealth and debt on the other. If we have been more decisively selecting the Japanese route we had let all the reckless bankers go out of business, we rather than the 1921 or the S&L approach of a more rapid would not have blown up our houses or our factories, or liquidation. Month by month we are voting for desperate carted off our machine tools to Russia, nor would we have life support systems – at the tax payers’ expense – for machine gunned any of our educated workforce, even our zombie banks and industrial companies that have been bankers!

When the smoke had cleared, those with money technically bankrupted by years of excess and almost would have bought up the bankrupt assets at cents on the criminally bad management. dollar and we would have had a sharp recovery in the I do think I know one thing, however. If a government economy. Moral hazard would have been crushed, lessons invests directly, drawing employment from a large pool learned for a generation or two, and assets would be in of the unemployed, and only invests in projects with a stronger, more efficient hands. Debt is accounting, not high societal return on investment such as hiring workers reality. Real economies are much more resilient than they with well-stocked tool belts to install insulation, or repair are given credit for. We allow ourselves to be terrified by bridges and transmission lines, or lay track to accommodate the “financial-industrial complex” as Eisenhower might a respectably fast train from Boston to Washington (Yes!), have said, much to their advantage.

Quarterly Letter – May 2009 7 GMO Appendix Just for Fun: One Strategist’s List of (Hopefully Well-informed) Guesses Branch #1: Probabilities The economies of the U.S. and some other leading countries kick up by late this year or early next year .80 In which case: „ Chances of a new low in the next three months .333 and rapidly declining „ Chances of a new low late next year or beyond as the painful longer-term truth dawns .167 „ Therefore, chances we have already seen the low .50 Branch #2: The global economies prove to be so weak that they do not start to recover until late next year after a series of disappointments .20 In which case: „ Chances of a new low this year or next .80 „ Chances that somehow hope triumphs over disappointment .20 Aggregate probabilities of a new low: Branch 1: .50 × .80 = .40 = .56 Branch 2: .80 × .20 = .16 Branches 1 and 2: „ Chances that this is the start of a lasting bull market destined to take us to new highs within three or four years (after inflation) .15!

„ Therefore, chances we face a long, drawn-out period to reach a new high (up to 20 years) .85 Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending May 5, 2009, and are subject to change at any time based on mar-ket and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.

Copyright © 2009 by GMO LLC. All rights reserved.

GMO 8 Quarterly Letter – May 2009