倒计时继续

GMO Quarterly Letter October 2004 Jeremy Grantham, Chairman The Countdown Continues & Letters to the Investment Committee I Introduction strongest quarter of the election year since 1932 has been We’re down to 3 little months, probably quite good ones the fourth quarter, and I still think a decent fourth quarter before we reach the difficult years one and two of the this year for equity markets is a better than even bet. Presidential Cycle. In the meantime, the third quarter was very stealthy. Nothing seemed to be happening, and The Hubris Award for 2004 yet, by the end, there had been important shifts, most of Amid the reasonable predictions from last year, the one them happily to our advantage. Our biggest bets this year for emerging markets equity stands out as remarkably on emerging and small cap international equities, and to a aggressive. Since it is up 13% (as of 10/4/04) in a flattish lesser extent REITs, all relative to the S&P, had won year, and may do some more yet, a simple preference for handsomely in the first quarter and had been hammered emerging would have worked out fine, but the hottest in the second. In this recent quarter, the emerging and language yet was wheeled out. “Without a Chinese crisis, REIT indices both beat the S&P by over 10%, and the emerging could go straight up 30%, 40%, or more.” small cap international index slightly increased its year- Well I did and still do believe that emerging will beat the to-date lead over the S&P to +8%. In fact, all 17 S&P from then by 30 or 40% eventually, but “straight components in GMO’s Global Balanced Asset Allocation up” or straight anything is to completely ignore one of the Strategy (from regular domestic bonds and TIPS to EAFE central market truths: careful estimates based on value equities) beat the S&P in the quarter, and also year-to- eventually winning will usually treat you well, but timing date, except for our new Quality Strategy which, will usually try to kill you. unkindest cut of all, fell behind on the last day of the quarter because of Merck’s unexpected withdrawal of Accuracy of Intermediate-Term Forecasts Vioxx. In a choppy year, the steadiest trends have been Exhibit 1 reproduces our actual 10-year asset class in the underperformance of technology stocks, growth forecast done at the top of the market, 4½ years ago in stocks, and highly volatile (or risky) stocks. Each of March 2000. (Our current 7-year format started a year these trends continued in the third quarter later.) What is surprising to me now is how many of the asset classes looked quite attractive then despite the Accuracy of GMO’s Short-Term Forecasts ugliness of the S&P 500. Table 1 is a ranking at March Coming into this year, we had predicted outperformance 2000 by estimated attractiveness of 12 asset classes, 10 of by foreign and emerging equities, and as growing which come from Exhibit 1 with cash and forestry believers in the Presidential Cycle, we had also looked excluded, and two are added from the usual part two of for a typical low volatile year with quite good US equity our monthly forecasts – the important US small cap value gains. Well, we’ve certainly had a wonderfully low and large cap value categories. The table compares our volatile year for the S&P with about half the normal forecasts to the actual results. It is far from a perfect volatility almost exactly equal to the remarkably low ranking, but on the right is the average for the delivered average for all year fours of the Presidential Cycle. returns of the best four original estimates, the middle Foreign and emerging equities also outperformed US four, and the worst four. They are certainly ranked in the equities as predicted, but the US equity market itself is right order, and the average error of each block is not yet up as much as we forecast in last year’s fourth unexpectedly small with outperformance of some quarter letter (+11%). The year however is not yet over favorites offsetting underperformance of others. The and it turns out, counter-intuitively I think, that the average outperformance of the benchmark by GMO was Exhibit 1 GMO 10-Year Asset Class Return Forecasts* As of March 31, 2000 Stocks Bonds Other 14% 12.2% 12% 0.4% 10.4% 10% 4.1% 9.1 8.3% 8% 1.9% 7.0% 2.0% 6% 2.0% 0.4% 5.1% 4.2% 4.4% 10.0% 8.1% 1.4% 3.6% 4% 3.1% 7.2% 1.4% 6.3% 2.5% 1.5% 5.0% 2% 2.0% 3.7% 4.0% 2.0% 2.8% 2.1% -0.6% 1.1% 0.5% 0% -2.2% -2% 1.6% -4% U.S. U.S. Int'l. Int'l. Equities U.S. Bonds Int'l. Bonds Bonds Bonds U.S. REITs Managed equities equities equities equities (emerging) (gov't.) (gov't.) (emerging) (inflation treasury (30 Timber Estimated (large cap) (small cap) (large cap) (small cap) indexed) days to 2 Range of yrs.)

10-Year ±5.5 ±6.0 ±5.5 ±6.0 ±9.0 ±3.3 ±3.3 ±7.0 ±1.0 --- ±5.0 ±4.5 Annualized Returns *The chart represents real return forecasts1 for several asset classes and an estimate of value expected to be added from active management. These forecasts are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. 1 Long-term inflation assumption: 2.2% per year. 3 Bond with same duration as J.P. Morgan Non-U.S. Government Bond Index. Forecast is for unhedged 2 Bond with same duration as Lehman Brothers Government Bond Index. international bond returns. Hedged is 0.2% higher. 4 Alpha transported from management of global bonds.

Table 1 March 31, 2000 GMO Asset Class Ranking: Forecasts vs. Actual Results estimated to be 1.7% per year and was actually 4.1%, Estimate Actual flattered by the market decline and the typical bear REITs 10.0 17.5 market bias of our strategies. Notable for me is the equal Emerging Equities 8.1 0.4 weighted average estimate of our 12 asset classes of Avg. Avg. +7.5 +9.6 +3.8% which compares to the average delivered Emerging Debt 6.3 9.4 performance of (drum roll) +3.8%! In real life the Small Cap Value 5.5 11.2 delivered 3.8%, when added to our actual 4.1% alpha, International Small 5.0 1.2 produced a perfectly respectable 7.9% real return. (Ah, the good old days.) And our ultra bearish US large cap Inflation-Indexed Bonds 4.0 Avg. 8.2 Avg. estimate of -2.2% real was trumped by the market +3.9 +5.0 US Bonds 3.7 5.1 actually dropping 7.2% a year! Now if we could just Int'l Govt. Bonds 2.8 5.4 control our unjustifiable optimism… Our inflation US Small 1.1 0.2 estimate in March 2000, for the record from the footnotes, was 2.2% per year and the actual was 2.3%.

US Large Value 0.8 Avg. 1.2 Avg.

International Large 0.5 +0.1 -6.6 -3.1 The only bad news here is having bragged about these US Large -2.2 -7.2 so-far-so-good estimates, we will, no doubt, be nagged into doing it again at the 10th anniversary in March Total 45.6 46.0 2010, where the Laws of Averages are no doubt lying in Average 3.8 3.8 wait for us.

GMO Quarterly Letter – October 2004 2 GMO Third Quarter and Year-to-Date Performance quantitative strategy, lost 14 of the first 15 down days this Over 80% of our money under management beat its year and won the first 18 out of 18 up days – a uniquely respective benchmark for the third quarter, and over 70% aggressive posture for this strategy, which typically wins won year-to-date. Strong outperformers for the quarter 62% of down days. Well, over the last 3 months, it has were our emerging markets and emerging country debt won 60% of down days; perfectly satisfactory, but not yet strategies, international value, international bonds, and heroic. GMO’s largest developed country international US core. Underperforming for the year are emerging quant strategy (International Intrinsic Value), which equities, behind by about 2%, and almost all our US typically wins a remarkable 77% of down days, has won equity portfolios, other than US core, although all the 62% of them in the last 3 months, already a bear market underperformers are contained in the 0% to -2% range, bias, but clearly not yet our normal bias. Our Global rather than a severe decline. The particularly choppy year Balanced Asset Allocation Strategy, a proxy for our asset in the US has been brutal for our momentum streams – allocation strategy, has beaten its benchmark on 65% of and everyone else’s – and our quality bias to value has the down days in the quarter compared to a normal 80%. been quite strongly perverse. Our value models are about GMO, for the record, has had a distinct winning edge on level with the S&P, but far behind lower quality versions the downside in the past for all its equity portfolios, like price/earnings and price/book. except emerging equity, which is neutral.

A Short Digression on ‘Quality’ and ‘Beta’ Measured in more traditional qualitative ways, we have This last point – the underperformance this year of high reduced our risk in the International Intrinsic Value quality – is interesting to us as it represents a divergence Strategy this year by lowering our overweight in small from the outperformance of low volatile or low beta cap to just +4.2% from over +8%. The bet on high stocks. Most of the world, including us, have tended to quality (best 25%) has moved from -3 percentage points think of quality – fundamentally defined as low debt, to +9, and particularly dangerous high volatile stocks high profit margins, and high margin stability – as having (highest 25%) have moved from +6 percentage points to generally the same portfolio virtues and vices as low beta, -5. In U.S. Core, our highly unusual 17% overweighting but they turn out to be interestingly different.

For starters, in the 25% highest volatile stocks that existed last year the best 25% by market cap on our high quality definition and into this year has disappeared completely. In all is down 4½% year-to-date while the least volatile 25% is equity strategies, including emerging and UK equity, up 5%, both relative to the market. More surprisingly, the there has been a steady, but cumulatively large move to long-term correlation in their relative performance is increased quality and away from high volatility over the negative 6%! We are currently researching the ins and last 9 months. outs of this puzzle. The results could bear quite importantly on how to best protect portfolios in the next The Bull and Bear Cases for the US Equity Market 2 dangerous years. We will cover our early work on this I have to reluctantly admit that the current bear case at our client conference, but our initial work suggests that seems complicated and relatively sophisticated or historical low beta and low volatility is even more helpful “intellectual” unlike March 2000 when it seemed very, in a decline than we expected and high quality less so. very simple: the market was obviously overpriced on Stay tuned. every reasonable measure.

The bull arguments then, in contrast, could be summarized (no doubt with some GMO Digs In negative spin) as falling into two camps. First, Abby As mentioned in several quarterlies, I was hoping for a Cohen, et al.: “the economy, productivity, and profits are quiet year with some market gains to buy us time to fine so the market will be fine.” Second, the more reposition carefully to more conservative portfolios. We ludicrous Dow 36000 type of argument: “stocks are less could still use a few more months, and as mentioned, I do risky than bonds and therefore should sell at a lower total expect the fourth quarter to be up, but we have already return than bonds,” which meant, for the record, since covered some considerable ground in making our bond rates were low, that the market would sell at four portfolios more conservative. times replacement cost!

Now, in contrast, the current bull case seems straightforward, appealing, and easily The best proof of the pudding is in the eating, so how understood. The bull case is that due to very strong have our strategies performed recently compared to earnings for 2 years, the earnings have caught up with a earlier in the year? To start with, U.S. Core, our flagship recently flat market to bring the p/e multiple down to 3 Quarterly Letter – October 2004 GMO 18½, and a multiple of 18½ is reasonable given the The Nightmare for Asset Allocators: What on Earth current above average profit margins, low interest rates, Can We Do to Prevent Losses? low inflation, and quite strong outlook for next year’s GNP growth, for which the consensus is +3½%, which is As mentioned in other quarterlies, asset allocators like at or above long-term trend, and global growth is Ben Inker and me have a lot in common with bond expected to be among the highest of the last 20 years managers in that both groups wail and gnash their teeth when their bets win because of lost opportunities, in Unfortunately, if that indeed is the bull case, then it is complete contrast to equity investors, who when wrong both theoretically and historically.

First, above presented with strong market gains don’t appear to notice average profit margins are a negative for future forecasts, the lost opportunities, but jump up and down with cries of not a positive, since profit margins are dependably mean “Whoopee we’re rich!” Well things have gone so well for reverting and, historically, very high margins, as we have value based asset allocation in the last 4½ years that now, are followed by below average stock markets as opportunities are looking extremely thin. (When, I margins move back down. Second, GNP growth has wonder, did a run of mean reverting bets like this one last unfortunately no easy relationship with stock market occur?) The results of this have been that our asset returns. My favorite example of this is that the decades allocation has had 5 consecutive very easy years: our of the 1990s and the 1970s – which felt like Heaven and Global Balanced Asset Allocation Strategy, for example, Hell, respectively, in the stock market – had almost has outperformed its benchmark in sequence by 10%, identical GNP growth rates, and productivity growth rates 10%, 11%, 5%, and 2½%.

And, it has done so at much for that matter. This year’s GNP growth is negatively lower risk. The Great Ugly for our allocation was, in correlated with next year’s market returns (-26%) in that contrast, only 3 years (1997 to 1999) and, although our above average GNP this year tends to be followed by asset allocation underperformed badly for these 3 years, below average market returns next year. Thirdly, interest it at least did so with far less risk, I add unpersuasively. rates do not affect the fair value of the market, which I (For the record, why was much lower real risk so hope we agree is equal to replacement cost, and unpersuasive then and why is it still?) replacement cost is obviously not affected by interest rate changes. As further encouragement, the 90-year The nightmare today for asset allocation is exactly the historical record is that the correlations between interest result of these 5 successful years for mean reversion or rates and equity market moves is approximately nil. value.

Small stocks and value stocks globally were brilliant and have used up either all their under valuation Finally, and most importantly I believe, you simply or even more than all. US REITs have delivered at least cannot look at unnormalized p/e ratios when dealing with 80% of the benefits that might have been expected from the total market. In addition to adjusting for the profit their enormous relative cheapness 4½ years ago. cycle, you have to allow for write-downs of prior claimed Emerging country equity and emerging country debt earnings. In theory, operating income and net income handsomely beat the S&P 500 as did all other fixed should be the same, with unusual debits in the long run income, with our favorite TIPS at the front. The closest being offset by unusual credits. In real life there is a bias to failure of any asset class bet was on EAFE to beat the to unusual debits because of systematic overstatement of S&P 500, limping home by a +3% total over the 4½ earnings.

In the last 10 years, there has been an average years. That same bet – EAFE to beat the S&P 500 – is, of 14% net write-downs. So fair market value today not so coincidentally, by far the best bet remaining. should be based on current operating earnings less the normal 14% downward adjustment for write-offs, and a But what else is interesting? On our current 7-year further downward adjustment to allow for abnormally forecast every equity and fixed income asset class shows high current profit margins that will regress, very as overpriced except for emerging equity, which is just probably in the next 2 years. A normal profit margin about fair value. combined with a normalized or trend line p/e of 16 Our summary advice for asset allocation on a relative to unfortunately produces for the S&P 500 a fair value of benchmark basis is easy enough though: 725, which compares painfully to the S&P’s current price of just over 1100.

Today’s easy logic of current market • Tilt equities as much towards international and away reasonableness is both very seductive and very common from the US as your career risk account will allow, with and therefore quite dangerous. emerging more overweight than developed, but GMO Quarterly Letter – October 2004 4 recognizing the potential for some heart stopping down in real terms, in startling comparison to years three and periods in emerging before the US bear market is over. four when only 5 years are down. To make matters worse, the value of the market (which does not matter in • Tilt all portfolios (US and international) to quality and year three where expensive markets go up anyway) low volatile stocks, especially those with low debt. Be matters a lot in years one and two. If you are in the worst particularly careful of US small low quality issues half of all years by value in years one and two, your odds whose increased leverage may turn out to be very of a loss rise to about 70% for each year separately! dangerous.

These fairly miserable odds cover the normal run of • Have a slight tilt to fixed income versus equity. A events. What remains to be decided is whether the risks heavy tilt to fixed income needs to place an awfully now are higher than normal. high confidence on the timing of a large equity decline, for with fixed income itself moderately overpriced, our The first incremental risk is that we are not only in the 7-year estimates for several equity sub categories, plus most expensive half of all markets since 1925, we are in their imputed alphas (our GMO outperformance), look the worst 10%. Second, the Presidential Cycle is better than most or all fixed income categories. primarily a financial or monetary phenomenon and without getting into terrorism, which I assume rightly or Our summary advice on an absolute basis is much more wrongly will have little effect, we can all agree that the painful to deliver though shorter: PANIC. With the rallies risks to the financial system are above average. in the third quarter in global fixed income, emerging Corporate debt is at the higher end of its range as are both equity and debt, and US REITs, there has never been a the federal deficit and the trade deficit, while more broadly overpriced mix of assets. Hide in accumulated foreign debt is at a 100-year high, and conservative hedge funds. Buy some foreign and accumulated household debt is at a new US all-time emerging equities, but be reconciled to periods of record. The housing market is also clearly over negative return. Look closely at diversification into stimulated through prolonged easy and cheap credit and commodities including forestry, and if you can stand the contains a real threat to consumption when home prices low returns, hold some cash. But whatever you do, and finally fall off even a little. A major potential risk is that however desperate you may be, do not reach for return; a combination of price weakness in financial assets and do not try to get blood out of stones. The extra potential price weakness in housing, both resulting from return for taking extra risk is very low or even negative overpricing, will coincide with some financial crisis, even after a wonderful rally for risky assets in 2003. Now is a minor one. The threat posed by high oil prices to the time to lower risk and survive to fight another day consumer demand and the possibility (slight I believe) of with your assets as intact as you can manage. a Chinese derailment are other quite separate risks. Outlook for 2005 & 2006 All things considered, I would say we are at the more No news is bad news in this case as our forecast remains vulnerable end of the spectrum of overpriced markets the same – gloomy. To cut the argument down to its going into the dangerous year one of the Cycle. But, basics: over half of all years one and two of the probably and hopefully, we have 3 more reasonable Presidential Cycle since 1932 have been down, 19 in total months to enjoy.

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.

5 Quarterly Letter – October 2004 GMO GMO Special Topic October 2004 Jeremy Grantham, Chairman Letters to the Investment Committee I Introduction sooner or later get a lot of company to bid down the It’s my intention to write a series of topics designed to returns. Conversely, all investors in 2000 faced with a cover the most important investment issues seen through market p/e of 33x, and an imbedded return of under 3% a the eyes of those committee members who are well year while bearing full equity risk, will eventually lose informed, but not full-time professionals. This, my heart and sell. A mix of behavioral inefficiencies and opening effort, starts at the very beginning of what I value based efficiencies means that bubbles will form and believe is the basic machinery that drives the stock all of them will break. market. Our markets are certainly not the well oiled We have in fact searched through absolutely all the data machines of the efficient market hypothesis, but that we can find on currencies, commodities, and stock cantankerous and unreliable machines that sometimes run markets and have found 27 bubbles. Unlike Chairman smoothly and sometimes have fits. Greenspan, we have no trouble in defining a bubble: we arbitrarily use a two standard deviation event, the kind Letter #1: “Regression Is Mean” that would occur randomly every 40 years. Predictably Everything important about markets is ‘mean reverting’ (at least for believers in regression to the mean), all 27 or, if you prefer, wanders around a trend. Prices are bubbles broke and went all the way back to the pre-pushed away from fair price by a series of “inefficiencies” existing trend! To be equally predictable, the current and eventually dragged back by the logic of value. bubble, which at its maximum inflation in March 2000 In markets where investors are acting for themselves, was the biggest bubble in American history, will have to prices are pushed away from fair price by behavioral pass through its trend of 720 on the S&P 500, currently at twitches. We are not hard wired to be ‘economic man’, just over 1100. If it does not do this it will be the first quickly and efficiently processing all available data. In failure to do so in modern times. contrast, we are plagued by herding, overconfidence, Exhibit 1 shows the 12 most famous bubbles in their wishful thinking, and difficulties when processing respective classes. All have reverted to trend except the top multiple factors, particularly when they involve right hand corner – the current US equity bubble. It has probabilities. In markets where investors hand over their had a solid bear market rally as all three others next to it money to professionals, the major inefficiency becomes had, and will probably join the other 27 at or below trend. career risk. Everyone’s ultimate job description becomes “keep your job.” Career risk reduction takes The problem with bubbles breaking and going back to precedence over maximizing the clients’ return. Efficient trend is that some do it quickly and some slowly. Exhibit career risk management means never being wrong on 1 also shows this point by highlighting three of the your own, so herding, perhaps for different reasons, also bubbles with the most obviously different timing. characterizes professional investing. Herding produces momentum in prices, pushing them further away from So at extremes you will always know what will happen fair value as people buy because others are buying. but never when. You will know something certain about the indefinite future, but usually nothing material about Prices are eventually pulled back to fair price by the need the immediate future. This is why asset class prices for the return of each asset class to relate sensibly to its resemble feathers in a hurricane – all certain to hit the risk. This is the force that exercises a persistent ground, but lord knows when. If the timing was also gravitational pull on inefficient prices and this force is knowable, it would be an arbitrageable situation: if you generally described as ‘value’. An investor in equities in knew what would happen and when, then, like a Star Trek the ultra cheap markets of 1982 or 1945 who is receiving “paradox,” it would be anticipated and could, therefore, 10% or 20% a year real return for owning equities will never occur.

Exhibit 1 All Bubbles Break: but Not at the Same Speed!

Stocks S&P 500 1920-1932 3 Years S&P 500 1946-1984 18 Years 3.0 Japan vs. EAFE ex-Japan 1981-1999 S&P 500 1992-September 2004 2.3 2.5 2.6 Detrended Real Price ?

Detrended Real Price Detrended Real Price 2.0 2.5 2.2 Relative Return 1.8 ?

2.0 ?

1.5 1.8 1.3 1.5 ?

Trend Line 1.0 1.4 Trend Line 1.0 ?

0.8 0.5 1.0 ?

0.5 Trend Line Trend Line ?

But not knowing the timing creates critical career and they are hard to engineer.) The good news is that human business risk, which has molded the business of nature, which leaves its mark on all financial markets, investing. If you are smarter than most and want to take will never change and we will always have these great no career risk, then anticipate other players and be opportunities to make money and have dangerous quicker and slicker in execution, or as Keynes said, “beat careers. them on the draw.” Refusing on value principles to buy in a bubble will, in contrast, look dangerously eccentric Or if you prefer serious brevity… and when your timing is wrong, which is inevitable sooner or later, you will, in Keynes’s words, “not receive much mercy.” The Way the Investment World Goes Around The more the investment industry has become specialized Career Risk and the more carefully benchmark deviations are measured, the greater the career risk of moving outside Timing Herding & your narrow style. This has weakened the arbitrage Uncertainty Momentum mechanism and guaranteed increasingly larger and longer market distortions. Today the challenge is not getting the big bets right, it’s arriving back at trend with the same clients you left with, and GMO, for sure, has not solved this problem. The key investment task is to structure a Mean Reversion Market firm where you can make more of these long-term mean Risk / Return Inefficiency reverting bets and live to tell the tale. (Warren Buffet’s Pulls Prices Back Prices Move Away to Fair Value from Fair Value closed end fund, Berkshire Hathaway, or a forestry fund with a 10-year lock-up are nearly perfect solutions, but GMO 2 Letters to the Investment Committee I, October 2004