清算之日或

GMO Quarterly Letter October 2005 Jeremy Grantham, Chairman The Day of Reckoning or Ready or Not, Here Comes the Risk Premium plus Letters to the Investment Committee V You Have Nothing to Fear but the Lack of Fear Itself the Chutzpah Award for 2005 and his fifth consecutive We are nearing the end of the first year of the Presidential Career Positioning Award. When a more normal risk pre-Cycle which, along with year 2, is typically when house mium returns, its consequences will be borne by his suc-cleaning gets done, and moral hazard is reduced. The nor- cessor (lucky fellow – it would almost be easier follow-mal stock market response to this is to struggle, which is ing Jack Meyer at Harvard Management, but not quite). exactly what it is doing. Risky assets typically do partic- And Greenspan can be the elder statesman who warned ularly badly in these first 2 years, before doing very well him (or her) of the risks of a sustained low risk premium. with the stimulus of year 3. Through May this year, risky stocks were underperforming steadily, especially small cap and volatile stocks. Then, just as we were feeling Exhibit 1 cocky – since this is what we had predicted and positioned Performance of High Volatility Stocks for – there was a vicious rally in everything risky. This Relative to S&P 500 continued the ebb and flow of battle between risk and caution that was described in last quarter’s letter. This time, 30% though, it hurt us badly in the U.S. and left riskier assets ahead of conservative assets for the year.

25% The record of this third quarter rally in risk was impressive, given that it came on top of the already extreme 2003-04 Relative Performance strength in risky assets. Exhibits 1 and 2 highlight the last 20% 3 years’ performance in the most volatile quarter of the mar-ket by market cap and also in the Russell 2000, both relative to the S&P 500. Many risk measures in fact have now reached record levels, resulting in probably the lowest risk 15% premium on average recorded in modern times.

Even Mr. Greenspan was shocked and awed. “History,” 10% he said, “cautions that extended periods of low concern about credit risk have been invariably followed by rever-sal, with an attendant fall in the prices of risky assets.” Well it took him awhile, but mean reversion lives! How 5% embarrassing to finally be on the same side of this argu- O ct Ja 2 nAp 3 -0 r-0 Ju 3 O 3l-00 ct -0 ment with the Chairman himself. Since, in my opinion, Ja 3 nAp 4 r-0 Ju 4 l-00 O 4 ct Ja 04 nAp 5 -r-00 Ju 5 l-0 5 he produced most of the fuel for this move and threw it Source: GMO, Standard & Poors. As of September 30, 2005 on the fire himself, this expressed concern gets him both Exhibit 2 tion and hopefully have some partial answers at our con-Performance of Russell 2000 ference in November. For the time being, we have a Relative to S&P 500 strong hunch that the predominant input is extrapolation.

That is to say, today’s conditions, whatever they are, are 25% assumed to be permanent. Today’s much improved financial condition of the emerging countries – for example, in 20% terms of GNP growth and improved reserves, currency strength, modest local inflation, and lack of financial 15% crisis – is assumed to be a permanent condition, despite a long and painful history to the contrary. Similarly, with Relative Performance junk bonds and equity quality spreads the difference in 10% profitability between high quality companies and low quality has narrowed materially, as it did back in 1980 in 5% the oil crisis. If such a narrowing were indeed to be per-manent, it would justify the narrowing in P/E differentials and yield spread that has taken place. It is possible that 0% high quality companies have permanently lost their profitability premium and that the market is right. It is of -5% course far more likely that this ratio ebbs and flows in a largely unpredictable way and that extrapolating the cur--10% rent point, particularly when it is at an extreme, like now, O ct Ja 2 -0 will produce a painfully wrong conclusion. nAp 3 Ju O 3r-00 l-0 3 ct Ja 3 nAp 4 -0 r-00 Ju 4 Everyone agrees that there are extreme imbalances in the O 4 ct Ja 4 nAp 5l-0 -0 Jur-0 l-0 5 Source: GMO, Standard & Poors. As of September 30, 2005 U.S. and the global economy, in part due to our extreme lack of savings and associated accumulated personal debt, and our extreme trade deficit, now at 6% of GNP.

Let’s Do the Numbers: The bulls believe that all will work out, and certainly so far is so good. The bears believe that sooner or later these imbalances will come home to roost. Historians have to Asset Category 15-Yr 15-Yr believe that financial conditions, and confidence at all (in percentages) Peak Current Low levels, ebb and flow over time and that we have extreme-Emerging Debt Spread* 15.5 2.4 2.4 ly favorable levels of confidence now, despite potential Junk Bonds Spread* 12.9 3.6 2.4 problems. The probable winning bet is not to extrapolate, but to expect a very mean reversal. This shift in the risk High Quality Stock Premium vs. Low Quality** +8 -23 -26 premium, back to normal levels, will dominate the ins and outs of investing, I believe, for the next few years. * Emerging Country Debt and Junk Bonds yields over 10-yr U.S.

Treasury yields. As always, though, the problem is timing. What can we ** High quality stocks compared to low quality on our broad- offer on this topic? First, the first 2 years of the based value model. Presidential Cycle are typically very risk averse and on average show poor relative equity markets and very poor One of the reasons Greenspan was surprised at the risk- returns to risky stocks. Minus 2% real in the first year taking rally was of course that he had continued to raise and minus 4½% real in the second year is the average the rates, despite New Orleans, to 3.75 and left the world return since 1964 to the riskiest quarter of the market cap, with the impression that two more raises to 4.25 are in the with risk defined as volatility. (And I don’t mean minus bag in the next few months. This will leave us for the 2% and minus 4% relative to the market. I mean an hon-first time in several years close to ‘normal’ real return at est-to-goodness negative absolute return!) Second, value the short-end. matters in the first 2 years (unlike year 3), and the market is expensive now with the risky quarter of the market An interesting question is why the risk premium is so low more expensive than the market. The low quality versus and, indeed, why does it move around so much in gener- high quality spread (see Exhibit 3), after a very strong al and what factors move it? We will address this ques- return to risk in the third quarter, is now close to its low- GMO Quarterly Letter – October 2005 2 Exhibit 3 that the odds of the risk premium widening in the next Valuation of High Quality vs. Low Quality Stocks 12 months are at least 2 to 1 and probably 3 to 1. 1.9 Potential for a Downward Spiral in Risky Assets 1.8 Today the most accepted definition of risk is volatility.

Expensive We can all agree that the degree to which a stock or asset 1.7 class bounces around its long-term trend is an important 1.6 part of risk. Some of us, though, can agree that it is an incomplete definition as it ignores value and liquidity.

1.5 The most popular technique for measuring risk is known as VAR, or value at risk. It is used to estimate the proba-1.4 bility of portfolio losses based on the analysis of histori-High cal price trends and volatilities. But those using VAR will 1.3 Quality consider two markets having the same volatility as hav-1.2 ing the same risk, even if one is selling at 8x P/E (1982), and the other at 33x (2000). In real life, the probability 1.1 and extent of loss has directly varied historically with value, or the price you pay, and it is hard, if not impossi-Cheap 1.0 ble, to imagine that this will not continue. For example, 0.9 since 1925 if you bought the S&P when it was in the Dec-65 68 71 74 77 80 83 86 89 92 95 98 01 04 cheapest quintile by price to trailing 10-year earnings and held it for 10 years, you made an average of 10.6% real Source: GMO As of September 30, 2005 per year. In the most expensive quintile, you made a measly 0.6%. Statistically it certainly seems that value est point ever. Third, Greenspan is retiring and his desire had a lot to do with the risk of receiving a disappointing to get out intact may have something to do with the return. unusual speculative strength this year. Moral hazard (or the Greenspan put) plays a critical role in the level of The problem with using volatility as a complete measure speculation, and this last year for him is more like the of risk is exaggerated by the market’s usual tendency to fourth and last year of a Presidential Cycle when the extrapolate present conditions rather than to assume overwhelming desire is to coast up to the election and not today’s conditions will tend to regress to normal. Thus, rock the boat. For Greenspan there is only one quarter extremely low volatility today is seen as predicting that left of coasting. Fourth, short rates are rising and are the market will have low risk into the indefinite future. squeezing the level of comfortable leverage for specula- When volatility becomes high, that too will be extrapolattion. Fifth, profit margins, so critical to sustaining confi- ed. Using VAR thus results in very large changes in the dence (see our last quarter’s letter), are unsustainably ‘appropriate’ portfolio as volatility changes. Today, for high and exposed to many pressures – oil prices, rising example, volatility is very low and portfolios that at nor-rates, and just the plain increased competition that goes mal volatility would be considered very risky are now with record margins. These pressures on profit margins considered acceptable. suggest to me that they have probably already peaked and will be revised down later, as they were in 1998 and 1999. The second important missing ingredient in today’s definition of risk is liquidity. The market always demands a This is a long list of problems and leaves me feeling that big risk premium for illiquidity to reflect the extra cost the period from now to late next fall is very vulnerable to and delay in changing investment positions quickly and a widening risk premium, with all that portends for equi- cheaply as data changes. A strong case can be made that ty prices in general and risky assets in particular. Even the liquidity premium is unreasonably large, for no insti-this fourth quarter looks vulnerable to me, for Greenspan tution ever has to be 100% in cash by Thursday after-is engaged in a tricky balancing act between encouraging noon. But in a behavioral world where career risk is overconfidence (moral hazard) and overtly warning important and investors value their ability to stay with the against it. I believe his several warnings will probably tilt pack, a large liquidity premium exists. In U.S. stocks, for the scale too much and indeed rock the boat. Long-term example, the most illiquid quarter of the market by mar-believers in mean reversion like us try to stay in “sooner ket capitalization has outperformed the broad market by or later” land, but this long list makes it irresistible to say over 1% a year over at least the last 40 years.

3 Quarterly Letter – October 2005 GMO From time to time, the market has had liquidity crises in drawn internationally. Our biggest bet was overweight-which the need to sell illiquid positions has caused ing emerging market equities. We argued that a big rally extreme price weakness, which in turn has precipitated was probable for emerging if the U.S. market merely more selling. We now exist in a world of a 1 trillion dol- hung in; the emerging index is 22% ahead of the S&P lar hedge fund industry (without counting their huge year-to-date. Our big mistake, of course, was warning of leverage) that has risen to at least 25% or 30% of total a weakness in speculative, low quality issues. daily stock trading. Hedge funds are fairly reliably claimed to be longer less liquid holdings than they are GMO Strategy Performance short, since they attempt to benefit from the risk premi- We had a very bad third quarter mainly due to the rally in um.

The Long Term Capital crisis was an example of low quality. Our U.S. strategies lost by 2 to 3 percent for what can happen as a wave of selling illiquid issues the quarter and went from modest year-to-date gains to snowballs. substantial year-to-date losses, mainly in the range of -1% to -2%. In international we were about level with the VAR runs the risk that illiquidity and volatility can inter- market in the quarter with most strategies still ahead for act. Any major liquidity crisis will show up as a spike in the year. Our emerging equities strategies squeezed out a market volatility, causing VAR portfolios to lower their gain for the quarter and are up about 2% year-to-date over aggregate risk by selling into weakness, creating a dan- the benchmark. In U.S. and international bond strategies, gerous self-reinforcing cycle of a kind that hedge funds we were slightly better than even for the quarter except are paid to anticipate and exploit. for emerging debt, which once again won by over 1% and is up 4% for the year.

Asset allocation was also up nice-As if this were not enough, rising interest rates are also ly in general with its flagship global balanced strategy up involved. Low rates justify more leverage, just as low over 1% for the quarter and 3% for the year – its sixth volatility does. As rates rise, the justifiable level of lever- consecutive yearly gain. Hedge strategies’ returns were age contracts, and selling of leveraged hedge fund portfo- mixed. For example, Market Neutral had a bad quarter lios begins. An equal reduction of long and short portfo- and is down over 2½% for the year. Mean Reversion and lios, if hedge funds are long illiquid issues, will then Emerging Debt were up over 3% and 6%, respectively, result in less liquid issues underperforming and may start for the quarter and over 8% and 11%, respectively, for the the turtles running down the beach. year, while Multi-Strategy was up just ¼% for the quarter and 3¼% year-to-date.

High leverage and rising rates, plus rising volatility and VAR, combined with a liquidity premium and asymmet- In general, it was a tough quarter with poor results, rically illiquid hedge fund portfolios is a heady brew, and although we are still close enough to be bailed out in rel-a dangerous one. The usual brake on a market decline is ative terms by a fourth quarter rally in quality, which I value: as stocks and assets decline, they become cheaper believe is quite possible. and hence more attractive. In our new world that seem-ingly ignores value as a risk component, falling assets are Update on the Real Estate Market more likely to merely become more volatile and hence be In April the quarterly letter covered the near-global land seen as riskier and less attractive. bubble. Using Australia and the U.K. as leading indica-tors, I suggested that the U.S. probably had at least anoth-Success and Failure of Recent Calls er year, but that some of the bubbliest markets, like We warned this year of a bearish, but not disastrous, out- Boston, should peak out sooner, just as London and look for U.S. equities and at zero real return for 9 months, Sydney had led other cities.

It is now clear that several this looks close enough. We positioned for outperfor- U.S. cities that had appreciated the most on the way up mance of the stocks of foreign developed countries, and are now flat to down on a rolling month-to-month basis. they are ahead of the S&P by 6% in dollar terms despite And more cities are showing rising inventories of unsold a decline in their weighted currency of just over 10%. In houses. My best guess now (6 months later), is that aver-small cap we largely went to neutral, and they have drawn age U.S. house prices will peak after 6 months or so. For with large cap this year after 5 years of consecutive the record, as U.K. house prices flattened, growth in con-crushing wins. We also warned of problems with old sumption did indeed drop rapidly from almost +10% a fashioned value and reduced our value bets in U.S. Core, year ago towards zero.

There was a similar but less dra-for example, to a level where we now have a slight over- matic effect in Australia. The odds are that this cooling weight in growth stocks for the first year since 1991. effect will kick in sometime next year for the U.S. All the Year-to-date, value has modestly won in the U.S. and more reason to be careful.

4 Quarterly Letter – October 2005 GMO “Double Double; Oil & Trouble”* ical fortunes: without 9/11, President Bush would proba-On the bright side, there is indeed almost endless poten- bly not have been re-elected. His re-election had importial supply of gasoline from coal, oil shale, and tar sands, tant effects for the economy, the financial system (notably and all from politically safe regions, except for those including the level of government debt), and the stock tricky Canadians. The problem is that it would take about market.

7 years for a new incremental barrel to flow and 20 to 30 Hurricane Katrina will have much more short-term eco-years to get a serious job done even with a full court press. nomic effect than 9/11, particularly in the energy area. Its Even with the uncertainties of long-term oil prices, total economic effect in a year will be negligible once though, enormous courage along with enormous capital again. Its political effect, in contrast, runs a real chance, will be required – in the hundreds of billions – to tap once again, of being immense. New Orleans could well these new sources. It will be hard to commit billions into prove to be a political watershed event that could change a 7-year horizon knowing you need, say, $42 per barrel to the relative strength of the two parties for years, includ-make a return. Even if today’s oil is $65, you know it ing the outcome of the next presidential election. If that may be half of that or less in 7 years. were to be the case, then the economic consequences of Katrina could be immense and long lasting.

As for environmental issues … fuhget about it … they will be massive. We will all be lucky if enough of these Forecasts new sources can be brought in at under $50 a barrel. In I’ve already heavily committed myself to an anti-market, the meantime, traditional sources of supply will no doubt anti-speculation forecast. Beyond that, the biggest ques-cause spikes and troughs in the price. A good guess, tion is: can emerging equities at least hang in if we have based on history, would be that the price range will be far a general increase in the risk premium? It is probably wider than we care to think about: say $20 to $100 a bar- wishful thinking, but I believe their fundamentals and rel-rel. And, as usual, horribly unpredictable! ative value are so advantageous that they have a 50/50 shot at outperforming the S&P in anything up to a 10% It’s an Ill Wind decline for the index. I still believe that if the market sur-Immediately after 9/11 I wrote in a quarterly letter that it prises me and goes up, emerging equities will bury every-would have a negligible immediate economic cost in thing once again. terms of the GNP, and probably even a positive longer-term effect as it would encourage stimulus. This predic- Summary of Advice tion was a good call on the economic fallout. What it Once again, but with even more enthusiasm: reduce risk-badly missed was the much more important shift in polit- taking everywhere and do it now.

• With apologies to Macbeth’s prescient witches.

Disclaimer: The foregoing does not constitute an offer of any securities for sale. Past performance is not indicative of future results. The views expressed herein are those of Jeremy Grantham and GMO and are not intended as investment advice.

Copyright © 2005 by GMO LLC. All rights reserved.

GMO Quarterly Letter – October 2005 5 GMO Special Topic October 2005 Jeremy Grantham, Chairman Letters to the Investment Committee V* The Bullish Bias in the Investment Industry When President Bush listed as an achievement the make the article’s intended point. It made the unintended increase in jobs in his first term, although it was in fact point that if you wanted to be in good standing in a sell the lowest percentage increment in a 4-year term since side firm in 1999, you had better put a bullish spin on the President Hoover in 1932, he was demonstrating one of data. It also made the point that you could readily get a the most important aspects of the U.S. economy and the bullish article published with easily provable bad data, stock market: an enormous bullish bias. Bearing bad even in The New York Times. news is not rewarded in politics any more than it is in stock broking or investment management. Relentless Analysts optimism, in contrast, is not only good for business and So at the top level, the overall spin of the major firms is politics, but it may even be one of America’s important bullish. Their stock analysts reflect this in a now well-and often admirable features. For investors, however, it known way: buy recommendations outnumber sells by is a particularly dangerous characteristic and one worth 20:1. The need to stay friendly with management in order understanding. To this end, a few characteristics of to get information has been underlined in the period since bullish bias are listed below. 1995 by more aggressive behavior on the part of many corporations. They became overtly hostile to any critical Brokerage Houses comments, sometimes going far beyond the curtailment of Particularly as a bull market builds up, it would be nice to access to top management. Direct complaints about have an even-handed presentation from the major firms. critical reports were sometimes made to the senior Unfortunately, the structure of the brokerage business has management of investment banks, accompanied by not so resulted in an almost ludicrous bullish bias. The typical veiled threats to reduce the amount of investment banking advertisement for the largest brokerage house in the last business. Not even a star analyst welcomes an irate call couple of years of the bull market consisted of a bull so from S*nd* W**ll! Several analysts making negative large it could barely squeeze on the page. There was only comments were in fact fired and the investment banking room left for two large words at the bottom: “Be Bullish.” business was sometimes realigned. Perhaps not The same firm had trouble living with the periodically surprisingly those companies whose hands have now been bearish outlook of its experienced economist, whose caught in the cookie jar were some of the worst bullies. views were particularly respected precisely for this Analysts’ remuneration became sometimes very much reason. His replacement quickly proved where his heart more a function of their usefulness to the investment lay (or that he simply got the point) by writing a piece for banking division than their usefulness to clients. It is The New York Times in which he argued, among other hardly surprising that there was, by the market peak, so things, that the ‘90s was the best decade economically of little serious negative criticism or warnings of severe the 20th Century and that was why the market deserved to overpricing, despite the clearest proof of general do so well. Being quants, it took us about 2 minutes to list overpricing ever presented by a U.S. bull market. the hard data for the 10 decades. The 1990s were in fact mediocre, 6th out of 10 decades in GNP growth and 5th More basically, what happened to the broad use of in productivity, about the same as the dreaded 1970s. rigorous value models in the analysts’ work? Suffice it to say the ‘90s fighting the ‘70s to a draw did not Recommendations increasingly became based on the immediate outlook for earnings growth, where earnings * The Letters to the Investment Committee series is designed for a very were available. For the many cases where there were no focused market: members of institutional committees who are well informed earnings, they had to make do with sales growth and but non-investment professionals.

growth in ‘earnings before almost everything’. Enron all but 7 of the 1070 voted that the P/E would pass proved a telling example of this lack of statistical rigor. It downward through 17.5x. When the question was asked, is tough when you are lied to, although a few hedge fund the market multiple, never previously above 21x, even in analysts with a real incentive to find the truth indeed 1929, was rising to the new peak of 33x. This question nosed out some truth. Jim Chanos, a hedge fund was always asked before the presentation began and to an manager, sent out a warning on Enron based on footnotes audience who were far away from their bosses, typically and unanswered questions. But that required real at 1-week training programs. All participants also agreed ferreting out of data and real research, the lack of which that a decline in P/E to below 17.5x would guarantee a is a pity but not the point. We in our quantitative division substantially disappointing market. at GMO believed every lie that Enron delivered. We entered the violently overstated earnings data into our This is a straightforward story so far; 99% of full-time dividend discount model – which has a good long-term professionals in 1999 believed in data that guaranteed a record at getting more right than wrong – and the answer bear market. The straightness of the story becomes less came back in March 2000 that Enron was priced at over straight (I hesitate to say crooked) if we ask how many 5 times the average value of the top 1000 blue chips. clients were aware of the general bearish belief that (This average was itself well over twice fair value.) existed in these firms in 1999! Widely publicized views Listening to analysts defend their Enron of major firms often do not represent the views of the recommendations to the Senate Sub Committee on the “engineers” doing the real work, and this divergence grounds they were lied to was therefore a teeth-grinding seems to constitute one of the larger betrayals of trust in experience. Value had simply not entered the equation. our industry.

By the top of the market, almost every industry analyst, Investment Managers benchmarked by his industry stocks, was almost always expected to come up with positive recommendations Keynes’s advice was to never, ever be wrong on your regardless of the general level of overpricing in that own if you valued your investment job. This particularly industry. Predominantly, this was done on momentum. applies, apparently, to giving bearish advice in a bubble Stock prices, earnings margins, or sales that were rising that grows and grows. Gary Brinson, whose advice in were all good, regardless of the price of the stock. 1998 and 1999 was excellent (i.e., agreed with mine), was shot by UBS less than a month from the market peak. He The same principles of momentum and extrapolation also was a tough nut and, if anyone could get away with dominated general market advice.

If GNP and unpopular advice, he could. His failure makes me believe productivity looked likely to rise, then the market was that no large, public enterprise with quarterly described as attractive and likely to go up. This could responsibilities to shareholders can stand the pain of have been merely seen as typical institutional momentum substantial short-term loss of business in these situations. except that these strategists also described the U.S. stock When majority opinion is strongly bullish, these firms market as ‘cheap’ – clearly a statement of value. The must avoid clear separation from the pack by being market was claimed to be ‘reasonable’, even at 33x bullish themselves. overstated earnings. As a postscript, in early 2003, not backing off an inch, the leading strategist added, “My GMO had the great advantage of being an independent, record speaks for itself.”

That time I think she got it right! private firm, but we also paid a high price, although at least I was not fired. We lost 45% of our book of business Bearish Belief of Analysts, but not Bosses in 2½ years. We made the right bets to reduce risk for the Back at the hive, what did the worker bees – the rank and right reasons and won them, but lost more business than file analysts and fund managers for the great firms – any competitor. Given these responses to bearishness, actually believe? On this topic, I have some unusual and who would want to volunteer to oppose a strong bullish revealing data. Over the 4 years from 1997 to 2001, I consensus? asked over 1000 full time professional equity analysts and fund managers some simple survey questions. The Human Nature: Go with the Flow key question was to determine how many of them Homo sapiens learned to cooperate in the hunt. believed that the P/E ratio of the S&P 500 would return Individuals going off on their own more easily starved or to below 17.5x earnings sometime in the following 10 were killed.

The cooperative groups survived better and years. The 100-year history was just below 14.5x so multiplied. The species learned to respect group opinion. 17.5x was a friendly number. In response to the question This solidarity can emerge for good in times of war, but GMO 2 Letters to the Investment Committee V, October 2005 for bad in times of investment bubbles. ‘90s, special adjustments were overwhelmingly negative and the 10-year average net write-down had risen to Recent research suggests that we are also fairly 14%! This means that 14% of what is claimed as remorselessly overoptimistic and overconfident in our earnings today will turn out to have been overstated and views and that our confidence rises with each piece of will eventually be written off. additional data, even though the quality of our decisions peaks with only three pieces of data. All of which makes The Media us peculiarly vulnerable to getting carried away with The great 2000 bubble was unlike the 1929 and 1965 bull serial bombardments of bullish data. markets in the degree of stock ownership.

In 1929, just The Bullish Bias of Corporate Officers 10% of families owned stock and only 25% did in 1965. By 2000, in contrast, half of all families owned stock, so Stock options have been used excessively and have that almost the entire readership of serious magazines seldom been adjusted for market or peer performance, so was stock holders. At the same time, the potential that they often become licenses to raise even leaky boats television audience interested in stock programs became with the market tide. Their excessive use does not just large enough to justify much expanded programming, moderately increment senior management’s total income; making it impossible to eat lunch in the local greasy it sometimes results in multiples of the income. A second spoon without being surrounded by stock prices instead important reason to want a higher stock price is that it of the usual football games. facilitates take-overs – the fastest way for a corporation to grow.

Size, in turn, is highly correlated with the incomes The print diet, with some honorable exceptions, was of corporate officers. With these rewards, manipulation overwhelmingly bullish, and the breadth of stock and overstatement of earnings – effected by pushing ownership allowed a critical mass of bullish propaganda accountants as well as pushing accounting standards – to be formed. But it is not fair to blame the media for stand to be hugely rewarded and are therefore very their generally bullish bias, for they are not paid to common. educate or warn. Their job description is primarily to sell magazines or attract viewers, and it was increasingly The bullish bias was particularly evident in the obvious from 1996 to 2000 what the audience wanted to assumptions used by corporate defined benefit pension read and hear: “10 Great Telecom Stocks,” “How to retire plans. By the ‘99 bubble their return assumptions had at 55 richer than you thought,” “Dow 36,000.”

Bullish risen to an average of over 9½% even as the bond market covers provably increase sales. That’s their excuse and had fallen to 5% and P/Es had risen to 33x, implying an it’s a good one. But the investment industry, in contrast, earnings yield to stocks of 3%. (Stocks would have a 3% is paid to give its best fiduciary advice, and its bullish yield, for example, if corporations paid out all their bias clearly interferes with doing that. earnings at 33x earnings.) Using unrealistically optimistic assumptions allowed pensions to take a Summary ‘holiday’ from contributions that they would later desperately need, and resulted in earnings being about The commercial or political imperative to deliver 10% overstated for several years. Even today, with long relentlessly bullish opinion is extreme, even when bonds at 4½% and the earnings yield at under 5½%, the insiders may actually feel more bearish.

To make matters assumption for long-term pension returns is still showing worse, it seems that most of us are hard wired to be its bullish bias at over 8%! gullible; to believe that authorities know what they are doing, and that a large consensus view should probably As a bottom line measure of all their bullish biases, we be adopted. We also tend to exaggerate the importance of can look at the gap between net earnings and operating often repeated advice, and once a view is accepted as our earnings after ‘special effects’. In an unbiased world, own opinion we are overconfident in it and reluctant to when you sell a division, for example, you will have a change it. Before taking advice, particularly in bull pleasant write-up from selling overdepreciated asset markets, you should always remind yourselves of the values as often as you will have an unpleasant write- industry’s bullish slant and vested interest and always ask down.

In the ‘50s and ‘60s this was the case. But by the yourselves who are the foxes and who are the chickens.

Disclaimer: The foregoing does not constitute an offer of any securities for sale. Past performance is not indicative of future results. The views expressed herein are those of Jeremy Grantham and GMO and are not intended as investment advice.

Copyright © 2005 by GMO LLC. All rights reserved.

Letters to the Investment Committee V, October 2005 3 GMO