因果报应与市场再次犯傻

GMO QUARTERLY LETTER October 2009 Just Deserts and Markets Being Silly Again Jeremy Grantham Just Deserts 2. The Other Teflon Men I can’t tell you how surprised, even embarrassed I was to get Larry Summers, with a Financial Times bully pulpit, the Nobel Prize in chemistry. Yes, I had passed the dreaded had done little bullying and blown no warning chemistry A-level for 18-year-olds back in England in whistles of impending doom back in 2006 and 2007. 1958. But did they realize it was my third attempt? And, And, famously, in earlier years as Treasury Secretary yes, I will take this honor as encouragement to do some he had encouraged (I hope inadvertently) wild and serious thinking on the topic. I will also invest the award reckless financial behavior by helping to beat back to help save the planet. Perhaps that was really the Nobel attempts to regulate some of the new and most Committee’s sneaky motive, since there are regrettably no dangerous instruments. Timothy Geithner, in turn, green awards yet. Still, all in all, it didn’t seem deserved. sat in the very engine room of the USS Disaster and And then it occurred to me. Isn’t that the point these days: helped steer her onto the rocks. And there are several that rewards do not at all reflect our just deserts? Let’s others (discussed in the 4Q 2008 Letter). You know review some of the more obvious examples. who you are. All promoted!

1. For Missing the Unmissable 3. Misguided, Sometimes Idiotic Mortgage Borrowers Bernanke, the most passionate cheerleader of The more misguided or reckless the borrowers, the Greenspan’s follies, is picked as his replacement, more determined the efforts to help them out, it partly, it seems, for his belief that U.S. house appears, although it must be admitted these efforts prices would never decline and that at their peak had limited effect. In comparison, those who showed in late 2005 they largely just reflected the unusual restraint and either underhoused themselves or rented strength of the U.S. economy. As well as missing received not even a hint of help. Quite the reverse: on his very own this 3-sigma (100-year) event the money the more prudent potential buyers held in housing, he was completely clueless as to the back from housing received an artificially low rate. potential disastrous interactions among lower house In effect, the prudent are subsidizing the very same prices, new opaque financial instruments, heroically banks that insisted on dancing off the cliff into Uncle increased mortgages, lower lending standards, and Sam’s arms or, rather, the arms of the taxpayers – internationally networked distribution. For these many of whom rent. accumulated benefits to society, he was reappointed!

So, yes, after the fashion of his mentor, he was lavish 4. Reckless Homebuilders with help as the bubble burst. And how can we so Having magnificently overbuilt for several years by quickly forget the very painful consequences of the any normal relationship to the population, we have previous lavishing after the 2000 bubble? Rewarding decided to encourage even more homebuilding by Bernanke is like reappointing the Titanic’s captain for giving new house buyers $8,000 each. This cash facilitating an orderly disembarkation of the sinking comes partly from the pockets of prudent renters ship (let’s pretend that happened) while ignoring the once again. This gift is soon, perhaps, to be extended fact that he had charged recklessly through dark and beyond first-time buyers (for whom everyone with dangerous waters. a heart has a slight sympathy) to any buyers, which would be blatant vote-buying by Congress. So what 8. Overpaid Large Company CEOs else is new? Even outside the financial system, there are many 5. Over-spenders and Under-savers painfully obvious unjust deserts in the form of top To celebrate the overwhelming consensus among management rewards. And most of the excessive economists that U.S. individuals have been rewards come out of the pockets of our clients and dangerously overconsuming for the last 15 years, we other stockholders, which is particularly galling. have decided to encourage consumption and penalize When I arrived in the States in 1964, the ratio of CEO savers by maintaining the aforementioned artificially pay to the average worker was variously reported to low rates, which beg everyone and sundry to borrow be between 20/1 and 40/1. This seemed perfectly even more. The total debt to GDP ratio, which under respectable and had held for the previous 30 years. our heroes Greenspan and Bernanke rose from 1.25x By 2006, this ratio had exploded to between 400/1 and GDP to 3.25x (without even counting our Social 600/1, which can only be described as obscene. The Security and Medicare commitments), has continued results certainly don’t suggest such high rewards: a) to climb as growing government debt more than 10-year stock market returns are close to zero in real offsets falling consumer debt. Where, one wonders, terms; and b) U.S. GDP growth has finally slipped does this end, and with how much grief? below its 100-year trend of 3.5%. After deducting the effect of the rampant increase in the financial system, 6. Banks Too Big to Fail the growth in GDP ex-finance has fallen to 3.1% since Here we have adopted a particularly simple and 1982 and well below 3% since 2000, all measured comprehensible policy: make them bigger! Indeed, to the end of 2007 to avoid the recent crisis. The force them to be bigger. And whatever you do, don’t corporate system, to be frank, seemed to run faster have any serious Congressional conversation about and more efficiently back in the 1960s before CEOs breaking them up. (Leave that to a few journalists and and financial types began to gobble up other people’s commentators. Only pinkos read pink newspapers lunches. I suppose I have done my share of gobbling. anyway!) This is not the first time that a cliché has But, it still ain’t right! triumphed. This one is: “You can’t roll back the clock.”

9. Holders of the Stocks of Ridiculously Overleveraged (See this quarter’s Special Topic: Lesson Not Learned: and Wounded Corporations On Redesigning Our Current Financial System.)

Yes, I admit this is part envy and part hindsight 7. Over-bonused Financial Types investment regret. But, really, our financial leaders Just look at Goldman’s recent huge “profits,” two-thirds so overstimulated the risk-taking environment that of which went for bonuses. It is now estimated that this junky, weak, marginal companies and zombie banks year’s bonus pool will be plus or minus $23 billion, produced a record outperformance (the best since the largest ever. Less than a year ago, these same guys 1933) of junk over the great blue chips. (Ouch!) were on the edge of a run on the bank. They were In a world with less moral hazard, which would be saved only by “government” – the taxpayers’ supposed a world of just, although painful deserts, scores of agents – who decided to interfere with the formerly these should-be-dead companies would be. As it infallible workings of capitalism. Just as remarkably, it is, they live to compete against the companies that is now reported that remuneration for the entire banking actually deserve to be survivors. Excessive bailouts industry may be approaching a new peak. “Well, we are just not healthy for the long-term well-being of got rid of some of those pesky competitors, so now we the economy. can really make hay,” you can almost hear Goldman and the others say. And as for the industry’s concern 10. The Well-managed U.S. Auto Industry about the widespread public dismay, even disgust, about While firms in other industries fail and their workers excessive remuneration (and, I would add, plundering look for new jobs, the auto industry is rewarded by of the shareholders’ rightful profits)? Fuhgeddaboudit! direct subsidized loans, governmental arm-twisting of In the thin book of “lessons learned,” this one, like most creditors forced to settle far below their legal rights, of our other examples, will not appear. and direct subsidies for their products. All of this for GMO 2 Quarterly Letter – Just Deserts – October 2009 their well-deserved ranking as the most short-sighted kind you buy and sell. And I would have been right industry of the last 20 (40?) years, and one of the there, Alan, with very ripe tomatoes. worst managed.

The Last Hurrah and Markets Being Silly Again 11. The World’s Most Over-vehicled Country The idea behind my forecast six months ago was that We chew up a dangerously large amount of Middle regardless of the fundamentals, there would be a sharp Eastern oil (and oil desperately squeezed from rally.1 After a very large decline and a period of somewhat Canadian tar sands), which is ruinous for our global- blind panic, it is simply the nature of the beast. Exhibit 1 political well-being (and ability to avoid war) and shows my favorite example of a last hurrah after the first also not so good for an overheating world. So the leg of the 1929 crash. answer must be to subsidize more car purchases, and when the subsidies run out, you can have all the fun After the sharp decline in the fall of 1929, the S&P 500 again. Good long-term thinking! rallied 46% from its low in November to the rally high of April 12, 1930. It then, of course, fell by over 80%. But 12. Stock Options on April 12 it was once again overpriced; it was down This, of course, is the crème de la crème of unjust only 18% from its peak and was back to the level of June deserts. Recent practices have basically been a 1929. But what a difference there was in the outlook legalized way to abscond with the stockholders’ equity. between June 1929 and April 1930! In June, the economic So if the stock price crashes, perhaps with considerable outlook was a candidate for the brightest in history with help from management, that’s all right – just rewrite effectively no unemployment, 5% productivity, and the options at the new low prices. There has been over 16% year-over-year gain in industrial output. By no serious attempt to match stock option rewards (or April 1930, unemployment had doubled and industrial total financial rewards for that matter) to the building production had dropped from +16% to -9% in 5 months, of long-term franchise value. Instead, the motto is: which may be the world record in economic deterioration. grab it now and run! You can fill in your own favorite Worse, in 1930 there was no extra liquidity flowing anecdotes here – there are so many of them! around and absolutely no moral hazard. “Liquidate the labor, liquidate the stocks, liquidate the farmers”2 was 13. Finally, Just in Case You’ve Forgotten, We Have My their version. Yet the market rose 46%.

Old Nemesis, Greenspan Alan Greenspan receives the title of Maestro in the How could it do this in the face of a world going to hell? U.S. and is knighted by the Queen for thoroughly My theory is that the market always displayed a belief demolishing the integrity of the U.S. financial system. in a type of primitive market efficiency decades before He overtly ignored the great threat of bubbles in the academics took it up. It is a belief that if the market asset classes and, in fact, encouraged them. He Ayn once sold much higher, it must mean something. And Rand-ishly facilitated the progressive dismantling in the case of 1930, hadn’t Irving Fisher, arguably the of governmental restrictions on financial behavior, greatest American economist of the century, said that he deliberately kept real interest rates at zero for the 1929 highs were completely justified and that it was the decline that was hysterical pessimism? Hadn’t E.L. years, etc., etc., etc. You have heard it before. Now, Smith also explained in his Common Stocks as Long remarkably, in his very old age he has become imbued Term Investments (1924) – a startling precursor to Jeremy with the spirit of Hyman Minsky: “Unless somebody Siegel’s dangerous book Stocks for the Long Run (1994) – can find a way to change human nature, we will have that stocks would always beat bonds by divine right? And more crises.” Now he finally gets it. Too late! In his there is always someone of the “Dow 36,000” persuasion merely old age, he ignored or abhorred Minsky, and consistently behaved as though markets were efficient 1 Erratum: Last quarter I cast mild aspersions on Finanz und Wirtschaft by and the players were honest and sensible at all times. suggesting that I had not precisely said that the S&P would scoot rapidly up to 1100; I remembered it more as between 1000 to 1100. Never mess But for all of the egg on his face, the Maestro continues with a Swiss journalist: this one duly pointed out that his tape of April 1 to consult with the rich and famous, considerably to confirmed his accuracy. Either way, here we are, more or less (at 1098 on October 19). his financial advantage. In the good old days, he would have been set in the village stocks, and not the 2 Andrew Mellon, Secretary of the Treasury, 1931.

Quarterly Letter – Just Deserts – October 2009 3 GMO Exhibit 1 The Last Hurrah: 1929-1930 9/7/1929 33 31.92 6/14/1929 4/12/1930 27 25.93 25.89 S&P Price -45% +46% 6/30/1929 4/30/1930 Unemployment Rate 2.06% 3.60% 17 11/13/1929 YoY Industrial Production 16.40% -9.48% 17.66 1/2/ 2/2/29 4/2/ 5/2/ 6/2/ 7/2/ 8/2/ 9/2/ 11/2 /2/2 /29 2/2/ 3/2/ 4/2/ 29 3/2/29 29 29 29 29 29 29 12/2/29 9 30 30 30 1/2/30 Source: Global Financial Data to reinforce our need to believe that as markets decline, continue to live in exciting times, which is not all bad in higher prices in previous peaks must surely have meant our business. something, and not merely have been unjustified bubbly bursts of enthusiasm and momentum. Economic and Financial Fundamentals and the Stock Market Outlook Today there has been so much more varied encouragement The good news is that we have not fallen off into another for a rally than existed in 1930. The higher prices Great Depression. With the degree of stimulus there preceding this crash (that were far above both trend and seemed little chance of that, and we have consistently fair value) had lasted for many years; from 1996 through expected a global economic recovery by late this year 2001 and from 2003 through mid-2008. This time, we or early next year. The operating ratio for industrial also saw history’s greatest stimulus program, desperate production reached its lowest level in decades. It should bailouts, and clear promises of years of low rates. As bounce back and, if it moves up from 68 to 80 over three mentioned six months ago, in the third year of the to five years, will provide a good kicker to that part of Presidential Cycle, a tiny fraction of the current level of the economy. Inventories, I believe, will also recover. In moral hazard and easy money has done its typically great short, the normal tendency of an economy to recover is job of driving equity markets and speculation higher. In nearly irresistible and needs coordinated incompetence to total, therefore, it should be no surprise to historians that offset it – like the 1930 Smoot-Hawley Tariff Act, which this rally has handsomely beaten 46%, and would probably helped to precipitate a global trade war. But this does not have done so whether the actual economic recovery was mean that everything is fine longer term. It still seems a deemed a pleasant surprise or not. Looking at previous safe bet that seven lean years await us.

“last hurrahs,” it should also have been expected that any rally this time would be tilted toward risk-taking and, the Corporate ex-financials profit margins remain above more stimulus and moral hazard, the bigger the tilt. I average and, if I am right about the coming seven lean must say, though, that I never expected such an extreme years, we will soon enough look back nostalgically at tilt to risk-taking: it’s practically a cliff! Never mess such high profits. Price/earnings ratios, adjusted for even with the Fed, I guess. Although, looking at the record, normal margins, are also significantly above fair value these dramatic short-term resuscitations do seem to breed after the rally. Fair value on the S&P is now about 860 severe problems down the road. So, probably, we will (fair value has declined steadily as the accounting smoke GMO 4 Quarterly Letter – Just Deserts – October 2009 clears from the wreckage and there are still, perhaps, some of low rates, plenty of money, and the promise of future smoldering embers).

This places today’s market (October help if necessary seem stronger than value over a few 19) at almost 25% overpriced, and on a seven-year horizon quarters. And the forces of herding and momentum are would move our normal forecast of 5.7% real down by also helping to push prices up, with the market apparently more than 3% a year. Doesn’t it seem odd that we would quite unrepentant of recent crimes and willing to be silly be measurably overpriced once again, given that we face once again. We said in July that we would sit and wait a seven-year future that almost everyone agrees will be for the market to be silly again. This has been a very tougher than normal? Major imbalances are unlikely to quick response although, as real silliness goes, I suppose be quick or easy to work through.

For example, we must it is not really trying yet. In soccer terminology, for eventually consume less, pay down debt, and realign our the last six months it is Voting Machine 10, Weighing lives to being less capital-rich. Global trade imbalances Machine nil! must also readjust. To repeat my earlier forecast, I expect developed markets to grow moderately less fast – about Price, however, does matter eventually, and what will 2.25% – for the next chunk of time, and to look pretty stop this market (my blind guess is in the first few months anemic compared to emerging countries growing at twice of next year) is a combination of two factors. First, the that rate. We are nervous about the possibility of a major disappointing economic and financial data that will begin shock to Chinese growth. (My personal view of a major to show the intractably long-term nature of some of our China stumble in the next three years or so is that it is problems, particularly pressure on profit margins as the maybe only a one in three chance, but is still the most quick fix of short-term labor cuts fades away.

Second, likely important unpleasant surprise of the fundamental the slow gravitational pull of value as U.S. stocks reach economic variety.) Notwithstanding this concern, I +30-35% overpricing in the face of an extended difficult believe we are well on the way to my “emerging emerging environment. bubble” described 18 months ago (1Q 2008 Quarterly On a longer horizon of 2 to 10 years, I believe that Letter). I would recommend to institutional investors, resource limitations will also have a negative effect (see including my colleagues, to give emerging equities the 2Q 2009 Quarterly Letter). I argued that increasingly benefit of value doubts when you can. For once in my scarce resources will give us tougher times but that we miserable life, I would like to participate in a bubble if are collectively in denial. The response to this startling only for a little piece of it instead of getting out two years revelation, for the first time since I started writing, was too soon.

Riding a bubble up is a guilty pleasure totally nil. It disappeared into an absolutely black hole. No one denied to value managers who typically pay a high price even bothered to say it was idiotic, which they quite often to the God of Investment Discipline (Thor?) for being so do. Given my thesis of a world in denial, though, I must painfully early. I think the first 15 percentage points over say it’s a delicious irony. fair value would satisfy me. If I’m right, the first 15% will be a small fraction of the eventual bubble premium. So, back to timing. It is hard for me to see what will stop the So in a sense, we would be early once again. charge to risk-taking this year. With the near universality of the feeling of being left behind in reinvesting, it is We believed from the start that this market rally and nerve-wracking for us prudent investors to contemplate any outperformance of risk would have very little to do the odds of the market rushing past my earlier prediction with any dividend discount model concept of value, so of 1100.

It can certainly happen. it is pointless to “ooh and ah” too much at how far and how fast it has traveled. The lessons, if any, are that low Conversely, I have some modest hopes for a collective rates and generous liquidity are, if anything, a little more sensible resistance to the current Fed plot to have us all powerful than we thought, which is a high hurdle because borrow and speculate again. I would still guess (a well-we have respected their power for years. And what we informed guess, I hope) that before next year is out, the thought were powerful and painful investment lessons market will drop painfully from current levels. “Painfully” on the dangers of taking risk too casually turned out to is arbitrarily deemed by me to start at -15%. My guess, be less memorable than we expected.

Risk-taking has though, is that the U.S. market will drop below fair value, come roaring back. Value, it must be admitted, is seldom which is a 22% decline (from the S&P 500 level of 1098 a powerful force in the short term. The Fed’s weapons on October 19).

Quarterly Letter – Just Deserts – October 2009 5 GMO Unlike the really tough bears, though, I see no need for a we do not micromanage the portfolio dispositions, but new low. I think the history books will be happy enough try to allow for extremes to occur and then make a very with the 666 of last February. Of course, they would significant move. Although the U.S. market is still in a probably be slightly happier with, say, 550. The point routine overpricing range, we are making an exception is that this is not a situation like 2005, 2006, and 2007 this time since we had a strong prior assumption in April when for the first time a great bubble – 2000 – had not yet that a healthy last hurrah would overrun and eventually broken back through its trend. I described that reversal slam into the longer-term disappointments of the seven as a near certainty. I love historical consistency, and with lean years variety. And it still seems likely to work out 32 bubbles completely broken, the single one outstanding that way. So we are breaking our rules and teasing out – the S&P 500 – was a source of nagging pain. But that a few percentage points more of safety margin as the was all comfortably resolved by a substantial new low for market runs. The 1Q 2009 Quarterly Letter, by the way, the S&P 500 last year. This cycle, in contrast, has already said “in a rally to 1000 or so, the normal commercial established a perfectly respectable S&P low at 666, well bullish bias of the market will of course reassert itself, below trend, and can officially please itself from here. A and everyone and his dog will be claiming it as the next new low (or not) will look compatible with history, which major multi-year bull market.” Well, now it’s happened makes the prediction business less easy. precisely that way, and you should not believe them! As we have demonstrated to our clients in earlier cycles, Forecast Summary earnings estimates in particular merely follow the market Bonds, except emerging, have very low seven-year return up (not the other way around, as one would hope). So forecasts: on our numbers, they are below 1.25% real. The it is a law of nature that strong estimates will abound forecast for the S&P 500 is well below 3%, but the high- after a major market rally. The earnings and economic quality subset is still handsome. We score international growth estimates in such cases are usually throwaways. developed stocks as close to fair value, and emerging But the economic data next year will indeed look strong. equities as expensive, although just within range of normal The irony may well be that just as nine months of weak if I am allowed to give them a seven-year bonus of 2% a economic data this year has been accompanied by a very year (15% in total). strong market, so the strong economic data next year is likely to be accompanied by a weak stock market.

Portfolio Recommendations Having reinvested back in March to be almost neutral Yet Another Plug for U.S. Quality Stocks in equities, we have recently taken just a few chips off Our main argument is quantitative. Quality stocks (high, the table and recommend that anyone who was neutral stable return and low debt) simply look cheap and have weighted in equities or even overweighted (lucky you!) gotten painfully cheaper as the Fed beats investors into do the same. For us, the neutral 65% equity position that buying junk and other risky assets, a hair-of-the-dog we reached has been slightly pulled back to 62%, leaving strategy if ever there was one. In our seven-year forecast plenty of room to pull back further if the market runs the quality segment has a full seven-percentage-point above 1100, say, to 1200 later this year. This reduction is lead over the whole S&P 500, or 9% over the balance ex-slight for two other reasons. First, we can find a sufficient quality. This is now at genuine outlier levels. group of equities at or very close to fair value. U.S. high quality, foreign developed (EAFE), and some emerging In addition, there are qualitative arguments. We like (with the benefit of the doubt) are collectively a reasonable owning high-quality blue chips if we are indeed going buy. [Let me take a moment to make it clear that this is into a more difficult seven years than any we have faced my personal view on emerging, since my suitably stern since the 1970s. The problems of reducing debt and the colleagues don’t believe in giving the benefit of the potential share dilution that can go with it as it did in doubt, and feel that the overpricing of emerging should Japan for a decade, particularly play to the strength of determine everything. This is a pretty mild disagreement, the largely debt-free high-quality companies. And for and I recognize that I may be getting carried away by nervous investors there is yet another reason for favoring my confidence in an emerging bubble.] The second quality stocks: their more than 50% foreign earnings reason for the smallness of our pullback is that typically component, which is higher than the balance of the S&P GMO 6 Quarterly Letter – Just Deserts – October 2009 500 with its heavy financial component. In the long run, the rise of valuations. The truth is that colleges spent quality stocks have proven to be the one free lunch: you these last 20 years half believing, at least, in the efficient simply have not had to pay for the privilege of owning market. Even now, after the shocking revelations of the the great safe companies, as plain logic and established NASDAQ-Growth bubble of 2000 and the Housing-theory would both suggest. Exhibit 2 shows that quality Asset bubble of 2008, they still seem to half believe it. stocks have slightly outperformed the market for the last Keynes said, “Practical men who believe themselves 40 years. Not bad. to be quite exempt from any intelligent influence are usually the slaves of some defunct economists.” Well, A Footnote: Endowment Troubles, or, The Budgeting our independent committee members in this case are the Blues unwitting (or witting) slaves of the theories of French, Suddenly we are reading of serious college cutbacks and Fama, Malkiel, Lucas, et al. And one could not find a janitors being laid off. What has precipitated this crisis more defunct collection of theories than these! Rational is a decline in a broad range of assets to … fair price! expectations and the efficient market hypothesis are as Global equities were underpriced for a few months, and dead as dodos, yet their baleful and painful influence by the end of the scholastic fiscal year on June 30, market lives on in two ways. prices were approximately on their long-term trend. In fact, they were about as close as they ever get, with foreign First, committee members by and large buy into the idea stocks slightly cheap and U.S. stocks almost spot-on fair that portfolio composition should not change and should value. So why would a drop to fair value induce so broad be fixed as closely as possible to the policy benchmark, a crisis? Clearly, this was a budgeting problem rather which certainly would make sense in that parallel universe than an investment performance problem. Because asset where markets really are efficiently priced. This means prices had been above normal prices for most of the last 20 that you cheerfully own just as much equity in 2000 at years (defined, as usual, by normal profit margins times 35 times earnings as you did in 1982 at 6 times. This normal price/earnings ratios), the budgeting departments, is not a good idea unless you derive enormous personal sometimes perhaps advised by investment committees, utility from a display of discipline, perhaps better viewed had built abnormally high prices into normal income as inflexibility in this case. Assets in our very inefficient assumptions. The percentage of the budget coming world should surely be moved slowly toward the best mix from the endowments had been allowed to increase with of risk and return.

Exhibit 2 The One Free Lunch 60% Relative Return of 50% 40% 30% 20% Quality Stocks (Quality Equity / S&P 500) 10% 0% -10% -20% 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 9/30/09 Quarterly Letter – Just Deserts – October 2009 7 GMO Second, and the point of this argument, is that budgeting had contributed a huge win last year. You could call this should be based on asset values at fair price. Withdrawals the winner’s curse or winner’s inertia. Regardless, it has should be a fixed percentage of fair price or should lean always been a big thing in investing and one that’s hard to heavily in that direction. The more common practice is resist. Greater flexibility might well have suggested that to take out more when assets are overpriced, particularly emerging equity and small cap international were close when the overpricing lasts for years as it did for the enough to U.S. quality stocks in expected return to justify 1993-2007 period and so is incorporated into smoothing some greater risk diversification. We regret these missed equations. And yes, it is satisfying to take out more, which opportunities and will very seriously consider being more means to sell more when prices are high, but this approach flexible next time. of having your funding boat rise with the temporary tides can get you hooked on unsustainably high withdrawals. Today, at these very different prices, there are two Such a situation is bound to end badly. All overpriced important mitigating arguments. First, even if we had markets will eventually mean revert and when they do they reduced a big chunk of our quality bet in the spring, with will leave most institutions with, shall we say, withdrawal today’s extreme spread we would now be moving most, symptoms. In contrast, a policy that recognizes fair value and maybe all, of the money back into quality. Second, will effectively build up a safety margin in overpriced there is the classic GMO argument. Even back in March times that can be drawn down in underpriced times. we believed it was a winning bet against the market over our seven-year horizon, and by enough to cover most And while I’m defending endowment managers, I might as of our typical measurement errors. Quality was also well add that complaining about an 8%+ underperformance the cheapest subset of global equities. Over the years, by the traditionally elite managers for the single year just we have had some very tough times waiting out losses ended, after they have beaten the average endowments in the early days of some of our forecasts, only to have by at least 5% per year for the previous 10 years using the forecasts eventually prove correct. Too, the S&P 500 the very same approach, is pure short-term silliness. It could have gone much lower – 500 or so would have been gives the alumni, the local papers, and the college VIPs quite normal. Had this happened, quality stocks combined who are not on the investment committee a long-delayed with our cash reserves would have given us relative and satisfying opportunity to complain. (Yes, I know you performance from heaven. We have all been learning to don’t need defending!) live with regrets these last 18 months!

Recent Shortcomings To rub in the previous point that our forecasts are useful, Where we got most things right last year, ex-fixed income, we are reproducing the seven-year forecast from seven we have tended to mess up this year, again ex-fixed income, years ago in June (Exhibit 3). This is a particularly which has now climbed a remarkable three quarters of the interesting point in time because markets were close to way out of the deepest hole I ever remember seeing. Our fair value in June. At fair value our estimates, in theory, biggest mistakes this year clearly involved a dose of the should turn out to be pretty close. As can be seen, it “terminal paralysis” that is so hard to overcome on those worked out well. As my 2Q 2009 Quarterly Letter said, rare occasions when the world really is trying to fall to it was “Boring Fair Price.” Because our methodology pieces and actually might pull it off unless the authorities assumes a move back to normal pricing every time the get lucky or clever. We were simply too slow to get the market hits fair value, about every six or seven years, for a message that the combined stimulus package was so few minutes, our forecasts almost by definition look nearly heavily weighted toward stimulating risk-taking and perfect at those rare fair value moments. (By the end of paper transactions and relatively less toward stimulating September, in contrast, with most markets overpriced, the the real economy. It was, as they say, “an available average return for all 13 asset classes taken together was insight!” The data was there for intelligent analysis. over 2.5% a year above our forecast of seven years ago, We showed less flexibility than is desirable, and stayed although the rank order was still better than chance at a 1 precisely with our seven-year forecasts in asset allocation, in 30,000 level.) We now have over 70 estimates since where we could have substantially tilted more to risk and 1994, admittedly with overlapping time periods, and generally raised our beta. In equity accounts we stuck every single one of them was better than random, and the with a massive overweight in quality even though quality best – 10 years ending October 2008 – had a 1 in 100,000 GMO 8 Quarterly Letter – Just Deserts – October 2009 chance of being just lucky. Still, it would be very nice far – by underweighting emerging equity last summer just indeed to twist and turn a little more along the seven-year in time to avoid its two-month freefall of 40%. So maybe path in order to make more money and avoid losses. After there’s hope for a second time. all, we’ve done it once – I’m afraid that’s all there is so Exhibit 3 The 7-Year Forecast from June 2002 to June 2009: ‘Boring Fair Value’ Forecasts from June 30, 2002 vs. actual as of June 30, 2009 GMO 7-Yr Forecast June-02 Actual Estimated (% Real 7-Yr Actual Asset Class Rank Return/Yr) Return* Rank Emerging Market Equities 1 10.0 14.3 1 International Small Cap 2 8.9 7.7 3 U.S. REITs 3 8.1 1.5 10 Emerging Country Debt 4 6.9 9.2 2 EAFE 5 6.5 4.0 7 Foreign Bonds 6 4.6 6.8 4 U.S. TIPS 7 3.1 5.3 5 U.S. Small 8 2.8 3.0 8 Lehman Aggregate 8 2.8 4.4 6 U.S. T-Bills 10 2.1 2.1 9 U.S. Large Value 11 1.1 0.9 12 S&P 500 12 0.5 0.8 13 U.S. Large Growth 13 -0.2 1.2 11 Correlation of rank order: 78.7% Probability of picking same or better rank order randomly: 1 in 900 * Actual compound annual real returns are for the period 6/30/02 to 6/30/09.

The accuracy of these forecasts does not guarantee that current or future predictions will be accurate either with respect to the ranking of those asset classes over a 7-year period, the absolute levels of real return, or results over shorter periods. The accuracy of forecasted rankings and absolute returns in the asset class forecasts generally varies from period to period. Source: GMO P.S.: We plan to post the entire set of forecasts to our website along with some preliminary analysis of the results. We will keep you informed as to when these will be available.

Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending October 26, 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 – Just Deserts – October 2009 9 GMO GMO SPECIAL TOPIC October 2009 (Written in early July and held back from last quarter’s letter for health reasons: attacked by a small tick bearing a large grudge.)

Lesson Not Learned: On Redesigning Our Current Financial System Jeremy Grantham I can imagine the company representatives on the We have a once-in-a-lifetime opportunity to effect genuine Titanic II design committee repeatedly pointing out that change given that the general public is disgusted with the the Titanic I tragedy was a black swan event: utterly financial system and none too pleased with Congress. unpredictable and completely, emphatically, not caused by I have no idea why the current administration, which any failures of the ship’s construction, of the company’s came in on a promise of change, for heaven’s sake, is policy, or of the captain’s competence. “No one could so determined to protect the status quo of the financial have seen this coming,” would have been their constant system at the expense of already weary taxpayers who are refrain. Their response would have been to spend their promised only somewhat better lifeboats. time pushing for more and improved lifeboats. In itself It is obvious to most that there was a more or less complete this is a good idea, and that is the trap: by working to mitigate the pain of the next catastrophe, we allow failure of our private financial system and its public ourselves to downplay the real causes of the disaster and overseers. The regulatory leaders in particular were all far thereby invite another one. And so it is today with our too captured and cozy in their dealings with reckless and efforts to redesign the financial system in order to reduce greedy financial enterprises. Congress also failed in its the number and severity of future crises. role. For example, it did not rise to the occasion to limit the recklessness of Fannie and Freddie. Nor did it encourage After a crisis, if you don’t want to waste time on palliatives, the regulation of new financial instruments. Quite the you must begin with an open and frank admission of reverse, as exemplified by the sorry tale of CFTC Chairman failure. The Titanic, for example, was just too big and Brooksley Born’s fight to regulate credit default swaps. therefore too complicated for the affordable technology of its day. Given White Star Line’s unwillingness to But, at least now, Congress seems to realize the problem: spend, she was under-designed. The ship also suffered the current financial system is too large and complicated from agency problems: the passengers bore the risk of for the ordinary people attempting to control it. Even unnecessary speed and overconfidence in “too big to Barney Frank, were he on his death bed, might admit sink!” while the captain stood to be rewarded for breaking this; and most members of Congress know that they the speed record. No captain is ever rewarded for merely hardly understand the financial system at all. Many of the delivering his passengers alive. Greenspan, nearly 100 banks individually are both too big and so complicated years later in his short-lived “irrational exuberance” phase, that none of their own bosses clearly understand their did not enjoy being metaphysically slapped by the Senate own complexity and risk taking. The recent boom and Subcommittee for threatening the then speedy progress the ensuing crisis are a wonderfully scientific experiment of the economy. What is needed in this typical type of with definitive results that we are all trying to ignore. agency problem is for the agent on those rare occasions And, except for bankers, who have Congress in an iron when it really matters, whether a ship’s captain or a Fed grip, we all want and need a profound change. We all boss, to stop boot licking and say, “No, this is wrong. It is want smaller, simpler banks that are not too big to fail. just too risky. I won’t go along.” And we can and should arrange it!

Step 1 should be to ban or spin off that part of the trading not be is advantaged at the cost of taxpayer back-up or of the bank’s own money that has become an aggressive insurance, as is now the case. hedge fund. Proprietary trading by banks has become In the early 1930s, following the famous Pecora hearings, by degrees over recent years an egregious conflict of the conflict of interest between the management of other interest with their clients. Most if not all banks that prop people’s money as fiduciary and the business of dealing trade now gather information from their institutional and underwriting in securities was considered so inimical clients and exploit it. In complete contrast, 30 years ago, to the public interest that Congress almost compelled Goldman Sachs, for example, would never, ever have separation of proprietary trading and client trading. traded against its clients.

How quaint that scrupulousness Close, but no cigar. Instead, Glass-Steagall made the now seems. Indeed, from, say, 1935 to 1980, any banker probably less useful step of separating commercial and who suggested such behavior would have been fired as investment banking. Unfortunately, they left intact the both unprincipled and a threat to the partners’ money. I, obvious conflict between the banks’ managing their own for one, saw Goldman in my early days as a surprisingly money and simultaneously that of their clients. We now ethical firm, at worst “long-term greedy.” (This steady have a unique opportunity to revisit this matter. loss of the old partnership ethic is typically underplayed in descriptions of Goldman.) Today, Goldman represents (As we ponder the problem of prop trading, let us consider a potential hedge fund trade as being attractive precisely Goldman’s stunning $3 billion second quarter profit.

It because they themselves have already chosen to do it. appeared to be almost all hedge fund trading. Be aware These days, all – or almost all – large banks do proprietary also that this $3 billion is net of about $6 billion reserved trading that is pure hedge fund in nature. Indeed the for future bonuses. Goldman’s CEO had, in fact, the largest bank, Citi (owned by us taxpayers), is gearing up interesting job of deciding how much of this $9 billion to substantially increase its aggressive prop trading as I profit would be arbitrarily awarded to shareholders. [In write. (“No, no, we’re not!”) this case, one-third. Could be worse!] This means that they extracted every penny of $9 billion from a fragile Some insiders have argued that we should not worry financial system. “Good for them,” you may say, and they about prop trading because they claim it did not play indeed are very smart.

But surely they should not have an important part in the recent crisis. I think this is been insured against failure by us taxpayers! Remember, completely wrong for it misses the very big picture. Prop they are now also a commercial bank yet very, very trading can easily introduce an aggressive hedge-fund type little of their $9 billion came from making loans. Three mentality into the very hearts of what ideally should be months later their bonus pool for the year is estimated to conservative, prudent – even boring – banks. This hedge-be a new record at $29 billion. And the whole banking fund mentality became a dominant organizing principle, industry is back to a new record for remuneration. How particularly with respect to compensation practices. It resilient! How remarkable! How basically undesirable encouraged personal aspirations over corporate goals and for our economy!) invited bonus-directed behavior at the clients’ expense and ultimately, as we have seen, at the taxpayers’ expense to In Step 2, the Justice Department, together with rid itself of this problem.

All Congress has to overcome Congressional and other advisors, should be invited to is the lobbying power and campaign contributions of the develop a special set of rules for the banking industry that finance industry itself, which I admit is no small feat. In a recognizes the moral hazard of “too big to fail.” If really bank with a hedge fund heart, you can’t reasonably expect too big to fail, banks should be divided by Justice into ethical or non-greedy behavior, and you haven’t seen it. manageable, smaller pieces that can indeed be allowed to fail. With these two steps and possibly with an intelligent Of course, commercial and investment banks need to son of Glass-Steagall, the deed would be done! Regulators invest their own capital. They probably should have the would have a fighting chance of being able to regulate, right to do genuine hedging against investments that flow unlike their recent woeful past.

If an angel appeared, naturally from their banking business. As for the rest, they waved his wings and, lo, it was so, almost every single could easily be required either to limit the leverage used Congressman would sigh with relief. on prop desk trading or to be restricted to investing in government paper and, at the very least, play by the same The separation of commercial banking from investment rules as other hedge funds. What they certainly should banking is not as vital as the removal of prop desk GMO 2 Quarterly Letter – Special Topic – October 2009 conflicts, but it would certainly make large and ineffably this point, in 1965 the financial sector of the economy complicated enterprises both smaller and simpler, which took up 3% of the GDP pie. The 1960s were probably the characteristics I for one believe are probably essential if high water mark (or one of them) of America’s capitalism. we are to avoid further disasters.

So what is the problem? They clearly had adequate financial tools. Innovation The argument against all major changes, without at least could obviously have occurred continuously in all aspects some of which we will soon surely be back in another of finance, without necessarily moving its share of the crisis, is always the same. “Oh, you can’t roll back the economy materially over 3%. Yet by 2007 the share had clock.” But, even repeated twice before every breakfast, risen to 7.5% of GDP! it is not persuasive. Why exactly can’t you roll back the The financial world was reaching into the GDP pie and clock? We did it once before and, although it was very taking an unnecessary extra 4%. Every year! This extra imperfect and probably missed the central point of conflict rent is enough to lower the savings and investment potential of interest, it still produced an improved system that was of the rest of the economy.

And it shows. As mentioned successful enough for 50 years. In general, countries earlier, the growth rate of the GDP had been 3.5% a year with simpler and less aggressive banks have had much for a hundred years. It had proven to be remarkably less pain in the recent crisis while we were pawning the robust. Even the Great Depression bounced off it, and Crown Jewels – sorry, the Federal Jewels – to bail out soon GDP growth was back on the original trend as if aggressive bankers who were out of their depth in the new the Depression had never occurred. But after 1965, the complexities. growth of the non-financial slice, formerly 3.4%, slowed Step by step, even as the complexity grew, our regulatory to 3.2%. After 1982 it dropped to 3.1% and after 2000 leaders enabled systemic risk to grow. They continued to fell to well under 3%, all measured to the end of 2007, push the boundaries for banks by allowing more leverage, before the recent troubles.

These are big declines. It is as new instruments, and less control. The details are familiar. if a runner has a growing and already heavy blood sucker All this was done in the name of untrammeled, unfettered on him that is, not surprisingly, slowing him down. In capitalism, and almost all of it was a bad idea. the short term, I realize that job creation in the financial industry looked like a growth driver, as did the surge in “Oh!” say the bankers, “If we become smaller and financial profits (which we now realize were ludicrously simpler and more regulated, the world will end and all overstated). But in the long term, like a sugar high, this serious banking will go to London, Switzerland, Bali stimulus was temporary and unhealthy.

Hai, or wherever.” Well, good for those other places.

If that means they will have knee-buckling, economy- The financial system was growing because it could. The cracking, taxpayer-impoverishing meltdowns every more complex and confusing new financial instruments 15 years and we will be left looking like a boring back became the more “help” ordinary citizens needed from water, that sounds fine to me. Remember, just like our the experts. The agents’ interests were totally unaligned investment management branch of the financial system, with the principle/clients’ interests. This makes a banking creates nothing of itself. It merely facilitates the mockery of “rational expectations” and the Efficient functioning of the real world. Market Hypothesis, which assumes (totally unproven, as usual) equivalent and perfect knowledge on both sides of Yes, of course every country needs a basic financial system all transactions. At the extreme, this great advantage in to function effectively with letters of credit, deposits, and knowledge and information held by the financial agents check writing facilities, etc. But as you move beyond has the agents receiving all the rewards, according to the that it is worth remembering that every valued job created recent work1 by my former partner, Paul Woolley, and his by financial complexity is paid for by the rest of the real colleagues at the Woolley Centre for the Study of Capital economy, and talent is displaced from real production, as Market Dysfunctionality. (With a great name like that symbolized by all of the nuclear physicists on prop trading desks. Viewed from the perspective of the long-term 1 Biais, Bruno; Rochet, Jean-Charles; and Woolley, Paul. Rents, Learning and well-being of the whole economy, the drastic expansion Risk in the Financial Sector and other Innovative Industries. September, 2009. Working Paper Series 2009, The Paul Woolley Centre for the Study of of the U.S. financial system as a percentage of total GDP Capital Market Dysfunctionality. in the last 20 years has been a drain on the health and cost h t t p : / / w w w. l s e . a c . u k / c o l l e c t i o n s / p a u l Wo o l l e y C e n t r e / n e w s / structure of the balance of the real economy. To illustrate RentsLearningAndRisk.htm Quarterly Letter – Special Topic – October 2009 3 GMO their job is half done before they start.) terrified to make any substantial changes. And the one person with the character to make tough changes – Paul The second problem, right on the heels of the too-big-andVolcker – is window dressing, exactly as I suggested in complicated issue, is that of inadequate public oversight.

January. A sad, wasted opportunity!

Even with existing institutions, we would have avoided most of the recent pain, borne by taxpayers, if we had had Summary better public leadership. Yes, the public bodies had flaws, but the individuals running the shop had far bigger flaws.  Yes, this was a profound failure of our financial Greenspan, with arguably the most important job in the system. world, simply did not believe in interfering with capitalism  The public leadership was inadequate, especially in at all. His regulatory colleagues such as Bernanke and dealing with unexpected events that often, like the Geithner fell into line without any challenges. And housing bubble breaking, should have been expected. Congress, strongly influenced by the financial industry, or merely misguided, or often both, facilitated the approach  Of course, we should make a more determined effort that capitalism in general and banking in particular would to do a more effective job of leadership selection. But do just fine if left entirely alone. It was a very expensive excellence in leadership will often be elusive. error. Does anyone think we would have run off the cliff  Equally obvious, we could make a hundred with even one change – Volcker at the Fed? I, for one, am improvements to the lifeboats. Most would be modest confident that we would have done far less badly. beneficial improvements, but in the long run they would Behind this weakness in the recent cast of characters is be almost completely irrelevant and, worse, they might a systemic (suddenly the trendiest word in the English kid us into thinking we were doing something useful! language) weakness in our method of job selection. How can Greenspan, with his long-established record of failure  But all of the above points fail to recognize the main as a professional economist, have resurfaced as the Fed problem: the system has become too big and complicated boss? With no record of success in any important job, he for even much-improved leaders to handle. Why gets one of the world’s two most important jobs! Now should we be confident that we will find such improved we have to decide how much more decision-making leaders? For, even in an administration directed to power to give to the Fed – an institution with a 25-year “change,” Obama and his advisors fell back on the proven record of failure. How can we separate the logical same cast of characters who allowed, even facilitated, neatness of institutional design from our recent proven the development of the current crisis. Reappointing inability to pick effective, principled leaders with strong Bernanke! What a wasted opportunity to get a “son backbones? of Volcker” type. (Or should that be “grandson of Volcker?”)

It is a conundrum: too many regulatory agencies and you have too many opportunities for financial interests to shop  The size of the financial system continues to grow and around for regulatory bargains and to find and exploit the shows every sign of being out of control. As it grows, it ambiguous seams between them. Too few agencies and becomes a bigger drain on the rest of the economy and we run the risk of my worst nightmare: waking up and slows it down. finding Alan Greenspan with twice the authority!  The only long-term hope of avoiding major recurrent At the least we must recognize the improbability of crises is to make our financial system simpler, the acquiring great leaders and that our financial system units small enough that they can be allowed to fail, must be simple and robust enough to withstand the worst and, above all, to remove the intrinsically conflicted efforts from time to time of poor or even bad leadership. A and dangerously risk-seeking hedge fund heart from simpler, more manageable financial system is much more the banking system. The rest is window dressing and than a luxury. Without it we shall surely fail again. And wishful thinking. it looks as if we are bound and determined to bend once again to the will (and the money) of the financial lobby,  The concept of rational expectations – the belief in which is encouraged by the unexpected conservatism of the natural efficiency of capitalism – is wrong, and is the current administration’s “Teflon” men. They seem the root cause of our problems. Hyman Minsky, on GMO 4 Quarterly Letter – Special Topic – October 2009 the other hand, was right; he argued that the natural PS: As quite often happens, since I write painfully slowly outcome of ordinary people interacting is to make (even without extra tick-borne delays), a professional occasional financial crises “well nigh inevitable.” slipped in with a great column that gets to the heart of Crises are desperately hard to avoid. We must give this matter. Please read John Kay in the Financial Times ourselves a chance by making the job of dealing with of July 9. It is short and persuasive. “Our banks are them much, much easier. beyond the control of mere mortals” – now, that’s what I call a title!  All in all we are likely to have learned little, or rather to act, through lack of character, as if we have learned nothing. In doing so we are probably condemning ourselves to another serious financial crisis in the not-too-distant future.

Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending October 26, 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 – Special Topic – October 2009 5 GMO