无聊的合理价格！

GMO QUARTERLY LETTER July 2009 Boring Fair Price!

Jeremy Grantham Waiting for Markets to be Silly Again of long-term fundamentals, but was merely a response to great stimulus and great implied promises.

A year is certainly a long time in markets, and so is a quarter. A year ago, equities globally – and everything Well, this time once again, enough risk takers were found else for that matter – were very overpriced, particularly to get the job done, and the market rose to 950, with if they were risky. A quarter ago, in mid March, prices presumably at least a decent shot (say, 50/50) at rising everywhere were cheap. Now they have all – or almost over 1000 in the next two to three quarters. all – converged for a few unusual moments at fair value.

In addition to making the sharpest upward move since A year ago, it was very easy to know what to be: a risk 1938, the market had a record speculative bias, as avoider. It was not so easy reinvesting when terrified, but shown in Exhibits 1 and 2. On this topic I failed badly to most of us knew that we should have been doing more. emphasize enough one aspect of the analogy to the third But today? It’s difficult to be inspired at fair value. year of the Presidential Cycle: it is usually extremely Since early March, the market has had the type of strong speculative. Where the S&P outperforms normal by 12 speculative rally that often follows extreme declines. percentage points in Year Three, the most volatile quarter The danger of a breathtaking rally is that it leaves those of the market outperforms by 21%! This is a lot of money few investors who raised considerable cash waiting for in a year. Exhibit 1 shows the gap between high and low a pullback and psychologically invested in the case for a new bear market leg. This was covered in our mid- Exhibit 1 March posting, “Reinvesting When Terrified.” That Speculative Rallies I theme was developed a few weeks later for me when the Top Quartile versus Bottom Quartile penny dropped: the extreme stimulus and moral hazard Volatility Return after Market Bottom of recent quarters resembled the stimulative third year 60% of a Presidential Cycle. Indeed, it seems to have turned 48.7% Cumulative 3-Month Return Difference 50% this usually restrictive Year One into a giant Year Three effect. The market in Year Three typically outperforms 40% its average by 12 percentage points predicated on much 30% less desperation exhibited by the authorities than we had this year. A notionally independent Fed has to be at least 20% 15.4% somewhat discreet in its friendly support of an existing 10% administration in Year Three. While in Zurich on April 1 (you get what you pay for on April 1), under the impact 0% of that penny dropping, I told Finanz und Wirtschaft that -10% -7.4% -7.6% “Der S&P 500 Index kann rasch auf 1100 steigen.” That is, the S&P could move rapidly to 1100. I actually remember -20% saying that the move could be between 1000 and 1100, October July October March 1974 1982 2002 2009 but journalists hate wasting space. In a belated quarterly letter a few weeks after that, I tried to make the point that Note: The universe for the above data is the top 1000 U.S. stocks by market cap.

such a rally had absolutely nothing to do with the logic Source: GMO Exhibit 2 we fell last year with an average of 42% global equity and Speculative Rallies II we rose off the low with an average of 62%.

Stocks Under $5 versus Stocks Over $50 On its way up from 666, the S&P flashed through its fair 100% value of about 880 on our best estimates (our estimate of fair 90.9% value has decreased slightly again due to write-downs of Cumulative 3-Month Return Difference 80% book value, among other factors). The market’s overshoot 67.9% to 950 caused our seven-year forecast for the S&P to drop 60% to 4.8% real compared with its 5.7% estimate at fair price.

After 20 years of more or less permanent overpricing of 40% the S&P, we get five months of underpricing. There is no justice in life! Well, at least not for the apparent handful 20% of us who welcome the opportunity to invest at bargain 4.7% prices! There is more happiness, it seems, for the armies 0% of investors who prefer the temporary endorphin rush that -6.6% comes with a rising market, even if it’s overpriced. -20% October July October March In March and April, I wrote about Plan A: you must force 1974 1982 2002 2009 yourself to invest in a cheap market even when you are Note: The universe for the above data is the top 1000 U.S. stocks by market cap. terrified by rapidly falling prices, as I admit I was to some extent. I also suggested Plan B: if you missed the earlier Source: GMO lows, you must grit your teeth and phase slowly into a volatile stocks in each of the most impressive market cheap market.

You can’t gamble that it will oblige you by recoveries in recent decades, and Exhibit 2 shows the gap another low, and historical analogies with earlier, much between stocks under $5 and over $50, which has a very lower market lows are fraught with genuine differences. good record as a risk proxy. This current move clearly Now it is time for Plan C. looks like the record holder! And the rally did indeed leave institutional investors feeling left behind. In an informal Plan C: What to do if the Market Overruns survey at a recent meeting of 150 or so institutions, those Given our view that we are in for seven lean years in which admitting to feeling nervous about underexposure to risk the market will be looking for an excuse to be cheap, we outnumbered those feeling too aggressive by a neat 10 recommend taking some risk units off the table, including to 1!

This also suggests how a speculative rally can keep becoming underweight in equities – between 1000 and going longer than reasonable investors expect. 1100 on the S&P, if it gets there this year. Around 880 you should continue to move slowly to fair value, twiddle We at GMO, while we were really quite good in re-entering your thumbs, and wait to see what happens. Boring! the market, perhaps under-responded to the probabilities Otherwise, it is time to focus on the lesser issues: which of a particularly risky rally. As value purists (at least most types of equities are cheaper or more expensive than of the time), we were very constrained by the fact that we the market. This leads us back once again to the bet on still measured U.S. quality blue chips as the highest return quality stocks. global equities even at the very low.

This was in complete contrast to the situation at the low in 2002, where the best values were in risky emerging markets and small caps, The Quality Bet and we simply had to follow our value noses to really The easy winner of the cheapest equity sub-category participate in, even outperform, a strong rally. For any contest is still high quality U.S. blue chips. They were approach, some market stages cooperate and some try to really trashed on a relative basis by the second quarter really mess with you. We came very close to getting the rally in junk. I understand a rally in junk after the record point this time but still missed it, although all the pain can decline, but this was excessive and based apparently and very well may be recovered. One of the encouraging on unrealistic hopes for a strong, sustained economic things about investing is that you only have to be partly recovery.

Such a recovery seems most unlikely, whereas right: in our typical global balanced accounts, for example, a temporary, weaker recovery appeared very likely three GMO 2 Quarterly Letter – Boring Fair Price – July 2009 months ago as the substantial size of the stimulus package sell within five years or so at a distinct P/E premium to was revealed. The latter scenario still seems probable. celebrate their obviously superior GDP growth compared Our original estimate for the timing of some economic with that of an aging developed world. Emerging market recovery to occur late this year or early next year still equities are already selling at a modest premium to EAFE stands. Without an unexpectedly strong improvement in and the higher quality half of the U.S. equity market. the economy, it is hard to see high quality stocks losing Being pro-emerging yet anti-China is a dilemma for much more ground, given their extreme value gap over us; we are working to resolve it.

Meanwhile, emerging junky stocks – more than an 11 percentage point spread equities, like most risky asset components, are moderately per year on our seven-year forecast! If our numbers are overpriced. We in asset allocation may, however, push correct, long quality (or long quality and short junk) is our luck in emerging – particularly ex-China emerging – substantially the most outlying bet available today in using inertia to reduce our current modest overweight. If all global equities. (Let me admit here, once again, that we do this, it will be out of respect for the high probability there is always more subjectivity and, hence, doubt in that emerging equities will sustain and increase their measuring “quality” as a sector than there is in, say, large overpriced level relative to the rest of the world. caps versus small caps. But we have been estimating quality this way for 30 years and think we have a good Caveats record in doing so.)

What we specialize in at GMO, not surprisingly perhaps, Our other perennial favorite – emerging market equities is doing the easy job: we wait for extreme situations and – has had an amazing recovery, all things considered, predict that they will become normal once again. When and is no doubt also vulnerable to a reassessment of how markets sell at normal prices, life for us becomes much quickly the global economy is recovering. Deciphering harder, perhaps 10 times harder. Predicting movements the strength of the Chinese economy will also play a away from rational prices in an irrational world should major role in formulating our view of any future relative not be easy, and indeed it is not. Our one and only effort strength of emerging. My colleague, Edward Chancellor, at predicting a bubble – in emerging markets – is likely strongly suspects that the Chinese economy is dangerously to stay just that. Only U.S. quality feels (and measures) to unbalanced and very likely to come unhinged in the next us like a real outlier. As for the rest, if you feel yourself few quarters, surprising the pants off investors. On the becoming overconfident about anything, take a cold other hand, the strong longer-term case that I outlined in shower and start again. Just be patient. In our strange “The Emerging Emerging Bubble” 15 months ago seems markets, you usually don’t have to wait too long for intact. I suggested then that emerging equities would something really bizarre to show up.

Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending July 24, 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 – Boring Fair Price – July 2009 3 GMO GMO QUARTERLY LETTER July 2009 Initial Report: Running Out Of Resources Jeremy Grantham Getting Used to Lower Growth and Higher Prices also passed its peak. All attempts to maintain the growth of total hydrocarbon output must now depend on As the economy sorts itself out from the recent financial subbituminous coal, lignite (which is a little bit better turmoil, we are very likely to have lower growth rates than burning rock, but not much), and tar sands, which for quite a few years. We described the reasons for this are themselves increasingly energy- and water-intensive last quarter: writing down excessive loans and curtailing expenditures as we realize we are not as rich as we to exploit. thought. Modern agriculture has been described as a way of turning Economic expansion will also be held back by the hydrocarbons into food. Without cheap energy – a single decreasing growth of available man hours. Since 2000, this gallon of gas is the energy equivalent of 100 hours of old-growth has declined to below 1% per year from an average fashioned labor – the world would certainly have trouble of 1.62% for the prior 50 years. Over the next 30 years, producing half of the current food supply, and that fraction it is almost certain to continue to decline to about 0.5%, could be substantially less. Hydrocarbons are not only ignoring the temporary cyclical bounce in employment critical to farm equipment and food distribution over very that we will get as the current severe recession ends. large distances, but also play a dominant role in fertilizer production. With sparse hydrocarbon usage, American Behind these two issues, however, lurks another longer- agriculture would have to be totally and painfully term and more important factor affecting future growth, restructured away from very large scale monoculture. and that is the increasing limitations on resources: we are Hydrocarbons are very efficient in the use of manpower simply running out of everything at a dangerous rate. We but surprisingly inefficient with everything else, including apparently have trouble processing numeric issues of this output per acre and output per unit of energy. kind, and this missing faculty will cause considerable grief.

We do not understand the implications of exponential or All metals are facing the same depletion problem as compound growth rates: the main implication being that hydrocarbons. Where 30 tons of copper ore once produced they are impossible to sustain. a ton of copper, it now takes 500 tons of ore! And with every extra ton of ore required, the energy intensity also No better example of resource limitation in the face of rises. Several specialized metals critically important as both denial and strong efforts can be found than U.S. catalysts are past their peak production. Water resources, oil production. As is well known, we have been on so necessary for agricultural growth, are under incredible the steep downslope of production since 1974 despite economic pressure, and are simultaneously diminishing our best attempts to “Drill, baby, drill!” The largest oil in absolute terms. discovery in the Gulf in the last 20 years will keep our engines running for a mere 41 days.

Nothing we do can This would be a dangerous situation with zero population reverse the decline, and drilling our reserves faster has growth; in fact it would guarantee that per capita growth been described as “oil independence through more rapid would slow. Yet population growth in the last century has exhaustion of our reserves!” Coal reserves of the highest been the fastest in the history of man. The recent 100-year quality – anthracite – are basically mined out everywhere, growth exceeded that of any 2000-year block in history. and the second choice – bituminous coal – has probably And in terms of absolute numbers added, the world’s population has increased 2.5 times in my lifetime, from so Draconian but, of course, is.) Carter urged us to fully 2.5 billion to 6.5 billion. insulate 80% of our houses in 10 years and to continue President Ford’s auto fuel economy initiatives; following It should be obvious from simple arithmetic that population these recommendations would have actually freed us from growth is on a direct collision course with increasingly the need to import any sensitive Middle Eastern oil!

As a scarce resources. For millennia, food constraints held the famous symbol, he had solar panels installed on the White world’s population nearly constant. About 12,000 years House roof. Remarkably, this very un-American speech of ago, these constraints were altered significantly with the start of organized agriculture. Then, around 200 years ago, his was well received by its audience but, unfortunately for the so-called Agricultural Revolution – the introduction him (and probably for us also), very little else he did was. of science to farming – allowed for another doubling Carter was dispatched by President Reagan, who was in output. All of this was dwarfed, however, by the admirable in many other ways in my opinion, but harnessing of hydrocarbons – the sun’s energy stored over apparently had psychological problems when dealing hundreds of millions of years. This remarkable patrimony with limits.

In a display of brilliant politics and complete is now about half gone, and some time in the next 10 to 40 innumeracy, Reagan argued passionately and appealingly years, half of all of our resources will have been used or, that the whole idea that our children were not entitled to stated another way, one last doubling will remain. We are a much richer life than their parents was un-American, looking at the last of 14 doublings in the past 250 years. sacrifice was unnecessary, Carter had overstated the case, We are, if you prefer, 13/14ths of the way through the and down came the solar panels. Thus, our sole effort at game in exponential terms! At 1% growth in hydrocarbon dealing with some foresight with the iron laws of limits consumption, which would be a dramatic reduction in the was brushed aside, and the particularly egregious age growth rates of the last 30 years, our reserves would last of SUVs and increasing dependence on oil imports was for merely one more generation.

As we move through our ushered in. remarkable and irreplaceable hydrocarbon reserves, the price will, of course, rise remorselessly to ration supplies. Well, dear readers, happy thoughts and wishful thinking Hydrocarbons will increasingly be limited to their highest do not make it so; 30 precious years have passed, and there and best uses: (probably) petrochemical feed stocks and is now no safety margin. We must prepare ourselves for aviation fuels. The price rise, which for a while is quite waves of higher resource prices and periods of shortages likely to be parabolic – rising at an increasing rate rather unlike anything we have faced outside of wartime than a steady rate – will have an immediate effect on the conditions. In fact, I believe we are already several years price of all agricultural products. Also affected will be into this painful transition but are still mostly invested in the price of all metals, which too have become extremely denying it.

Everything within the investment business will energy-intensive, as has hydrocarbon production itself. be affected as well as everything outside of the business. GMO intends to make a sustained effort in this area to get This transition away from carbon-based fuels could ahead of the curve, and we will keep you posted. have been relatively painless on paper, but in real life our species has such a modest ability to deal with distant As a parting note, let me point out that China is showing outcomes or to defer gratification that a bad ending is every sign of being a country ahead of the curve. There probably inevitable. We need, it seems, the shock of a has been a whiff of panic – which I believe is justified Pearl Harbor to really gear up and make sacrifices. For – in China’s last 5 years of behavior regarding resource the record, in 1977 President Carter pointed out that we limitations and possible mitigation through truly were running out of oil and would need to make some dramatic increases in alternatives, desperate attempts at “sacrifices.”

By “sacrifices,” by the way, he did not mean resource acquisitions, and the fostering of special foreign real wartime-like sacrifices, but merely a time of settling relationships. Being more authoritarian may come with for a lower rate in the increase of wealth. He noted quite great long-term advantages in this field. It would be accurately that in the 10 short years preceding 1977, our convenient if we could offset China’s natural advantages planet’s population had used as much oil as in its whole with some of our own; for example, flexibility, a vigorous previous history! (That is to say, it had doubled usage in venture capital industry, and, above all, an enlightened 10 years, or had grown at 7% a year, which doesn’t sound government policy. A Carter-type statement of resolve GMO 2 Quarterly Letter – Running Out of Resources – July 2009 would be a good start, and would show a willingness to yourselves to be kidded by our usual optimism – this is take a short-term political hit in the interest of a significant the Real McCoy! long-term advantage.

I must confess to not holding my breath, but I am crossing my fingers. Do not allow Have a good (if worried) summer!

Reading and Listening List Hardin, Garrett. Living within Limits: Ecology, Economics, and Population Taboos, Oxford University Press, 1993.

Bartlett, Albert A. The Most Important Video You’ll Ever See, Arithmetic, Population, and Energy. 2009 <http:// Martenson, Chris. The Crash Course. 2009 <http://www.chrismartenson.com>.

Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending July 24, 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 – Running Out of Resources – July 2009 3 GMO