奥巴马与铁氟龙人，及其他短篇故事。第一部分。

GMO QUARTERLY LETTER January 2009 Obama and the Teflon Men, and Other Short Stories. Part 1.

Jeremy Grantham With economies and financial markets, it seems that if you 1. The Story So Far: Greed + Incompetence + stare hard enough and long enough at the fog of battle, A Belief in Market Efficiency = Disaster you occasionally get a glimpse of what may be going on Greed and reckless overconfidence on the part of almost when a favorable wind blows. This, for me, is decidedly everyone caused us to ignore risk to a degree that is not one of those occasions. It is obvious to all of us that probably unparalleled in breadth and depth in American these are momentous days in which government actions history. Even more remarkable was the lack of insight may well have make-or-break impact, but my confidence and basic competence of our leadership, which led them in government and leadership is at a low ebb. (Although to ignore this development, or worse, to encourage it. I must admit my confidence has increased enormously Ingenious new financial instruments certainly facilitated in recent weeks in all areas outside of finance. Even in and exaggerated these weaknesses, but they were not the finance it has increased a little.) Economic advice for most potent ingredient in our toxic stew. That honor goes President Obama covers the waterfront, and even the near- to the economic establishment for building over many consensus case for great stimulus is lacking in historical decades a belief in rational expectations: reasonable, certainties or intellectual rigor. Everyone seems to be economically-induced behavior that would always guessing at strategies and outcomes, knowing clearly that guarantee approximately efficient markets. In their desire the best strategy would have been to have avoided getting for mathematical order and elegant models, the economic into this pickle. The current disaster would have been easy establishment played down the inconveniently large role to avoid by making a move against asset bubbles early in of bad behavior, career risk management, and flat-out their lifecycle. It will, in contrast, be devilishly hard to bursts of irrationality. The dominant economic theorists so get out of. But, we are deep in the pickle jar, and it seems valued orderliness and rationality that they actually grew likely that, in terms of economic pain, 2009 will be the to believe it, and this false conviction became increasingly worst year in the lives of the majority of Americans, Brits, dangerous. It was why Greenspan and Bernanke were not and others. So break a leg, everyone! sure that bubbles – outbursts of serious irrationality – could It would be helpful at a time like this to have a Quarterly even exist. It was why Bernanke, who had studied the Letter that sounded convinced of something … anything. bubble of 1929, could still not see it as proof of irrationality So I apologize for overtly tickling around the edges. and could still view the Depression (à la Milton Friedman) I do not apologize, though, for pointing you to the best as a mere consequence of incredibly bad, easily avoidable thing I have read in The New York Times in a very long policy measures. Of more recent importance, it was why time: the article by Lewis and Einhorn1 does a great job Bernanke could dismiss a dangerous 100-year bubble in of summarizing where we are and how we got here, as U.S. housing as being nonexistent. It was why Hyman well as offering some helpful advice for the future. My Minsky was marginalized as an economist despite his contribution is to address a few peripheral topics that have brilliant insight of the “near inevitability” of periodic accumulated over recent quarters as more important topics financial crises. It was why the suggestion in academic have dominated. Half of the mini topics are covered in this circles of stock market inefficiencies, let alone major Letter, and the other half will be posted in a few weeks. dysfunctionality, was considered a heresy. It was why Burton Malkiel could rationalize the 1987 crash as being an efficient response to 12 or so triggers. These triggers, 1 Michael Lewis and David Einhorn, “The End of the Financial World as We however, had a trivial weakness: seasoned portfolio Know It,” The New York Times, January 4, 2009. This article is available online at www.nytimes.com. managers at the time had never even heard of most of them. Never underestimate the power of a dominant At times like this, animal spirits need nurturing. Obama’s academic idea to choke off competing ideas, and never election will help, at least for a while; talking up the power underestimate the unwillingness of academics to change of stimulus will help (whether or not the power is really their views in the face of evidence. They have decades there), and avuncular, optimistic advice from influential of their research and their academic standing to defend. figures will not go amiss.

The incredibly inaccurate efficient market theory was But let us look for a minute at the extent of the loss in believed in totality by many of our financial leaders, and perceived wealth that is the main shock to our economic believed in part by almost all. It left our economic and system. If in real terms we assume write-downs of 50% governmental establishment sitting by confidently, even in U.S. equities, 35% in U.S. housing, and 35% to 40% as a lethally dangerous combination of asset bubbles, lax in commercial real estate, we will have had a total loss controls, pernicious incentives, and wickedly complicated of about $20 trillion of perceived wealth from a peak instruments led to our current plight. “Surely none of this total of about $50 trillion. This relates to a GDP of about could happen in a rational, efficient world,” they seemed $13 trillion, the annual value of all U.S. produced goods to be thinking.

And the absolutely worst aspect of this and services. These write-downs not only mean that belief set was that it led to a chronic underestimation of we perceive ourselves as shockingly poorer, they also the dangers of asset bubbles breaking – the very severe dramatically increase our real debt ratios. Prudent debt loss of perceived wealth and the stranded debt that comes issuance is based on two factors: income and collateral. with a savage write-down of assets. Well, it’s nice to get Like a good old-fashioned mortgage issuer, we want the that off my chest once again! debt we issue to be no more than 80% of the conservative asset value, and lower would be better. We also want 2. Lost Illusions: The Loss of Perceived Wealth and the income of the borrower to be sufficient to pay the Stranded Debt interest with a safety margin and, ideally, to be enough to During the market’s rise, I wrote about the fallacy of paper amortize the principal slowly.

On this basis, the National wealth, particularly as it applied to houses. At three times Private Asset Base (to coin a phrase) of $50 trillion the price, they were obviously still the very same houses. supported about $25 trillion of private debt, corporate How could we kid ourselves that we were suddenly rich and individual. Given that almost half of us have small and didn’t need to save for our pensions when we were or no mortgages, this 50% ratio seems dangerously high. sitting in the very same buildings we bought in 1974? But now the asset values have fallen back to $30 trillion, With “wealth” built on such false premises, it is not whereas the debt remains at $25 trillion, give or take the surprising that we come to grief from time to time. But miserly $1 trillion we have written down so far. If we the good news is that, as we move back down to earlier would like the same asset coverage of 50% that we had a prices, they are still the same houses.

We have not lost year ago, we could support only $15 trillion or so of total wealth, but just the illusion of wealth. Illusions tend not debt. The remaining $10 trillion of debt would have been to have very long-lasting effects, but they obviously can stranded as the tide went out! What is worse is that credit and do have very powerful short- and even intermediate- standards have of course tightened, so newly conservative term effects. This particular illusion, which applied to lenders now assume the obvious: that 50% was too high, stocks, real estate, art, and almost everything else, was and that 40% loan to collateral value or even less would grand indeed, and it directly over-stimulated consumption be more appropriate. As always, now that it’s raining, and indirectly over-stimulated imports. In the process, bankers want back the umbrellas they lent us.

At 40% of it suppressed both savings and investments of our own $30 trillion, ideal debt levels would be $12 trillion or so, locally generated income. (Although there was plenty of almost exactly half of where they actually are today! It is foreign investment into the U.S. to fill the gap, which has obvious that the scale of write-downs that we have been its own long-term complications.) reading about in recent months of $1 trillion to $2 trillion will not move our system anywhere near back to a healthy Now the illusion of wealth has been lost, with formidably balance. To be successful, we really need to halve the negative effects on animal spirits. My hero, Keynes, level of private debt as a fraction of the underlying asset emphasized the importance of shifts in animal spirits in values. This implies that by hook or by crook, somewhere economics, and explained how shifts in such spirits could between $10 trillion and $15 trillion of debt will have to ruin the most carefully calculated investment decisions. disappear.

Given where we are today, there are only three GMO 2 Quarterly Letter, Part 1 – January 2009 ways to restore a balance between current private debt as the stock markets then were less developed and housing levels and our reduced, but much more realistic, asset was decidedly pre-McMansion. This time in the U.S., values: we can bite the bullet and drastically write down however, we must write down perceived wealth or capital debt (which, so far, seems unappealing to the authorities); by almost precisely one and a half times GDP, worse than we can, like Japan did, let the very long passage of time the Depression but happily much less than Japan. wear down debt levels as we save more and restore our consumer balance sheets; or we can inflate the heck out In this context, do not kid yourself that the Japanese did a of our debt and reduce its real value.

(In the interest of terrible job in extricating themselves. Even the Japanese completeness I should mention that there can sometimes often express dismay at the costs they have paid due to be a fourth possible way: to somehow re-inflate aggregate their heroic level of public spending. I believe that this asset prices way above fair value again. After the tech primarily reflects their original failure to realize how bubble of 2000 Greenspan found a second major asset deep their hole was. It can also be admitted that their class ready and waiting – real estate – on which to work program, while probably right in concept, was not highly his wicked ways. This time there is no new major asset efficient. Bridges to nowhere have not been as stimulating class available and, although Homo sapiens may not be or productive long term as a focus on energy conservation very quick learners, we do not appear eager to burn our and oil and coal replacement technologies would have fingers twice on the very same stove.

As a society, we been. It was often said that the Japanese should have bitten apparently need 15 to 20 years to forget our last burn. With the bullet as the U.S. did in its S&L crisis, taking a quick so many financial and economic problems reverberating hit rather than dragging out the pain. How superficial around the world and with animal spirits so crushed, re- and self-congratulatory those comments seem now. Faced inflating equity or real estate prices way above fair value with our own credit crisis, we discover there is no easy again in the next few years seems a forlorn hope if indeed cure – the bullet turns out to be a grenade, which doesn’t it is possible at all.) fit as easily into the mouth. At about 4 to 1, the Japanese Each of the three realistic possibilities listed above would corporate sector went into the 1989 crunch with much be extremely painful, each is loaded with uncertainties, higher leverage than the U.S. had ever seen.

Remember and even the quickest of them would take several years. too that their stock market, at 65 times earnings, was over Our path this time is likely to involve a hybrid approach: three times our market’s recent highs and their land was at we will certainly take some painful debt liquidations; this several multiples of ours. In 1989, Tokyo’s land per square crisis will almost certainly take far longer than normal foot was around ten times the value of Manhattan’s! So to play out; and probably, before a new equilibrium is they had higher write-offs conflicting with much higher reached, we will see inflation rates that are well above corporate leverage. If they had rapidly marked their normal. assets to market, the entire corporate Japan Inc. would have been under water. And since we know that around a It would be convenient if we could reach safety without quarter of Japan’s market – their Sonys and Toyotas – was having our global economy come to a complete standstill solvent, we can deduce that the remaining three-quarters for a few years; without a wave of very high inflation and, was shockingly under water, using the types of rules we ideally, without a dollar crisis or a trade war.

All of them, unfortunately, are what a quant would call “non-trivial are attempting to apply to ourselves now. As the years possibilities.” Traveling happily certainly has its virtues, passed, a few Japanese companies failed, but the great but in these dangerous times it is probably better to be mass in the middle painfully clawed their way back to braced at least for the right order of magnitude problem solvency. Somehow or other, Japan absorbed the greatest that we face. deleveraging in human history without incurring a severe depression. I can only hope we do as well!

This is a good time to look at the Japanese crisis of 1989 to present since, along with the Great Depression, it is Although Japanese corporations were in much worse probably one of the two most relevant examples for today’s credit shape than ours are now, the reverse is true for problems. The Japanese had an even bigger problem in consumers. Japanese individuals went into the 1989 event write-downs of “wealth” than we have now. They had with a very high savings rate and very high accumulated to write down perceived wealth by an amount equal to a savings. In contrast, our households go into our crunch stunning three times GDP! Even in 1929, we had to write borrowed to the hilt (or beyond) and painfully under-off amounts equal to only three quarters of a year’s GDP, saved. So our job is to nurture our average people in the Quarterly Letter, Part 1 – January 2009 3 GMO street and somehow restore the quality of their balance One can only admire Bob Rubin’s ability to retain sheets, just as Japan (admittedly taking 15 uncomfortable influence and have his protégés in powerful positions. years) did for its corporations.

Rubin is the guy who was last seen exhorting Citibank to take more leverage and keep swinging. No, come to think To finish this section on an optimistic note (my civic of it, he was last seen paying a visit to Hank Paulson, duty), it is worth remembering that real wealth lies not his relatively recent underling at Goldman Sachs. He in debt but in educated people, laws, and work ethic, as pleaded with his old chum, with brilliant success, for an well as in the quality and quantity of fixed assets and the unprecedented bailout. He was part of the establishment effectiveness of corporate organization. We, like Japan, that failed to express early, loud concerns over slipping are not proposing to destroy any of these assets. We, like financial standards, and in fact helped to create an Japan, have just tripped on make-believe assets and we environment where prudence was a career risk and CEOs now have to deal with chronic deleveraging and bruised felt obliged to keep dancing. animal spirits.

When we have dealt with this crisis, all of our assets will still be sitting around waiting to be His man Summers has proven he has some bite. Because fully used once again. It is helpful to consider that after he has written often for the Financial Times we at least the Depression, the U.S. GDP got back on its original know his public stance on matters financial. Well, let’s trendline as if the Depression had never occurred. put it this way: he runs no risk of being on any of the many lists of people who gave clear warnings of potential Also remember that although your portfolio is down financial disaster. And dozens did. Summers was 40%, just as you own the same house, you still control emphatically not a whistleblower. He did not rail against the same number of shares and hence the same fraction of falling financial standards.

What he did, with his allies long-term wealth that you had before. You simply over- Greenspan and Rubin, was beat back a heroic attempt in estimated your wealth before, believing that the companies late 1998 by Brooksley Born, then boss of the CFTC in you owned had quickly become twice as valuable. With Chicago, to supervise OTC derivatives. They held her an individual stock, this is rarely the case; on a broad off, presumably in the Greenspanian spirit of “the less market level, it is never the case. The good news is that regulation, the better.” with the market at half price, you now have much more powerful dollars. For consumption purposes, a dollar Obama appointed Gary Gensler to lead the CFTC. Gensler is always a dollar. Investment dollars, in contrast, are has a good reputation, but was hired into Treasury by … weak dollars in badly over-priced markets but powerful you’ve guessed it … Robert Rubin. dollars in cheap markets.

Today, investment dollars are a And as for Tim Geithner! The FOMC minutes are available, whole lot more powerful than they used to be. (In fact, to so at least we know what he added to Greenspan’s and encourage business, we will make a special January sale Bernanke’s meetings. Over the Greenspan years, there on our own investment management services: we will were a few cautionary words from other members – a manage the same number of global equity shares as last very, very few from a rather spineless group – and year for 40% less! Hurry, hurry, limited supply!) we know from the records how they were greeted. A typically precise response from Greenspan was: “So, this 3. Obama and the Teflon Men seems like a good time to break for coffee,” or words to I am naturally a contrarian and a nitpicker, so I found that effect.

And we can study Geithner’s objections to the myself becoming a Republican in the Clinton era and a Fed’s long journey down the primrose path, but our study real pinko in the Bush era. But after exulting in Obama’s period will not be a long one, for he questioned nothing! election, I couldn't even reach his inauguration before He was, if anything, a cheerleader, and wrote in support finding fault! As an environmentalist, I am delighted that of the new era of “Great Moderation.” He, however, was he has surrounded himself with the very top talent. I, for not picked by Rubin. No, he was picked by Summers, who one, find Hillary Clinton an exciting choice to head the was picked by Rubin. These guys are very, very loyal! State Department. But in the critical financial arena, he appears to have brought in Rubinesque retreads, “yes Mary Schapiro, appointed to head the SEC, has been men,” or both, none of whom appeared to have seen the greeted with great enthusiasm by the financial industry most obvious developing bubbles in the history of finance. precisely because she has been a great supporter of the GMO 4 Quarterly Letter, Part 1 – January 2009 industry’s financial well-being during her career, which rather than discouraged the bad tendencies in our financial has included positions at the SEC and the CFTC.

She is system. We have been amazed at the third-rate job done seen as one who poses no threat by way of introducing by the leaders of our great financial firms, above all by nasty, inconvenient new regulations. Where is Brooksley their lack of moral fiber in restricting what could best be Born when we need her? (In the interest of space, this described as an orgy of moneymaking at any price. As anti-Schapiro section is brief. To help out, on January 15, stockholders, we also know we did little to put on the there was a detailed criticism of her for being a softy in brakes; as individual clients and home buyers, we also The Wall Street Journal, of all newspapers. Bush would did our bit to make it easy for greed to win out. We were have been proud to hire her!) willing gulls in an age of gullibility.

Madoff has done historians a good turn by making it so clear that we were What a missed opportunity this all is. Obama was given looking to make our 1.5% fees rather than looking to do a mandate that could have included some serious bottom hard analysis, and that collectively, even when we were kicking. We could have quickly taken quite a few steps suspicious, we were trying not to rock the boat. And, most down the long road leading to a credible financial system significantly, our regulators were happy to leave no stone deserving of respect. The time to do that was now. Many turned! readers will object that these are all bright – even very bright – people. And so they are. But our financial ship But it was worse than merely a decay of financial is not doing a passable imitation of sinking because of a integrity.

2008 capped in incompetence what I am sure lack of intelligence. What was lacking was the backbone will be remembered as the most incompetent eight years to publicly resist the establishment's greedy joyride of of government in modern times, and a contender even if risk-taking and sloppy standards. Even more important, we include ancient times. Over an even longer period, as perhaps, was the breadth of vision that was missing. There Paul Krugman would say, we tore up the social contract; was plenty of intelligence, just not too much wisdom. So it through tax changes favoring the rich, we aided and abetted would be very encouraging if there were someone included the strong global economic forces that already tended to in Obama's appointments who had actually blown the concentrate wealth in the hands of the already rich. It was whistle on the spiraling Ponzi scheme that our leveraged an uncharitable, unsympathetic, and avaricious era in which financial system had become (which is why the Madoff the cult of the individual trumped overall society, and the fiasco is such a fitting capstone to our troubles).

If only drive for wealth and the luxuries of life took precedence there were someone with real toughness who could do over more worthwhile and longer-lasting values. Most unpopular things. Someone, say, like Volcker. Oh, wait a of our society got richer in the last 20 years, but there is minute. Didn't he get a job? Or was that only a game to get not a hint of research that suggests we got happier, and obstreperous characters like me on board with the program? plenty that suggests the reverse. In the process, we took Unfortunately, I have a sneaking misgiving that Volcker some giant steps toward ruining the planet and had to live was indeed window dressing for the Presidential campaign. with the sight of many wealthy firms funding expensive PR Dollars to donuts he has not been pestered around the clock programs that attempted to obscure the science and suggest for advice so far.

And I'll tell you one thing. You don't have that coal is clean and all is well. In short, we messed up to know him well to know that he'll resign within a year if on a very broad front, and last year was when it became they don't get serious. Since he is the only person on the impossible not to see it. If you ended the year without team proven to have the right credentials – a preference for becoming disillusioned, you were not paying attention. high standards of financial integrity and the backbone to push through unpopular but necessary actions – it would 5. Small Arguments with Two Heroes be a real shame to lose him entirely. First, Warren Buffett. At about 950 on the S&P on October 16, he announced that he was a personal buyer of U.S.

4. Disillusionment stocks because they were cheap and their prices reflected The single word that probably best summarizes all widespread fear. This is not typical for him, but he certainly of our feelings toward this last, truly miserable year is did it in 1974. When he said it back then, every stock in “disillusionment.” We have all been, I believe, serially our portfolio at Batterymarch yielded almost 10%! The shocked by the lack of competence and misguided portfolio P/E was below 7.5x. Even with hindsight, if you philosophy of our top officials, who for years encouraged value the market in 1974 using our current methodology, Quarterly Letter, Part 1 – January 2009 5 GMO it was very much cheaper than it is today at 950, which is Recent Recommendations and Performance what we calculate as almost precisely fair value. Well, we got it about as right over the past few years as we’re ever going to. “Avoid all risk.” “Don’t be too proud His recent announcement made the market seem so much to own cash.” “Let the other guys be brave.” “Expect at more exciting than boring old fair value. So what are the least one major bank to fail (July 2007).” “Many financial possibilities? Was he performing a civic duty? Certainly, companies will approach technical insolvency (January animal spirits are a critical component of any recovery, 2008).” Expect 50% of hedge funds to disappear and, so encouragement to take risk from an authoritative after a lag, expect a major crisis in private equity where source makes perfect sense. Does he believe that 1974-2006 and 2007 investments should approach zero in type cheapness can never return, or is very unlikely value. More fundamentally, we called for persistent, in this particular case? If that were the argument, we below-estimate growth in economies, especially in China would disagree; we suspect that cheaper prices are not and the U.K. and, most particularly, we expected falling just possible but probable, although admittedly far from profit margins globally. These views were perhaps best certain. Has he perhaps a tactical market timing model captured in our belief that risk-taking was at the heart of that produces his obvious excitement, despite these the bubble, and that risk premiums were nearly certain to ordinary values? Most unlikely, given his style. Or are our rise significantly. And, of course, house prices would fall numbers wrong? Perish the thought! In any case, it is all and cause considerable trouble. If we had implemented an interesting conundrum. as well as we got the big picture right, we would have Second, Nassim Taleb and the Black Swan logic, had a year from heaven – at least from that part of heaven which I have previously admired in public. Taleb is reserved for institutional managers: relative heaven. In completely dismissive – in a way only he can be – of any fact, we did a mixed job in implementation: some very near certainties. He implies that we have just suffered good, some bad, and some in-between but, all in all, we from an outlier event crashing up against standard risk had a good year. modeling that only assumes that events will occur in an Re-introducing the Very First of Our 7-year approximately normal way. He argues that modeling the Forecasts: Bullish Again!

95% or 99% normal range in Value at Risk (VaR) misses the whole point: that the real game is played out in the final For many years, we used a 10-year forecast for asset 1%. It's hard to disagree with this criticism of VaR, but is class returns. In January 2002, we made our first 7-year it relevant in this case? Was the recent breaking of our forecast, dated December 31, 2001. We moved from 10 to credit and asset bubbles a totally unpredictable outlier? 7 years because research proved that it was closer to the average time for financial series to mean revert. The data We believe that we live in a world where bubbles routinely is shown in Table 1. form and where there are – in complete contrast to Nassim Taleb’s belief – some near certainties. One is that bubbles As you can see, despite being called “perma bears,” we will break. Bernanke should not have said, “U.S. house overestimated the returns for global equities, except for prices have never declined,” thus implying that they never emerging, where we were more or less spot on. Government would. He should have said, “Never before has a three- debt – not surprisingly, given our crisis – also moderately sigma, 1 in 100, U.S. housing bubble occurred, and be outperformed our estimate. advised that all such analogous bubbles in other asset classes and in housing in other countries have always Current Recommendations burst.” (Robert Shiller for the Fed! He would have said Slowly and carefully invest your cash reserves into almost exactly that.) The bursting of the U.S. and U.K. global equities, preferring high quality U.S. blue chips housing bubbles, the profit margins, and the risk premium and emerging market equities. Imputed 7-year returns are in global asset prices were all “near certainties.” This was moderately above normal and much above the average of a White Swan, a particularly White Swan. Taleb’s work the last 15 years. But be prepared for a decline to new lows will no doubt be correct when we have a genuine Black this year or next, for that would be the most likely historical Swan, but this was most definitely not it. (Okay, Nassim. pattern, as markets love to overcorrect on the downside after I can hear you thinking: this guy Grantham is a complete major bubbles. 600 or below on the S&P 500 would be a loser who has obviously missed my entire point.) more typical low than the 750 we reached for one day.

GMO 6 Quarterly Letter, Part 1 – January 2009 Table 1 Fearless Forecasts for the Long Term The 7-Year Forecast from 7 Years Ago: Under the shock of massive deleveraging caused by Bullish as Ever the equally massive write-down of perceived global Forecasts from December 31, 2001 wealth, we expect the growth rate of GDP for the whole vs. actual as of December 31, 2008 developed world to continue the slowing trend of the last GMO 7-Yr 12 years as we outlined in April 2008. Since this recent Forecast Dec-01 Actual shock overlaps with slowing population growth, it will Estimated (% Real 7-Yr Actual soon be widely recognized that 2% real growth would be Asset Class Rank Return/Yr) Return* Rank Emerging Mkt Equities 1 9.4 9.9 1 a realistic target for the G7, even after we recover from the U.S. REITs 2 9.1 3.1 7 current negative growth period. Emerging countries are, of Emerging Cntry Debt 3 6.8 6.4 3 course, a different story. They will probably recover more Int'l Small Cap 4 5.2 4.9 4 quickly, and will continue to grow at double (or better) the U.S. TIPS 5 3.5 3.9 5 growth rate of developed countries. (See “The Emerging Lehman Aggregate 6 2.9 3.8 6 Emerging Bubble,” April 2008.)

Foreign Bonds 7 2.6 7.4 2 U.S. Small Cap 8 2.2 -0.5 10 Footnote on the January Rule and EAFE 9 2.2 1.0 8 the Presidential Cycle U.S. T-Bills 10 2.1 0.2 9 S&P 500 11 -1.0 -3.9 11 In January 2008, I pointed out that the market had started The accuracy of these forecasts does not guarantee that current or future the year with the worst five days ever recorded, and that predictions will be accurate either with respect to the ranking of those asset the signal was “both impressive and bearish” in that down classes over a 7-year period, the absolute levels of real return, or results over shorter periods. The accuracy of forecasted rankings in the asset class forecasts Januaries materially increase the probability of a down generally varies from period to period. year. Well, that turned out to be a useful tidbit: “Worst-* Actual real index returns are for 12/31/01 to 12/31/08 period. Source: GMO ever five days predict worst-ever year! Read all about it!”

This year the five-day return was up a bit (saved by the In fixed income, risk finally seems to be attractively last two hours), but the six-day return was down quite a priced, in that most risk spreads seem attractively wide. bit. Ho hum.

Long government bond rates, though, seem much too low.

They reflect the short-term fears of economic weakness The Presidential Cycle, as written about previously, has and the need for low short-term rates. We would be short been completely ruined by Greenspan. He over-stimulated long government bonds in appropriate accounts. during the first two years, which are meant to be the time for tightening up, not only in 1997 and 1998, but As for commodities, who knows? There were a few also during this past cycle in 2005 and 2006. Both times months where they looked like a high-confidence short, this caused an extra-speculative surge in the typically but now they are half-price or less, and are much lower-stimulative Year 3s, in 1999 in the NASDAQ, and in 2007 confidence bets. in housing prices and ugly financial instruments. Both In currencies, we know even less. It is easy to find surges set off collapses during the critical election years, currencies to dislike, and hard to find ones to like. There which are meant to be stable. In the coming Year 1 of are no high-confidence bets, in our opinion. the new cycle, we should be squeezing credit a little and tightening budgets so that we can re-stimulate in 2011 for For the long term, research should be directed into the next election. What a joke! 2009 will be the greatest portfolios that would resist both inflationary problems stimulus year ever, let alone in a normally restrictive and potential dollar weakness. These are the two serious year. So for the time being: Presidential Cycle – Rest In problems that we may have to face as a consequence of Peace! flooding the global financial system with government bailouts and government debt.

Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending January 21, 2009, 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 © 2009 by GMO LLC. All rights reserved.

Quarterly Letter, Part 1 – January 2009 7 GMO GMO QUARTERLY LETTER February 2009 Obama and the Teflon Men, and Other Short Stories. Part 2.

Jeremy Grantham 1. The Year of the Value Trap of over-discounting and handsome recovery has taken Since time immemorial, the most successful value place dependably for several cycles in a row. It begins investors have been the bravest. The greatest advantage to look like the natural, even inevitable, nature of things of value investing has always been that when your cheap rather than merely the most usual outcome. The growth stock goes down in price, it gets even cheaper and more in the number of quantitative investors exaggerated this attractive. This is the complete opposite of momentum tendency because quants model the last 10 or 20 years (or stocks, which lose their momentum rating as they decline even 40) without really requiring a full understanding of and hence become unattractive. But averaging down the very long-term pattern and why it behaves the way in value stocks can take lots of nerve and considerable that it does. And none of us modeled data that included ability in convincing anxious clients of the soundness of the last great value trap: the Great Crash of 1929. the strategy. For at least 60 years, those value investors In mild economic setbacks, even the wounded value who managed these problems and bought more of the stocks recover fully. In substantial setbacks, a very small stocks that had tumbled the most emerged with both the number fail, but not nearly enough to offset the large strongest performance and the most business success. (Of discounts. Only in the really severe economic setbacks course, analytical skills also help, but let’s assume that do enough casualties occur to bring home a truth: price-these skills were distributed evenly between brave and to-book (P/B) and price-to-earnings (P/E) are risk factors. nervous investors.) Major market declines in the past set Buying them and averaging down routinely has an element up the best opportunities for brave value managers: the of picking up not nickels in front of the steamroller – that 50% declines of 1972-74 and 2000-02. Value investors would belittle the substantial returns – but, say, $1000 in 1972 and 2000 were also able to buy value stocks at bills in front of the steamroller. Because of the extra their biggest discounts to the general market at least since discounts for career risk in the long run (at least for those 1945. In addition, averaging down in those value stocks who are not dead), the strategy will probably still pay off that fell the most eventually added substantially to an even if the rare, severe fundamental crises are included. already strong return. Those value managers with the But investors should be aware that the fundamental part best analytical skills within this group became the few of the risk premium is justified by the pain of these outlier handfuls of super-successful investors. events and is absolutely not a free lunch.

Outsiders could view this as a return to bravery, but it The value problems of the last two years were particularly was also a return to risk. The cheapest price-to-book bad because of the outperformance that value stocks had stocks are those deemed by the market to have the between 2002 and 2007. They won for five years in a row, least desirable assets. And Mr. Market is not always so that by mid 2007 the value/growth spread was about a complete ass. Because these companies are so often as unfavorable as possible for value stocks in the U.S. obviously undesirable and are seen as such by clients, (see Exhibit 1). (We recognize that some value investors they represent a career or business risk to the manager disagreed with this data when it was first presented. We who owns them. This career risk is usually reflected in an were, and still are, puzzled by how they arrived at their extra discount that will deliver an extra return for bearing more positive conclusion.) the career risk. This “career risk” return is in addition to the discount for buying lower quality companies with To put a measure on how awful the value trap was more fundamental risk. Problems arise when this pattern during this time, please see the Fall 2007 edition of Exhibit 1 Price to Book – Cheapest Quartile vs. Expensive Quartile 0.8 0.7 0.6 0.5 PB/PB 0.4 0.3 0.2 0.1 0.0 Dec-65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 Source: GMO As of 1/31/09 the Outstanding Investor Digest. This publication answer clearly. On the one hand, value stocks are now at concentrates on a dozen or so of the top value investors least much cheaper on a relative basis than they were a and is readable, interesting, and chock-full of insight. year ago. On the other hand, they can get a lot cheaper, However, that particular issue is a heartbreaker as one and they face the worst economy since 1938. I would give after another of these superior investors put forward the them at best a 50/50 bet this year. (“Thank you very much case that – down 30% to 50% – AIG, Lehman, Wachovia, for such useful advice!”)

Fannie Mae, etc., were ridiculously underpriced, and represented enormous long-term franchise value that the 2. GMO’s Central Skill Set and Loss of Near nervous market was missing. Certainties It has long been my view that the pricing of value stocks That last point leads neatly into one of my principal has a folk memory of the Great Depression when many regrets: in recent years we have been spoiled by the market cheap companies went bust and the expensive Coca- in that we were presented with investment opportunities Colas survived the best. Remember, you cannot regress that seemed to us to be near certainties, which we define from bankruptcy. Using proprietary research data, we as probabilities over 0.9. Our principal skill has been examined one fixed time slot: October 1929 to June 1932. to study major upside outliers or bubbles in all financial With no rebalancing, the data showed a massive “value” series, trying to understand and recognize their patterns. wipeout in which high P/E stocks declined far less than That’s it. Not a profound exercise. In fact, my hero low P/E stocks. Keynes was quite disrespectful of this exercise. You are probably familiar with his famous quote from 1923, “But As we have pointed out before, one thing is certainly true: this long run is a misleading guide to current affairs. In on fundamental measures of risk – level of profitability, the long run we are all dead.” What you may be unaware volatility of profitability, and debt levels – stocks with low of is how it continues: “Economists set themselves too P/B and P/E ratios have much lower “quality” and should easy, too useless a task if in tempestuous seasons they be expected to be hurt badly in a very serious economic can only tell us that when the storm is long past the setback such as the one we are now experiencing. And ocean is flat again.” Presumably, he would have been so it was that many of the very best investors had their equally contemptuous of the reverse: the prediction that very worst year in 2008, and were exceedingly happy to after a long calm, you had better be prepared for another see the back of it. Whether 2009 will see a snapback for storm sooner or later. I believe it is a rare example of value is an important question, and not one that we can Keynes simply being wrong in both cases. Ironically, for GMO 2 Quarterly Letter, Part 2 – February 2009 someone who 13 years later wrote the Bible on career bets, this one has also become a low-confidence bet, risk (Chapter 12 of his General Theory), his error in 1923 although one I personally still hold half of, principally was because he underestimated the career and business out of consideration for future housing weakness. And pressure to keep dancing. In real life, Mr. Market usually the same goes for the yen. It was fundamentally cheap acts as if the calm will go on forever, even though he and, as the reverse of the popular and risky carry trade, it presumably knows it cannot. It’s so deliciously profitable was a simple and powerful way of playing the movement until it isn’t. And even when the music stops, you can still against an ultra-low risk premium. It worked better than be considered a “prudent man” – you will have failed, one could have hoped. But now, after a magnificent with lots of company, in the traditional way. It turns out move, it is a low-confidence bet where I timidly cling to that shouting warnings about impending storms after a one-quarter of my original position, since I still believe long calm is a very unpopular pursuit. Even being bullish there are a few more shoes left to drop in the anti-risk when everyone else is finally bearish – i.e., predicting a move. But there may not be many more. calm after the storm – is not free of career risk.

The bets that global economic weakness was Well, dear Keynes, that is what we do at GMO. We are underappreciated – especially in China and the U.K. – specialists in warning of eventual storms after calms, were also near certainties, but, here again, perceptions and of calms after storms. In the last 10 years we have have changed so fast that these are ordinary, decent benefited from the opportunities offered by a world- bets now. This goes for economic policy as well. I was record number of extreme storms and outliers, and in completely confident that “they,” our noble leaders, were September 2007 I was able to warn of three bubbles in completely missing the point before. Now I’m not so sure. one sitting.1 All of them were world records, and all were Yes, I disapprove of the swallow-the-whistle retreads in “near certainties” to break: extremely high U.S. house Obama’s financial lineup, but these are brilliant (or, at prices, extraordinarily high global profit margins, and the very least, very bright) people who know now that the lowest risk premiums ever recorded! By then, we things are extreme. They may rise to the occasion. Their had already addressed the extraordinary bubble in U.K. potential ineptitude is by no means a near certainty. house prices, and soon afterwards we hit the mother lode: Thank heaven! So, all in all, the wonderful world of a warning of a bubble in all asset prices everywhere. Talk “near certainties” has come to an end, and a pity it is for about pigs in mud! those in the prediction business.

Now, regrettably in some ways, the outliers and near 3. On Exiting a World of Bubbles and Entering a certainties are ending. It is still nearly certain that World of Busts global profit margins will decline a lot further. But it Economic wipeouts and severe market over-corrections, is no longer certain that this belief is not reflected fully should they arrive, are second best for us. It is true that they in stock prices. It is merely likely that it is not, and that are outliers, but busts are not so dependable as bubbles. stock prices will therefore decline to new lows. Perhaps In contrast to Greenspan’s reluctance and vacillation in the odds are 2 to 1, which is a very good bet, but far from recognizing bubbles and Bernanke’s dismissal of their the rare 9 to 1 odds of a near certainty.

Similarly, U.S. existence, bubbles do, of course, exist. More to the house prices are very likely to decline their last 5% to point, they always, always break, and their breaking trendline and, since it was an extreme bubble, to overrun is the most dangerous situation the Fed – or the whole by, say, another 10%. But, again, this is at best a 2 to 1 economy, for that matter – ever faces. Similarly, strong bet. Yes, a bet that U.K. house prices will continue to economies and heroic profit margins always weaken. In decline is a lay-up, but it has always been hard to play. crunches, you must lower the odds of regression back to Its main effect now will be to impose a lot more pain on normal to “nearly always.” On rare occasions, you can a system already so weakened that it makes it very likely stay down for the duration.

If, like Zimbabwe, you really that more bailouts or the nationalization of U.K. financial want to take your country back to the Stone Age, you can companies will continue. Weakness in the pound was my probably do it. (Thank goodness for term limits in the favorite near certainty in the U.K., but that was at over $2 U.S.) Argentina, the fourth richest country in 1945, has to the pound. It is now at under $1.50 and, like the other taken its very best shot at resisting the tendency to revert 1 Danger: Steep Drop Ahead, Fortune, September 17, 2007. back upward to normal, and is still trying hard. If you Quarterly Letter, Part 2 – February 2009 3 GMO are in a bubble, then competition in one form or another for everyone. In difficult times, people make mistakes. is guaranteed to chip away at exceptional opportunities, Why don’t they say so?

As a typical, if painful, example, or confidence will suddenly break, or both. In a crunch, I followed Paul Bremer (a classmate, no less!) to the in contrast, no one will reliably come to your rescue or podium at a pension conference. He had just returned help you recover. You’re on your own, and can continue from his catastrophic series of miscalculations in Iraq. to make mistakes, which we in the U.S. may very well do All decisions had been the best that a difficult situation this time. had permitted, he argued, with a tone that implied that anyone suggesting otherwise should be locked up. This We at GMO have another problem: almost all of our was indeed the tone that characterized the whole last eight work has been aimed at the study of bubbles or upside years of government.

Are the Japanese the only people outlier events. Until eight minutes ago, the study of a real left with a code of honor? When you make mistakes, bust seemed, in comparison, academic. Now, however, or even when the people you are responsible for make we have thrown ourselves into studying the reverse. This serious mistakes, you should surely admit it, at least very morning – true story – I unpacked The Panic of 1819, once in a while. In cases of extreme error, of which we a new book by Murray Rothbard. As I write this at our have just had an unprecedented number, someone might large and untidy breakfast table, I can see the recently read even offer to resign. Not a prayer. As a postscript, hot The Forgotten Man by Amity Shlaes. It is a book about the plight of working men and FDR’s erratic experiments off the press (courtesy of Maureen Dowd in The New with stimulus programs in the Great Depression.

At York Times) comes a shocking admission of guilt from GMO, we are now in full-court press mode, studying former Vice President Dick Cheney on CBS Radio: “I the patterns of economic and market lows and looking think we made good decisions. I think we knew what we for predictive clues (with luck, see next quarter’s Letter). were doing.” Dowd also reports that Rumsfeld said, “My But this is a relatively new effort after spending 12 years conscience is clear.” Surely anyone saying that doesn’t studying bubbles. Ah, well. Of course, this is all written have one! In terms of admitting no errors and denying assuming that we are indeed heading to extremes of all responsibilities, the Bush administration is certainly undervaluation. It could be much worse: we could get going out with a bang. stuck in a no man’s land where stocks are around fair If this section is to be credible, I must do some confessing. price and all certainties disappear.

Please not.

Rats! Well here goes: I was not always effective in capturing, through implementation, the full benefits of 4. On Accepting Blame and Ethics in General top-down insights. The same could be said for our asset I think it would be cathartic if all professional investors allocation group, to which I belong. With the benefit of confessed to making a few mistakes. Lord knows, it hindsight, we as a firm took too much liquidity risk in has become a lost art. By degrees over recent years, one or two strategies, and tilted toward too much risk in we have become a culture that apparently never makes others. Even those insights we got right, we could have mistakes, or certainly never admits to them. Almost played harder. I regret all of these shortcomings, and none of the CEOs who brought companies to their knees believe that we can do better. I and GMO promise that – or graves – accepted blame clearly and emphatically. we will strive to be more effective help next time. Honchos at Lehman and Bear Stearns were victims, it seems, rather than incompetents. Hundreds of billions This has also been the very lowest point for ethical of stockholders’ money was obliterated without clear standards within the financial industry. Rather than go apologies. Government agencies that nearly ruined us on at length, allow me to single out one issue: the fees all have also admitted no mistakes. Greenspan only charged by managers, including large and previously apologized for other peoples’ shortcomings – he failed to reputable European banks, who shoveled off clients’ realize how bankers would be so greedy in the short term money to Bernard Madoff. Their legal documents are no and bereft of rigor and analysis. Really! More recently it doubt impeccable and make it clear they cannot be held is claimed that no one – neither the Fed nor the Treasury liable for anything, including outright fraud. Of course, – had the legal authority to save Lehman. But such we must then ask what the 1.5% fee plus performance excuses were given only after it appeared to have been a incentives were for, since they were not actually managing disastrous decision. The last two years were very difficult a dollar of the money. But that is not the point. Reflecting GMO 4 Quarterly Letter, Part 2 – February 2009 high ethical standards, they should return all of the money 1-year forecast done on the same basis we use today that for doing so shoddy a job. With even the merest hint of started in December 1974 would have predicted a 14% ethical standards, they should at least return their fees. return (which, by the way, it did not deliver since the Certain European private banks, for example, charged market stayed so cheap). For August 1982, the forecast a substantial fee for investing their clients’ money with would have been shockingly high – over 20% real! So Fairfield Greenwich Group, who, in turn, charged a lot do not think for a second that this is as low as markets to invest with Madoff, who actually did the “work!” At can get. Now, I admit that Greenspan and 9/11 tax cuts least Madoff had the decency to waive his fee. Settling caused the “greatest sucker rally in history” from 2002-for the principal was enough. You could call this a fund 07. We therefore cannot rule out another aberrant phase of funds of funds of Ponzi. Even if there had been a real in which extreme stimulus causes the market to rally once investment at the end of the pipeline, this would have again to an overpriced level for a few more years, thus been iniquitous. postponing the opportunity to make excellent long-term investments yet again. But I think it’s unlikely.

5. 7-Year Forecast and GMO’s Current Strategy GMO has attempted to tiptoe through the land mines in Our 7-year forecast as of December 31 is a very far cry asset allocation and to minimize regrets as described last from that of a year ago. Exhibit 2 shows what a dismal quarter, caught between the potential regret of missing forecast we had for everything on December 31, 2007. decent investment opportunities, and the potential regret Today all equities are moderately – one might say, of investing too much too soon and then watching our boringly – cheap. The forecast for the S&P has been tactical 2 to 1 guess of a new low come true. In October, jumping around +6% to +7% real, with other global our Global Balanced Asset Allocation Strategy was equities slightly higher. To put that in perspective, a at 39.8% in global equities, well below our 45% target Exhibit 2 GMO 7-Year Asset Class Return Forecasts* as of December 31, 2007 7% Stocks Bonds Other 6% 6.5 % Long-term Historical U.S. Equity Return 5.0% 5% Annual Real Return Over 7 Years 4% 3% 2.7% 1.9% 2% 1.4% 1.2% 0.9% 1% 0.6% 0.2% 0.0% 0% -1% -0.8% -1.1% -2% -1.6% -3% U.S. U.S. U.S. High Int'l. Int'l. Equities U.S. Bonds Int'l. Bonds Bonds Bonds U.S. Managed equities equities Quality equities equities (emerging) (gov't.) (gov't.) (emerging) (inflation treasury Timber 2 2 (large cap) (small cap) (large cap) (small cap) indexed) (30 days to 2 yrs.)

Estimated Range of 7-Year Annualized Returns ±6.5 ±7.0 ±6.0 ±6.5 ±7.0 ±10.5 ±4.0 ±4.0 ±8.5 ±1.5 ±1.5 ±5.5 *The chart represents real return forecasts1 for several asset classes. These forecasts are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Actual results may differ materially from the forecasts above. 1 2 Long-term inflation assumption: 2.5% per year. Return forecasts for international equities are ex-Japan. Source: GMO Quarterly Letter, Part 2 – February 2009 5 GMO minimum (itself lowered from 50% in the previous year end, we had added over 4% a year and lowered the real with clients’ consent). We are now at 55% against a 65% absolute volatility as opposed to the benchmark volatility. norm and a 75% maximum equity position. If the market Our timing of injecting quality into U.S. Core was better stays moderately below fair value, our current intention than the timing of the Japan bet as we won last year by 11 is to move “creeping like snail” toward a neutral 65% percentage points on a divided basis. (This is the number by late summer. If prices pull ahead of fair value, we that determines your compound advantage: for example, will freeze and stay underweight. If prices plummet a 10-point gain in a year when the market doubles is worth to new lows, we will invest more rapidly according to only 5% compounded, and a 10-point gain in a market a prepared schedule, e.g., at 600 on the S&P, invest in that halves is worth 20%. I wish there were a convenient, another several percentage points of equities, etc. This accepted terminology for this.) The bet on quality was plan minimizes our potential regrets and leaves us feeling perhaps U.S. Core’s once-in-a-lifetime override. as little discomfort as possible, given the strange world in Perhaps the biggest and most painful bets in GMO’s which we now live. career, though, were against the 2000 Growth Bubble. In asset allocation, we had the allowed minimum percentage 6. GMO and Big Bets (50%) in global equities, and within that 50% minimum, Dick Mayo and I bet on small caps and hard-core value we had a minimum exposure to U.S. equity. Further, in the Nifty Fifty blue chip market of 1972. Being young within that minimum U.S. position, we had the minimum and rash, and having a senior partner – Dean LeBaron – exposure to growth stocks and large caps. And, as we’ve who admired flash, we put 100% of our money into small been bragging recently, some of our long-term forecasts cap value before either small or value existed as sub were bizarrely accurate. Yet in the short term – two-and-a-categories. We were measured against the S&P, which half painful years – we delivered low double-digit returns made for a bumpy, but eventually very successful, ride. in a high double-digit world, and lost the quickest 60% of our book of asset allocation business on record!

We took that philosophy with us to GMO and refined it, with one refinement being to add a little more moderation, In early 2006, I was asked at a Boston Security Analysts but not too much. In 1987, for example, in EAFE accounts Society forum what the secret was to our rapid growth (where we were one of the earliest players) we went to zero of assets then (sic transit gloria). I replied that it was in Japan against a Japan weight in the EAFE benchmark the easiest question of the evening, and added, “We are that rose to 65%! More recently, for the last 10 years we simply willing to lose more business than the other guys.” had a handsome overweight in emerging equities and a By this I meant that we are extremely attached to the minimum weight in U.S. equities, reflecting our 10-year- idea that we make very big bets on those relatively rare ago forecasts of +10.9% real for emerging and -1.1% real occasions when we have very high confidence.

I believe for the S&P. (This 12.0% difference for 10 years would that career and business risk – the fear of losing clients – have compounded so that every $1.00 in the S&P would be dominate our business, and it is so hard to sidestep that the matched by $3.10 in emerging. This gives you some idea of big bets will always be available and will always be career the degree of aggressiveness in the forecast. And 10 years threatening. And that is the turf we have staked out: make later, on October 1, 2008, there was $3.20 in emerging for the “near certain” bets as large as we can, sweat out the every $1.00 in U.S. equities. Ta da!) But our biggest bet timing problems, and pray for patient clients. recently has been on quality stocks in the U.S. – a bet on the great franchise companies.

Our U.S. Quality Strategy 7. On the Joys of Buy and Hold became more than 90% of our U.S. equity money in our Jeremy Siegel and I have had several debates, and he Global Balanced Asset Allocation Strategy. And 50% of has always been the bull. In late 1999, he was nervous the quality stream was injected into our venerable U.S. about Internet stocks and a few tech stocks, but felt that Core Strategy. This was the first important override of our the S&P would muddle through with an about-normal U.S. quant model in its 29-year history! We used to call return. In his honor, I have always named two of our the Japanese underweight a once-in-a-lifetime override. exhibits “Stocks for the very, very long-term.” In the first It was done – of course – three years too soon, and cost us exhibit, which we’ve used before, we show that buying 10% a year against a dramatically rising EAFE market.

It at both the peak of 1929 and the peak of 1965 would then gained us almost 20% a year as Japan crashed. At the have sentenced investors to identical 19-year periods of GMO 6 Quarterly Letter, Part 2 – February 2009 waiting to get their investment back in real terms, with record and can be done quite simply. Let me give you an precisely zero positive return. Two 19-year periods in example of the power of asset allocation that is very close only the last 80 years, in a country that was spared the to home: GMO has a solid implementation edge in our worst of global misfortunes! The second exhibit shows broad range of equity funds and in emerging debt, which a 26-year round trip in Japan from 1982 until today that has equity-like features. Our average equal-weighted made no gain, and a 19-year period in Japan from 1989 alpha for all equity funds is around 2.0% per year, after all until today that cost the investors 78% of their money! costs, and cap-weighted is somewhat higher.

This is one Now patience is a virtue, but this is ridiculous! Heavy of the best records for a broad range of funds. Yet, despite buy-and-hold equity positions are fine for long-lived our very decent implementation edge, in our 16-year-old computers, but for impatient humans – given as we are to Global Balanced Asset Allocation Strategy, over 80% waves of overconfidence and abject fear – they are simply of the total outperformance of the benchmark and over dangerous and unsuitable. 60% of the reduction in volatility has come from moving The buying and holding of a fixed portfolio mix with the mix of assets, rather than from our implementation. annual rebalancing is okay, I suppose, for individuals (For the record, the total is about +2.9% a year over who are intimidated by making changes. And even for the benchmark, with a 22% reduction in volatility for these individuals we had better hope that they don’t panic an efficiency rating – return compared to volatility, or and abandon stocks completely when all risky assets fall Sharpe Ratio – that is 3.5 times the benchmark, or .49 together as they did recently.

But for institutions with compared to .14). Asset allocation is simply much easier access to professional advice and with long investment than adding alpha to a fund, since there is more to sink horizons, surely a fixed mix is aiming too low. If the last your teeth into. Counter-intuitively, asset classes are 15 years has taught us anything, hasn’t it taught us that more inefficiently priced than stocks. There is a large and asset classes can be incredibly mispriced, along the lines relatively efficient arbitrage between stocks, and the career of the 35 times inflated earnings for the S&P in 2000? risk of picking one stock versus another is quite modest. Why would you ignore these opportunities to sidestep In contrast, when picking one asset class against another, trouble? It is surely sensible to be fairly static when it is painfully clear when mistakes have been made.

This pricing is normal or even halfway normal, but when very immense career risk makes it likely that there will always large mispricings occur, should we not reasonably move be great inefficiencies, for investors are reluctant to move away from extremely overpriced assets toward more money across asset boundaries. Consequently, there is attractive ones? Markets are very mean-reverting over great advantage to be had in getting out of the way of longer horizons, and sophisticated clients always proclaim the freight train, rather than attempting to prove your their patience. Asset allocation based on serious action at discipline by facing it down. The advantage is in both the extremes and inactivity the rest of the time has a good higher return and lower risk.

Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending February 11, 2009, 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 © 2009 by GMO LLC. All rights reserved.

Quarterly Letter, Part 2 – February 2009 7 GMO