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GMO Quarterly Letter October 2008 Reaping the Whirlwind1 Jeremy Grantham The time to blame should be past, or at least in abeyance as the bubbles inevitably began to break, all was said until the crisis is past, but I find it impossible to avoid it to be contained and the economy was claimed to be completely. Sorry. In any case, just to set the scene, it is strong. necessary to review briefly the poisonous wind that we 4. The combination of favorable conditions and all sowed. irrationally exuberant encouragement from the 1. We had an extended period of excess increase in authorities produced an even more poisonous money supply, loan growth, leverage, and below bubble – that in risk-taking itself. Everybody, and I normal interest rates. mean everybody, got the point that risk-taking was 2. This combined with a remarkably lucky global asymmetrical and reached to take more risk. The economic environment that we described as “near asymmetry here was that if things worked out badly perfect” to produce a bubble in asset classes, as such they would help you out (this sounds very familiar!), a combination has done without exception according but if all went well you were on your own, poor thing. to our research. Since all these factors were global, Ah, the joys of pure capitalism! the combination produced what we have called “the 5. In this regard, some deadly groundwork had been first truly global bubble” in all assets everywhere with laid by the concept of rational expectations, or market only a few modest exceptions. efficiency. This argued that we were all far too sensible for major bubbles to appear. This is a convenient 3. While these asset bubbles were inflating, facilitated theory for mathematical treatment, but obviously by easy money, the authorities – the Fed, the SEC, totally unconnected to the real world of greed and the Treasury, and Congress – rather than tightening fear. It dangerously encourages the belief that if you existing regulations, partially dismantled them. They take more risk you will automatically receive more freed commercial banks while further reducing controls reward. That condition might often, even usually, on investment banks, allowing leverage to take wing. be the case because in normal quiet markets a rough More recently they almost gratuitously, without being approximation of that relationship is usually priced pressured, removed the uptick rule for shorting. And into the markets. But in wildly-behaving markets this is just a sample. Simultaneously, attempts in where risk is mispriced, it is not true. From June 2006 some quarters to address growing risks were beaten to June 2007 on our seven-year data, investors lulled back or diluted by Democrats and Republicans alike. by these beliefs and the conditions of the market Examples here include early efforts to rein in stock were actually paying to take risks for the first time in options and the attempt to add controls to Fannie and history.

Freddie. (I’m biting my lip not to name names.) Worse yet, the regulating authorities appeared to encourage 6. Just as all bubbles have broken, these bubbles did. the worst excesses by admiring the ingenuity of new Far from being a surprise, the bubbles breaking were financial instruments (okay, that was Greenspan), and absolutely not outlier events, contrary to protestations. by repeating their belief that no bubbles existed (or The bubbles forming in 1998 and 1999 and in 2003 perhaps could ever exist) and that housing at the peak through 2007 were the outlier events. The U.S. “merely reflected a strong U.S. economy.” Finally, housing market, which was a clear bubble with prices at least 30% above a previous very stable trend, is 1 “For they sow the wind, and they reap the whirlwind.” Hosea 8:7 well on its way back to normal, and equities and risk- with hurricanes blowing, the Corps of Engineers, as taking may well have made it all the way back. it were, are working around the clock to prop up a suspiciously jerry-built edifice. When a crisis occurs, 7. The stresses on the financial and economic world you need competence and courage to deal with it. of these bubbles breaking was always going to be The bitterest disappointment of this crisis has been great. To repeat a comment I made 18 months ago, how completely the build-up of the bubbles in asset “If everything goes right (as a bubble breaks) there prices and risk-taking was rationalized and ignored will always be lots of pain. If anything is done wrong by the authorities, especially the formerly esteemed there will be even more. It is increasingly impressive Chairman of the Fed. and surprising how much we have done wrong this time!” Where Was Our Leadership?

8. By far, the biggest failing of our system has been its This brings us to ask the question: Why did our leaders unwillingness to deal with important asset bubbles as encourage the deregulation, encourage the leveraging they form (see last quarter’s Letter). I started a long and risk-taking, and completely miss or dismiss the diatribe on this topic in 1998 and 1999 and reviewed growing signs of trouble and what we described as the it in Feet of Clay (2002), which is aimed at my arch “near certainties” of bubbles breaking? Well, I have two villain, Alan Greenspan. With the housing bubble theories. The first is our old chestnut and is related to my even more dangerous to mess with than equities, current stump speech, which is called “Career Risk and Bernanke joined my rogues’ gallery. If we change Bubbles Breaking: the Only Things that Matter.” Career risk is why CEOs, entrusted with our money, were still our policy and move gently but early to moderate dancing late into the game. So late that the clock had bubbles, this crisis need never be repeated. There already struck midnight and they had already turned back are signs that the previously intractable authorities into pumpkins or rats, but just didn’t know it. It’s what are reconsidering their bone-headed position on this I call the Goldman Sachs Effect: Goldman increased its topic. If they change, all this pain will not have been leverage and its profit margins shot into the stratosphere. totally in vain. (See Part 2 of this Letter, titled “Silver Eager to keep up, other banks, with less talent and energy Linings,” in two weeks or so.) than Goldman, copied them with ultimately disastrous 9. The icing on the cake as far as the bust is concerned consequences. And woe betide the CEO who missed the has been provided by Buffett’s “financial weapons of game and looked like an old fuddy-duddy. The Board mass destruction” – the new sliced and diced packages would simply kick him out, in the name of protecting of loan material so complicated that, shall we say, the stockholders’ future profits, and hire in more of a few understood them. The uncertainties and doubts gunslinger from, say, Credit Suisse. generated by their complexities were impressive. Trust My second theory would be even harder to prove, and this and confidence are the keys to our elaborate financial is it: that CEOs are picked for their left-brain skills – focus, structure, which is ultimately faith-based. The current hard work, decisiveness, persuasiveness, political skills, hugely increased doubt is a potential lethal blow to and, if you are lucky, analytical skills and charisma. The the system and must be addressed at any cost as fast “Great American Executives” are not picked for patience. as possible. Concern about moral hazard is secondary Indeed, if they could even spell the word they would be and must be put into abeyance for the time being. Wall fired. They are not paid to put their feet up or waste time Street leaders are in any case now fully scared and are thinking about history and the long-term future; they are likely to stay that way for a few years! paid to be decisive and to act now.

10. To avoid the development of crises, you need a The type of people who saw these problems unfolding, plentiful supply of foresight, imagination, and on the other hand, had much less career risk or none at competence. A few quarters ago I likened our financial all. We know literally dozens of these people. In fact, system to an elaborate suspension bridge, hopefully almost all the people who have good historical data and built with some good, old-fashioned Victorian over- are thoughtful were giving us good advice, often for years engineering. Well, it wasn’t over-engineered! It was before the troubles arrived. They all have the patience of built to do just fine under favorable conditions. Now Job. They are also all right-brained: more intuitive, more GMO 2 Quarterly Letter, Part 1 – October 2008 given to developing odd theories, wallowing in historical is the effect of both Rounds I and II on the real economy.) data, and taking their time.

They are almost universally When the U.K. housing shoe hits the floor it will come interested – even obsessed – with outlier events, and with another wave of write-downs and stress that, very unique, new, and different combinations of factors. These fortunately for everyone, the British taxpayers have been ruminations take up a good chunk of their time. Do such volunteered to share. Thank you from everyone! thoughts take more than a few seconds of time for the great CEOs who, to the man, missed everything that was Global profit margins, the second near certainty, are also new and different? Unfortunately for all of us, it was the declining rapidly, but have a long way to go. The estimates new and different this time that just happened to be vital. of future earnings that we have been sniggering at for a year are still inconceivably high.

Why do they bother? To It is therefore ironic that we fire these top CEOs when repeat our mantra: global profit margins were recently at the trouble hits. The headline should read: “Come back, record highs. Profit margins are the most provably mean-leaders of Merrill, Citi, Bear, and Lehman. All is forgiven reverting series in finance or economics. They will go (for a while).” The typical CEO is precisely equipped to back to normal. After big moves, they almost invariably deal with emergencies and digging out. Thus, Paulson overrun. With the current set of global misfortunes, they was just the man to miss the point, but equally just the are very likely to overrun considerably this time. man – or at least a typically good one – to deal with a complicated crisis under stress. But the most dramatic ground has been covered by the third near certainty – risk premiums.

From record While reading this section to my wife, she asked, narrow spreads 18 months ago in fixed income markets “But what about the Boards of Directors? Can’t they in developed countries, most are far beyond normal complement the CEOs’ short-term decisiveness with already, although a few probably still don’t get the full longer-term wisdom?” What a great idea – a balance of horror of some of the footnotes. (In contrast, in emerging left- and right-brained thinking. And so it should be, and countries we guess that most of the pain from the crisis actually is intended to be, on paper. What a shame that we unfortunately is still ahead, and here and there it could be have typically subverted this balance into a CEO fan club very severe, although in total much less than in developed of old friends and mutual backscratchers. countries.

It’s just taking a long time to work through the system for them.) Developed equities – which we have Near Certainties written about as the slow-witted of the two major asset The three “near certainties” we talked about in mid-2007 classes – had, as usual, a much harder time getting the have all behaved themselves. They were that U.S. and U.K. point than bonds. At least that was the case until what house prices would decline, that profit margins globally seems like a few minutes ago when, in a clap of thunder, would decline, and that risk premiums everywhere would they got the whole ugly point in a wave of panic. The rise, and all three with severe consequences on markets global equity markets moved in three weeks from quite and the financial and economic systems. The U.S. and expensive to moderately cheap for the first time in at least U.K. housing markets, the proximate cause of our current 20 years. troubles, have declined.

The U.S. market has probably quite a way to go, but likely is well over the mid-point Basics of its correction. The price declines of the U.K. market At times like this it is good to ask yourself what it is that have, in contrast, merely started. Housing transactions, you really know or think you really know. For us (in our in contrast, have vaporized. In fact, the scariest single asset allocation division) it is definitely not the ins and data item for me, out of a huge selection, was the August outs of the financial system, although we’re trying harder decline in U.K. net new mortgages of 98% year over and harder. The financial system is so mind-bogglingly year (from over £7 billion down to under £200 million, complex that very few, even those with far deeper a near total freeze-up)!

And this with the official house backgrounds than ours, fully understand it. Puzzlingly, price index pretending to be down only 10% at the end despite our relative ignorance of financial details, we of August. This is one of the biggest shoes left to drop were more accurate than many experts in the last year of Round I of this crisis. (I think of Round I as asset about the big picture, and we can speculate why. First, price bubbles breaking. Round II is the effect of this, as historians, we recognized that when bubbles break especially of housing on the financial system. Round III they almost invariably cause more pain than expected.

Quarterly Letter, Part 1 – October 2008 3 GMO Second, we are Minsky mavens and believe that, with for moderately more real growth in recent years. In the sadly defective humans making up the markets, Minsky six years since October 2002, the trend line has risen to was right to see periodic financial crises as well-nigh 975 (plus or minus a little – we are constantly fine-tuning inevitable. Thus in the middle of last year when the a percent here or there). Needless to say, two weeks ago experts at Goldman Sachs said they expected write- the market crashed through that level, producing Exhibit 1. downs of $450 billion, I immediately wrote that we’d So now all 28 burst bubbles are present and accounted for. be lucky if it wasn’t a trillion. I was playing off their Long live mean reversion! detailed expertise and adding a generalized historical observation as I had done with the prediction that “at least As for asset class returns, the early October crash has one major bank – broadly defined – would fail,” and that presented us with an opportunity to brandish our 10-year half of the hedge funds would be gone in five years. In forecasts even more than we did last quarter. Exhibit 2 previous banking crises, major banks had failed, and this shows our 10-year forecast from September 30, 1998 and crisis seemed likely, to us semi-pros, to be worse than the actual asset returns for the most important assets for most. So we studied in broad strokes previous crises and us in asset allocation. armchaired that we should up the ante. We got lucky Our 10-year forecast for the S&P 500 10 years ago was in an area in which we were not real experts, and we a lowly -1.1% real, an extreme outlier among forecasts. know we were lucky. We will attempt to keep the luck At the end of September the real return was exactly nil and hedge our bets by also increasing our skills. The (0.0%). But it only took three days of October to hit our addition of Edward Chancellor, an experienced financial -1.1% forecast on the nose! Ten years and three days. For journalist/historian with a focus on credit crises, has been emerging equities, our forecast was +10.9% real and the a very helpful start. actual was +12.8%. Not too bad, but even here in seven In contrast, what we do know, I believe, is asset class days – horrible days, admittedly – the return of emerging pricing and the behavior of bubbles, which are both crossed our forecast on the way down. So today (October derivatives of our single, big truth: mean reversion.

Exhibit 1 Bubbles Breaking The Bubble Finally Breaks Back in 2000, as we continued to shake in our boots as the 2.6 mad tech bubble kept defying gravity, we tried to reassure S&P 500: 1992-October 10, 2008 ourselves by looking at historical bubbles. We found 28 bubbles since 1920, defined arbitrarily but reasonably as 2.2 two-standard-deviation events that in a Gaussian world should occur once every 40 years. All but one burst all Detrended Real Price* the way back to the trend that existed prior to the start of the bubble. The single exception was the S&P 500 1.8 itself in 2000-02. Under the influence of what I’ve called “enough stimuli to get the dead to walk,” the S&P, down from 1550, could not quite reach its trend value, which 1.4 we had calculated to be 725. Instead it rallied at 775. (It had to fall 55% to reach trend, but fell 50%. Close, but no cigar. But, more critically, we had expected a fairly major 1.0 Trend Line overrun, which is historically so common.) Seeing this aberrant event led us to describe the market advance from 2002-07 as “the biggest sucker’s rally in history.” Now a 0.6 wrinkle here is that, unlike most, we measure bull and bear 92 94 96 98 00 02 04 06 08 markets based on their trend line growth after adjusting Note: Trend is 2% real price appreciation per year. for inflation. The real growth in the index has historically * Detrended Real Price is the price index divided by CPI+2%, since the long-been only 1.8% per year for the S&P, but for technical term trend increase in the price of the S&P 500 has been on the order of 2% reasons (low payout rates in particular) we have allowed real.

Source: GMO As of 10//10/08 GMO 4 Quarterly Letter, Part 1 – October 2008 Exhibit 2 10), our forecasts of 10 years ago were optimistic, if you On-Time Arrivals, Despite Some Turbulence allow us a few days’ leeway. S&P 500 Cumulative Real Return Where Are We Now?

50% So brandishing our old 10-year forecasts and resisting the 40% idea that even a blind pig will occasionally find a truffle, Actual we have had some confidence in saying that by October 30% 10th global equities were cheap on an absolute basis and 20% cheaper than at any time in 20 years. Full disclosure requires 10% that we add that, in our opinion, this is not as brilliant as it sounds, for markets have been more or less permanently 0% Crossed overpriced since 1994 and have not been very cheap since -10% Forecast over on 1982-83 and perhaps a few weeks in 1987. There is also a 10/7/08 terrible caveat (isn’t there always?), and that is presented -20% in Exhibit 3, which shows the three most important equity -30% bubbles of the 20th Century: 1929, 1965, and Japan in Sep-98 99 00 01 02 03 04 05 06 07 08 1989. You will notice that all three overcorrected around EAFE their price trends by more than 50%! In the interest of Cumulative Real Return general happiness, we do not trot out these exhibits often 100% and, until recently, they would have been seen as totally irrelevant and perhaps indecent. But, after all, it’s just 80% history. Being optimistic like most humans, we draw the Actual 60% line at believing something so dire will happen this time.

Crossed We can hide behind the fact that there are only three data 40% points, and therefore no self-respecting statistician can over on 9/5/08 give them much weight. We can convince ourselves that 20% things are different this time since the background to each 0% of the four events, including this one, is different. One of them had high inflation; three, including the current -20% Forecast situation, did not. Japan and 1929 were characterized -40% by complete incompetence, while this time we had Sep-98 99 00 01 02 03 04 05 06 07 08 only – shall we say – very widespread incompetence. This time we have thrown ourselves more quickly into Emerging Equities battle, although not so quickly as some would have liked. Cumulative Real Return Not all of the differences are favorable: we have a more 500% global, interlocking, and complicated system, including 450% Actual non-bank players like hedge funds. We also have the 400% “financial weapons of mass destruction” – asset-backed 350% securities that are tiered and sliced and repackaged – and, 300% perhaps most destabilizing of all, totally unregulated 250% credit default swaps. Did we have even more greed and Crossed 200% over on short-term orientation this time than they did? Well, we 150% 10/6/08 certainly didn’t have less! Still, a 50% overrun seems 100% unacceptable. Probably governments would feel that the 50% Forecast consequences of such a loss in asset value would simply 0% be too awful and would do anything to prevent it. And -50% perhaps, just perhaps, their “anything” would work. But a Sep- 98 99 00 01 02 03 04 05 06 07 08 reasonably conservative investor looking at the data would Source: GMO As of 10/10/08 want to allow for at least a 20% overrun to, say, 800 on Quarterly Letter, Part 1 – October 2008 5 GMO Exhibit 3 the S&P 500, and have a tiny portion of their brain loaded Overrun! with the notion that it just might be quite a bit worse. 2.3 S&P 500: 1920-1932 The Curse of the Value Manager 2.1 1.9 We at GMO have a strong value bias, and our curse, therefore, like all value managers, is being too early. In Detrended Real Price* 1.7 1998 we saw horribly overpriced stocks that at 21 times 1.5 earnings equaled the two previous great bubbles of 1929 1.3 and 1965. Seeing this new “peak,” we were sellers far, 1.1 Trend Line far too early, only to watch it go to 35 times earnings! 0.9 And as it went up, so many of our clients went with it, reminding us that career risk is really the only other thing 0.7 that matters. The other side of the coin is that only sleepy 0.5 value managers buy brilliantly cheap stocks: industrious, 0.3 wide-awake value managers buy them when they are 20 21 22 23 24 25 26 27 28 29 30 31 merely very nicely cheap, and suffer badly when they become – as they sometimes do – spectacularly cheap.

2.5 S&P 500: 1946-1984 I said as far back as 1999, while suffering from selling too soon, that my next big mistake would be buying too 2.0 soon. This probably sounded ridiculous for someone who Detrended Real Price* was regarded as a perma bear, but I meant it. With 14 1.5 years of an overpriced S&P, one feels like a perma bear just as I felt like a perma bull at the end of 13 years of underpriced markets from 1973-86. But that was long 1.0 Trend Line ago. Well, surprisingly, here we are again. Finally! On October 10th we can say that, with the S&P at 900, stocks 0.5 are cheap in the U.S. and cheaper still overseas. We will therefore be steady buyers at these prices. Not necessarily 0.0 rapid buyers, in fact probably not, but steady buyers. But 46 50 54 58 62 66 70 74 78 82 we have no illusions. Timing is difficult and is apparently not usually our skill set, although we got desperately 3.0 Japan vs. EAFE ex-Japan: 1981-1999 and atypically lucky moving rapidly to underweight in emerging equities three months ago. That aside, we play 2.5 the numbers. And we recognize the real possibilities of severe and typical overruns. We also recognize that the 2.0 Relative Return current crisis comes with possibly unique dangers of a global meltdown. We recognize, in short, that we are very 1.5 probably buying too soon. Caveat emptor.

1.0 Round III: The Economic Effects Trend Line 0.5 Rounds I and II – the asset bubbles breaking and the credit crisis – will soon be mostly behind us, but the effect on 0.0 the real world of economic output lies, unfortunately for 81 83 85 87 89 91 93 95 97 99 all of us, almost entirely ahead. Employing our usual historically loaded armchair technique, we have been Note: Trend is 2% real price appreciation per year. writing for several quarters that global economic weakness * Detrended Real Price is the price index divided by CPI+2%, since the long- will be substantially worse and will last substantially term trend increase in the price of the S&P 500 has been on the order of 2% real. longer than the official forecasts. We maintain that view Source: GMO even though official forecasts have dropped considerably.

GMO 6 Quarterly Letter, Part 1 – October 2008 The global economy is likely to show the scars of this so-called Anglo-Saxon countries, and will be a permanently crisis for several years. In particular, the illusion of wealth depressing feature of the next decade or so compared with created by over-inflated asset prices has been dramatically the last decade. It is indeed the end of an era. reduced and, though most of this effect is behind us, a substantial part of the housing decline in some European To end Part 1 of this Letter, there is only one further point countries and the U.S. is still to occur. We were all I want to add on this topic, and that is about China. spending and, in the case of the U.S., importing as if we were much richer than is in fact the case.

Particularly Like a Bear in a China Shop here in the U.S., increasing household debt temporarily I suggested last quarter that it was ridiculous to expect masked some of the pain from little or no increase in real great financial and economic skills from the Chinese hourly wages for 20 to 30 years. Household debt since government, which is faced with the spectacularly 1982 has added over 1% a year to consumer spending. complicated task of maintaining the highest economic Unfortunately, this net benefit does not go on forever. growth rate in history. “Surely they will stumble,” I said. Well, the more I think about it, the more likely it In the first year in which you borrow 1% of your income, seems that this is both the most likely and most dangerous the interest payment barely makes a dent and your spending disappointment (even shock) that awaits the current is close to 101% of your disposable income.

But each consensus. year you borrow an incremental 1%, your interest load grows. After 15 years or so in a world of an average 7% Moving back to our armchair at 56,000 feet (don’t you miss interest rate, the interest on the accumulating debt fully the Concorde?), an amateur economist could summarize offsets the new borrowing when one looks at consumers and simplify the Chinese economy as 39-37-37: an collectively. Well, we in the U.S. are closer to a model of astonishingly large 39% of the GDP is capital spending, 30 years of borrowing an incremental 1%, meaning that 37% is internal consumption, and an amount equal to we passed through break-even years ago and now pay 37% of GDP is exported. (These numbers do not sum to much more in interest than we borrow incrementally. This 100 as we are not using exports net of imports because is a situation favorable to an overfed financial structure as we are concerned with the vulnerability of total exports long as everyone can and will pay their interest, but it is to a weak global economy.)

The U.S., in comparison, is no longer beneficial to aggregate consumption compared 19-70-13, disturbingly on the other side of normal; 70% with the good old-fashioned way of waiting until you had consumption compared with 57% in both Germany and actually saved up to buy a TV set. Indeed, a visitor from Japan, for example, and nearly twice that in China. China’s Mars examining two countries, one with accumulated mix is of course an utterly unprecedented one, and comes consumer debt of 1.5 times GDP and the other with zero, with great advantages in booming times. Now, however, would, I am sure, notice no difference except for the we might ask: how do you stimulate the building of a new reduced number of consumer lending outlets. steel mill when rows of mills are sitting empty? How do you increase exports into a global economy that is not just This generally unfavorable picture gets worse when you slowing, but is unexpectedly very weak?

And are they consider that we are likely to have, for the next 10 years or good enough at stimulating local consumption to have an so, a modest annual reduction in personal debt of, say, 0.5% impact on such a small percentage of GDP in the face of of gross income per year as well as a continued interest a negative wealth effect from declining stock and housing payment. So the debt accumulation effect reverses as does prices in their local market? the illusion of the wealth effect from overpriced stocks and housing, especially the illusion of a decent accumulated Simple old “Econ 101” thinking would suggest that their pension. As we said two years ago (embroidering on capital goods sector will have a bigger drop than the rest Buffett), when the tide of overpriced assets goes out, it of the economy, and that export growth rates might slow will be revealed not only who is not wearing swimming from very large to even nil or worse.

The one open-shorts, but also who has a small pension! Our silly joke ended offset might be in Keynesian or Rooseveltian has become a sick one in just two years. government spending, upping their already massive infrastructure spending by A LOT. (This is a specialized This reversal of the illusory wealth effect added to economic term.) And they will surely do some of that. deleveraging will be felt worldwide, but especially in the On balance I find myself more and more convinced that Quarterly Letter, Part 1 – October 2008 7 GMO this is becoming our #1 disagreement with consensus. If have been set up for some very unusual developments. we are right, it will be a very important and distressing The market would have continued to fall for a few more surprise for global growth. The good news is that this weeks or worse (as by October 16th it seems to be doing) is far from the “near certainty” of our recent views on until eventually the world’s central bankers got their act housing, profit margins, and risk premiums.

At best, if together. The imputed seven-year returns by then might right, it is an inspired insight straight from the armchair. have reached, say, 15% real per year for emerging, 11% At worst, if wrong, an ill-researched hunch. for the U.S., and, say, 12% or 13% a year for EAFE. These exceptional opportunities, nearly equal to the legendary On the Virtues of Offsetting Errors lows of 1982 and 1974, would have set up, in my opinion, During early October (up to the 10th) global equities, in a paradox from hell for serious investors. They would our opinion, were finally quite efficiently priced, at least have been looking forward to an 18-month-long diet of for a day or two after a 20-year wait. But we did not sustained genuine disappointments; disappointments in get to this point where our 10-year forecasts were exactly both economic growth globally and, more importantly, in right for a second because the market had taken into its global earnings for the market’s consensus.

Yet into those head to finally be reasonable or efficient. No, it took two disappointments the market would likely have steadily giant offsetting errors! I am sure the market does not risen because the recovery from the extreme lows of the yet get the full extent of future earnings and economic panic would have inadvertently and accidentally more disappointments, nor does it easily accept how low trend than offset all the bad news. This would have proved line P/Es are. (Oh yes, I remember now. P/Es should intellectually very difficult to deal with: you predict an be higher because of much improved stability and better unpleasant surprise, but yet you should buy! It would economic management!) In fact I believe it will take at have been a rare historical event, which a big rally here least another year for the truly dreary global outlook to be may change.

Still, you never know your luck. Something fully appreciated and priced in. I was also counting on like it may still happen. (For the record, in 1932 a rally of over a year or more being required to break the high animal 111% started in the face of persistent disastrous economic spirits that had been baked in by years of exceptionally news.) fortunate events, moral hazard, and rising asset prices.

Provisional Recommendations Offsetting this optimism, we produced – with a fairly (October 10 - S&P 900) traditional mix of greed and incompetence, but in a giant At under 1000 on the S&P 500, U.S. stocks are very dose this time – a full-fledged panic. With no one trusting reasonable buys for brave value managers willing to be anyone’s financial integrity (often including their own), early. The same applies to EAFE and emerging equities and with margin calls, redemptions, and other technical factors causing forced selling, we had an old-fashioned at October 10th prices, but even more so. History warns, meltdown. And by some minor miracle, this confluence though, that new lows are more likely than not. Fixed of offsetting events or beliefs produced efficient long-term income has wide areas of very attractive, aberrant pricing. pricing for a few days. (P.S. The rally of October 13th The dollar and the yen look okay for now, but the pound may usher in a more sustained rally and help resuscitate does not. Don’t worry at all about inflation. We can animal spirits so that we might be able to limp through to all save up our worries there for a couple of years from my original target of a market low in 2010, but don’t hold now and then really worry! Commodities may have big your breath.) rallies, but the fundamentals of the next 18 months should wear them down to new two-year lows. As for us in asset If the U.K. plan (also advocated by both Soros and Buffett allocation, we have made our choice: hesitant and careful independently) had not been widely adopted and the global buying at these prices and lower. Good luck with your authorities had followed the dithering U.S. lead, we would decisions.

Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending October 17, 2008, and are subject to change at any time based on market 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 © 2008 by GMO LLC. All rights reserved.

GMO 8 Quarterly Letter, Part 1 – October 2008 GMO Quarterly Letter October 2008 Silver Linings and Lessons Learned Jeremy Grantham Summary and Conclusions progress from earlier sustained dollar weakness, helped by When asked by Barron’s on October 13th if we would new tumbling oil prices and falling consumption of other learn anything from this ongoing crisis, I answered, “We imports. Chief among the many benefits of this crisis are will learn an enormous amount in a very short time, quite a unprecedented opportunities for investing in some fixed bit in the medium term, and absolutely nothing in the long income areas where some spreads are so wide as to reflect term. That would be the historical precedent.” severe market dysfunctionality. As of October 18th, we also have moderately cheap U.S. and global equities for That is unfortunately likely to be the case. But over the the first time in 20 years. (You really have to put the dates next several years at least, there are many silver linings and in these days!) Probably quite soon, global equities too valuable lessons to be learned. We have had a generally will offer exceptional opportunities after the additional unattractive and difficult investment environment for the pain that is likely to occur in the next year. We at GMO past 10 years. For most of that time we have also had a are already careful buyers. We are reconciled to buying negative savings rate. too soon, but we recognize that our fair value estimate of We have had a bloated financial industry feeding off the real 975 on the S&P 500 is, from historical precedent, likely to world and a breach of the social contract with the increasing overrun on the downside by 20% to 40%, giving a range maldistribution of income (encouraged by tax changes!) in of 585 to 780 on the S&P as a probable low. The world favor of the very rich at the expense of ordinary people. We faces unavoidable declines in economic activity and profit also had unnecessary flaunting of this new great wealth. To margins, so this overrun is unlikely to be much less painful cap it off, we had blinkered, narrow-minded leadership by than average, although you never know your luck. the government and financial corporations. Well, much of this is ending. Some undesirable elements will disappear All We Have To Thank Is Fear Itself for a long time and some will just be moderated, but it is Thankfully, pure fear – approaching blind panic – finally truly the end of an era and a rather disgusting one in my induced some real action on the part of the authorities. opinion, speaking as a thrifty Yorkshireman. We can now This more decisive phase, injecting money directly into re-assess a lot of our thinking about investing, particularly the banks as well as supplying liquidity in many forms, market efficiency, outlier risks (boy, did Nassim Taleb get was initiated in the U.K. by Prime Minister Brown, that one right!), and theories of diversification and longer- the previously profligate Chancellor of the Exchequer. term asset allocation. European governments managed somehow to grind their A very weak global economy is not without partially teeth and overcome their natural reluctance to follow offsetting benefits: We can temporarily forget about Perfidious Albion anywhere. This, in turn, apparently consumer inflation and particularly enjoy the advantages encouraged the U.S. to jump on board with this more of lower oil prices as reflected in lower heating oil and direct approach. gas prices. Falling metal and agricultural prices will also This was a game-changing event that has probably saved help relieve some of the pressure on otherwise squeezed us from tipping into the pit. There will unfortunately be consumers. In a global crisis like this, the U.S. finds itself considerably more financial pain where the recent pain unexpectedly cast in the role of a safe haven. The dollar has come from: more global bank failures, more massive is as strong as a horse and yet our trade deficit still makes write-downs from credit cards and leveraged debt, and, increasingly now, the typical corporate defaults that follow downsides, it will be a giant step forward. I am not too a very weak economy. And the economies of most countries confident of the authorities, especially the Fed, but I am will surely be very weak. In the U.S., the downturn is pretty confident that at least the rest of society will take likely to rival 1982 or worse, and almost everywhere it is the formation of asset bubbles much more seriously. We’ll likely to be a much longer downturn than normal. take what we can get.

Also high up the list of silver linings and lessons learned is Another potential lesson learned might be our realization the Fed’s apparent change of heart on the topic of bubbles that capital markets don’t always work for the best. My in asset pricing. The breaking of the tech bubble set up friend and former partner Paul Woolley, now retired from the excess stimulus of 2001–03, which in turn created GMO, set up a center at the London School of Economics the housing bubble as surely as if a law had been passed a year ago bearing the tantalizing title: “The Woolley that all house prices had to be marked up 50%. And Centre for the Study of Capital Market Dysfunctionality.” now at last, there are signs of hope: signs that Bernanke (Fortunately for the title, his friend Wilde could not find is reconsidering: “Obviously, the last decade has shown the funding money.) I must confide that his investment that bursting bubbles can be an extraordinarily dangerous timing at GMO was seldom this perfect, for in one year and costly phenomenon for the economy (Ed.: the man’s he has gone from suspicious eccentric to enlightened indisputably a genius), and there is no doubt that, as we visionary, and long lines of luminaries are queuing up to emerge from the financial crisis, we will all be looking be involved. We have collectively had a touching faith at that issue and what can be done about it.” So all the that capitalism – just because it’s the only effective driving unnecessary suffering inflicted on us by short-sighted force behind economic growth – is basically flawless, and policies dictated by academic economists may not have any controls are bound to be counter-productive. Pure Ayn been entirely in vain! Rand capitalism obviously cannot deal with social issues of the tragedy of the commons variety, such as climate However it is definitely not a done deal. Few academics change. It cannot turn corruptible and greedy types into change their minds, and few scientific theories founder the reasonable and honest types that our readers represent. on the simple facts. “Science advances one funeral at a It cannot begin to address social justice. And apparently time” is how Max Planck expressed his belief in academic it does a lousy job at dealing with asset bubbles and the flexibility, but a suggestion that we use firing squads would ensuing economic and credit problems. Society’s attitude seem mean-spirited. Already, Fed members are making on this topic will change and, with a little luck, an increase the obvious point that interfering with investment bubbles in enlightened regulation will increase the public good. I as they grow by using the “blunt instrument” of raising for one am optimistic. The American ship of state (among rates would likely “in the short run curtail some economic many) appears to move forward by lurching too far in one growth!”1 direction and then like a super tanker with an amateur at But interfering with bubbles forming would not destroy the helm, overcorrecting. (And, oh my, have we had some growth, only postpone it, which is undesirable enough. real amateurs at the helm recently!) For the past eight Bubbles breaking, in contrast, reveal the destruction years, we have had a darned good lurch, and we need some of wealth produced by the extreme misallocation of correction. Somehow, in the long run, the ship seems to capital that has sucked so much investment into certain zigzag its way roughly in the right direction. The Jim areas – dotcom start-ups, overbuilding of housing, Grants of the world and other very sensible people, as well hiring multitudes of real estate agents, and designers of as the usual right-wing suspects, will say that increased elaborately structured financial notes, for example. And if regulation has a dismal record, and they are right. But so the bubbles precipitate a true credit freeze-up, then some does totally unregulated capitalism, apparently. We will inputs into really useful investments may be lost forever: have to muddle our way to an acceptable mix, and we can factories not built, education postponed indefinitely, and be sure of only one thing – that it won’t be highly efficient. man hours wasted in unemployment. If we collectively But it may be acceptable enough, and we must hope that become more leery of asset bubbles and their inevitable it is.

1 Gary Stern.

GMO 10 Quarterly Letter, Part 2 – October 2008 Still at the meta level, I would like to bring up the hope that remuneration and the structure that enables it. as a result of our current misfortunes we will re-examine Surely we will also reconsider the merits of having such an how we pick our leaders. It would seem for starters that a overdeveloped financial industry whose share of corporate lack of prejudicial bias would be helpful. If you’re looking profits had risen from 10% in 1982 to 27% last year. Some for an open mind, why would you pick Robert Rubin or of these people – ideally my better competitors – could find Hank Paulson for a job at Treasury that might, just might, something else to do with more redeeming social value. involve decisions on the life and death of their beloved They could be doctors or, perish the thought, actually Goldman Sachs?

And in the case of Paulson, why pick one make something. of the five leaders of financial firms who lobbied hard at the SEC against increased reserves for investment banks? The permanently bullish spin put out by the financial Why would you pick an Ayn Rand extremist like Alan industry – like real estate agents in heat – has also been Greenspan to be the Fed Boss when he openly deplored revealed, and I hope we can expect some serious reaction. increased regulation in almost any form and thought Permanent bullishness does not serve the clients well. The untrammeled capitalism was the bee’s knees? Wouldn’t ridiculous bullishness of bottom-up earnings forecasts has an open mind be better? Or Ben B, whose reflex is so long been a joke among serious investors, but we still see clearly to believe in market efficiency?

He believes it so them everywhere. The bullish bias pervades the industry profoundly that he prejudged important data such as the right up to Paulson and the other Wall Street CEOs. very dangerous housing bubble of the last few years. He Estimates even from more seasoned cool types, such as seemed to believe that since no such extreme inefficiency those at the IMF, and economists in general have their should exist, then it did not exist. Not a good idea. economic forecasts creeping downward while looking nervously over their shoulders: they are desperate to avoid On this same topic, why would we not insist on a proven getting too far ahead of the pack and committing Keynes’ record of excellence on a relevant topic for the really key crime of being wrong on their own. Thus, estimates important job? Ben B has an excellent record as an of global growth in GDP are still +3% for the world and academic economist, but has had little contact with the +9.2% for China.

In a crisis, the estimates always lag on messy, real world until now. And as for Alan! He had a the upside, and this does not help. Similarly, but worse, proven record. It was proven for years that he was a very the earnings estimates for the S&P have stayed ludicrously mediocre, lightweight commercial economist. He sat on a higher than were likely given the rolling crisis. For example few politically connected committees, met the right people the IBES earnings estimate for the S&P over the next 12 a lot, and, hey presto, had the second most important job months is still $98.5 a share. At even normal margins it in the land. would be $71, and at margins 20% below normal it would Lower down on the pecking order, I think we have learned fall to $56. With any luck, the usefulness of standard not to value CEOs so highly.

We have seen their limitations industry advice will be reconsidered and routinely adjusted when under novel stresses, and we have examined how for congenital bullishness. their reward system was out of kilter with the ordinariness Perhaps it is also time to reconsider the fixed asset of their talents. The boss of Lehman did an honorable allocation approach – what I used to refer to as the “watch and long service in my opinion, and I have no doubt he the locomotive coming” effect. It is fine in theory to urge tried hard. But frankly, Lehman even in its heyday was ordinary investors to grit their teeth in the face of losses a B player and, in its last few months, a D player. It is and show patience. But in the real world, many perfectly probably unfair to weigh too heavily his lack of skill down normal investors who take huge losses simply cannot bring the home stretch and the pain he inflicted on many by themselves to stand the pain.

Holding firm and waiting the holding out too long. He was obviously very unlucky to 15 or 20 years for earnings to catch up is great advice for be picked out as a sacrificial lamb. But even before the a computer, but computers don’t invest, and humans are unraveling, did he really deserve to have accumulated a … well, very human. They will often sell out near lows $650 million holding in Lehman – all wealth that would and lock in enormous pain. This is a great opportunity otherwise have accrued to stockholders – in addition to to re-evaluate the merits of moving more assets – if only immense annual rewards for basically doing an average marginally – away from dangerously overpriced asset job? I believe society will reconsider the merits of such classes toward relatively cheap ones before the great bear Quarterly Letter, Part 2 – October 2008 11 GMO markets do their usual thing.

I don’t mean to recommend The research science world is no doubt sighing with relief racing around on a day-to-day basis as some tactical asset at their silver lining: the prospect of once again recruiting allocators do. What I do recommend is an occasional some of the best PhDs who had been lining up to work for significant response to outlier events both at the bull and Goldman or a hedge fund (and even, I must admit, a few bear ends of the spectrum. This, of course, runs into major for GMO). There they designed the cleverly repackaged career or business risk. But, that’s life. mortgage paper so admired by Greenspan, or developed It will also be a silver lining if we get rid of some of the quant equity models and “stat arb.” Now they will have gilded-age excess on the part of the titans of industry, to waste their time once again designing nuclear facilities especially in the financial world.

They should have kept and second generation biomass projects. Oh well. their heads below the trench (see The Blackstone Peak and A real lesson will also have been learned on the “Let’s all the Turning of the Worms, July 2007), and they certainly look like Yale” front. (See Immoral Hazard, April 2008.) did not. They jumped way up, begging for a sharpshooter Yes, diversification is a great idea other things being equal, to notice them, and they were indeed noticed. It will now but if the demand is so trendy that it overwhelms either the surely cost them in hostile legislation in some form or liquidity of small asset classes, or the talent involved in other. hedge funds, private equity, and other fields, then there is One of the biggest silver linings will be in increased always likely to be a problem squeezing through the door household savings.

Now it is clear that the increased together. And that’s before someone shouts, “Fire! Fire!” wealth was only temporary. It was paper wealth based The great buying pressure from funds aspiring to look on very overpriced assets. The losses will have to be like the great endowment funds facilitated second-rate, repaired the hard way by deferred gratification – lower overpriced private equity deals. (See Appendix to Letters consumption and higher savings. The tragedy here is that XII: Evaluating the Usefulness of Private Equity Managers, since more than 10 years of normal savings were sacrificed July 2007.) Because these deals were typically overpriced to the grand illusion of paper wealth, it is unlikely that in the last three years, excessive leverage had to be used all of the lost savings can ever be made up. People will to even tease out the possibility of a decent return.

This, simply retire poorer than they might have done. in turn, guaranteed that in a profit margin squeeze all the It will be pointed out that increased savings will depress equity would be lost. The flood of money also allowed for consumption and lower GDP growth in the near term. over-funding of first-rate hedge funds and the start-up of This short-termism has been the logic in the past behind thousands of second-rate funds. Real investment talent has Bush and others who overtly encouraged consumption always been scarce, and does not jump out of the ground and therefore personal debt. But in the long term, which just because there’s a massive demand. Nuclear physicists economies grow the fastest: China with 40% savings, or do not immediately become investment talents even with the U.S. and U.K. with negative personal savings?

High IQs of 150. savings and investment rates, of course, encourage growth, The hedge fund industry is just an extension of our larger and we have to absorb the short-term negative effects of zero sum game. It adds collectively no value, it just what had become over-consumption if we want to be a reshuffles the existing pool of wealth minus the higher healthy economy. The recent crisis in credit and assets fees. Last year, in its prime, it offered mainly in place is a slap in the face, a rude wake-up call, and we will move to a better balance. The problem here is the timing. of real value added, or alpha, a simulated alpha that was Although we need this re-adjustment to greater savings dependent on rising asset prices, falling interest rates, or for the long term, if we get there too quickly – since one easy credit.

All three in many cases. The existing alpha person’s extra saving is another person’s unexpected loss did not increase to meet the increased demand but probably of top-line revenue – we risk getting caught in a downward shrank under the competition, and then the shrunken alpha spiral that breaks animal spirits. This is the nightmare that was spread more thinly over more capital. And all that kept Keynes up at night in the 1930s. So it has to be slow was needed for this phony alpha to be seen as wearing and steady, at which level the extra capital spending and no clothes was a steady return to more normal conditions. increased industrial capacity creates its own offsetting Lord knows, it did not need to be stripped naked in the city stimulus. square so abruptly! Fate really can be cruel.

GMO 12 Quarterly Letter, Part 2 – October 2008 All of these new, recently sexy alternative investment How Low Is Low? areas will now be re-evaluated: their illiquidity and their We have a pretty good fix on fair values. For the S&P tendency to pick up nickels in front of steam rollers will 500 we believe it is about 975 ±25. This is calculated, be fully taken into account. Value at risk (V.A.R.) as a as always, by the simple technique of assuming that at reliable measure of risk will hopefully be taken out and fair price we will have a normal P/E ratio, and that profit shot at dawn. In short, we will all live in a more realistic, margins will also be normal. We also showed two weeks if less exciting, world. ago how typical it is for great bubbles to overrun badly.

Usually we don’t invest our money on estimated likely What I Learned overruns, but instead filter our money in slowly and hope This experience has, not surprisingly, reinforced my faith to get lucky. After all, if stocks are attractive and you in mean reversion – that all bubbles break and that it is best don’t buy and they run away, you don’t just look like an to study the data, make up your own mind, and screen out idiot, you are an idiot. Still we are informed by our work general opinion. It has underlined the importance of mixing on overruns. So where are we this time? History says a with the right people: I never realized how many sensible 50%+ overrun has characterized the aftermath of the three people there were sprinkled through our business. We important equity bubbles. I believe we could also come are certainly grateful for their input and reinforcement in at this from a very different angle: We could work out nerve-wracking times. One never has enough confidence. what we think the likely range of profit margins is going That little voice is always there suggesting that, since to be in a severe recession, and then look at what multiples there are so many of them, there may be something to their have historically been applied to earnings that are equally arguments. So you go long the Yen and short the financials depressed. but never enough. It was rammed home to us that some In a rational world, low profit margins would be multiplied of the best bets were very technical and we needed help. by a high P/E and vice versa to normalize for the economic So we got help and we hired good people, but much too cycle. In a Bernanke/French and Fama world, the slowly, while opportunities of a lifetime slipped through correlations would be -1. High margins would always our fingers, leaving us with merely a decent profit. We be exactly offset by low P/Es and vice versa, so that the have learned that in the future we need to have expertise – market would always sell at fair value or replacement or at least moderate competence – in almost every aspect cost. The market would thus always be efficient, and that of the global capitalist system. It’s not easy, but we have chunk of the financial establishment that urges the buying learned the hard way – missed opportunities that did not and holding of index funds regardless of price would last long and would not wait for us – that it is necessary. unarguably be correct. In the crazy real world, in contrast, Above all, we learned to never, ever trust the competence we can’t even get the correlation sign right: it is positive of government officials. .32, which means that high margins are multiplied by high P/Es and vice versa. Remarkably, this is particularly The Gold Lining true at the extremes where the correlation rises. Thus in Topping off all of the offsetting virtues of this ugly last 2000, the equity bubble that Alan could not see forming year is the arrival of cheap assets. All too easily we forget sold at the highest P/E in history (35) multiplied by the that you can compound wealth rapidly only by having highest margins in history! 1982, in contrast, sold at 8 cheap assets. For those with a long horizon, it is always times depressed margins. This double counting makes better to have assets fall in price so that the compounding the market far more volatile than it needs to be by driving returns are higher. For an unparalleled 20 years, global prices far above and far below efficient price levels. equities, especially U.S. equities, have been overpriced.

Exhibit 1 shows our series on U.S. profit margins. This Now, finally, they are cheap and likely to get cheaper. is a pretty dependable mean reverting series so you can Likely, I believe, to set up a once-in-a-lifetime investing be extremely confident that margins will come back to opportunity (or maybe twice in a long career). normal. What is easy to forget is that, of course, they spend half their time below normal. In the global conditions that we expect, S&P margins should fall below their normal Quarterly Letter, Part 2 – October 2008 13 GMO Exhibit 1 upside, however, and somehow profit margins hang in, the Profit Margins for the S&P 500 result would of course be far less severe. Our conclusion, though, that the S&P is likely to bottom out in the 600 8.5% to 800 range within the next two years can unfortunately be seen as not particularly pessimistic from a historical 7.5% perspective.

Average: 5.6% 6.5% 21% Finally, a Single Piece of Advice for the Profit Margin above Government 5.5% average profit I have never been a fan of the hysteria that has surfaced on margins all sides in recent years at a hint of recession, and the panic 4.5% to throw public money at the economy. Mild recessions have several long-term advantages discussed in earlier 3.5% Letters, but in recent years we seem to have lost interest in the long term.

Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending October 24, 2008, and are subject to change at any time based on market 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 © 2008 by GMO LLC. All rights reserved.

GMO 14 Quarterly Letter, Part 2 – October 2008