Jeremy Grantham: Overheating in China, speculative rallies and fair value

Jeremy Grantham is out again with a very important investment strategy piece entitled “Boring Fair Price!”  He leads off by talking about how markets went from extremely overvalued a year ago to cheap back to a state which he considers fair value.  But, he sees the recent rally as a speculative rally which is a response to the savage beating markets took late last year and this past Winter.

Waiting for Markets to be Silly Again A year is certainly a long time in markets, and so is a quarter. A year ago, equities globally – and everything else for that matter – were very overpriced, particularly if they were risky. A quarter ago, in mid March, prices everywhere were cheap. Now they have all – or almost all – converged for a few unusual moments at fair value. A year ago, it was very easy to know what to be: a risk avoider. It was not so easy reinvesting when terrified, but most of us knew that we should have been doing more. But today? It’s difficult to be inspired at fair value. Since early March, the market has had the type of strong speculative rally that often follows extreme declines. The danger of a breathtaking rally is that it leaves those few investors who raised considerable cash waiting for a pullback and psychologically invested in the case for a new bear market leg. This was covered in our mid- March posting, “Reinvesting When Terrified.”…

I tried to make the point that such a rally had absolutely nothing to do with the logic. of long-term fundamentals, but was merely a response to great stimulus and great implied promises. Well, this time once again, enough risk takers were found to get the job done, and the market rose to 950, with presumably at least a decent shot (say, 50/50) at rising over 1000 in the next two to three quarters.

This is my tack as well as I explained in a June post Market manipulation, short-covering rallies and cyclical bulls.  Just because the fundamentals do not support a rally, doesn’t mean it can’t happen. Momentum, stimulus, moral hazard, technicals, you name it – they can all be factors causing a market to bounce significantly despite poor fundamentals.  And these speculative moves can certainly continue for much longer than a fundamental bear with a short position can withstand.  But, now it is looking like the market may have surged beyond what is even sustainable in the short-run.  What to do?  Grantham gives his perspective.  I have linked some of the points he makes to previous posts of mine that make the same arguments.

Plan C: What to do if the Market Overruns

Given our view that we are in for seven lean years in which the market will be looking for an excuse to be cheap, we recommend taking some risk units off the table, including becoming underweight in equities – between 1000 and 1100 on the S&P, if it gets there this year. Around 880 you should continue to move slowly to fair value, twiddle your thumbs, and wait to see what happens. Boring! Otherwise, it is time to focus on the lesser issues: which types of equities are cheaper or more expensive than the market. This leads us back once again to the bet on quality stocks.

The Quality Bet

The easy winner of the cheapest equity sub-category contest is still high quality U.S. blue chips. They were really trashed on a relative basis by the second quarter rally in junk. I understand a rally in junk after the record decline, but this was excessive and based apparently on unrealistic hopes for a strong, sustained economic recovery. Such a recovery seems most unlikely, whereas a temporary, weaker recovery appeared very likely three months ago as the substantial size of the stimulus package was revealed. The latter scenario still seems probable. Our original estimate for the timing of some economic recovery to occur late this year or early next year still stands. Without an unexpectedly strong improvement in the economy, it is hard to see high quality stocks losing much more ground, given their extreme value gap over junky stocks – more than an 11 percentage point spread per year on our seven-year forecast!

My synopsis: expect a weak recovery of uneven quality late this year or early next year.  That means you want to be overweight value and not reach for yield or risk as these asset classes are overvalued on a relative basis.  This is the same advice from Richard Bernstein, the astute market strategist formerly at Merrill Lynch.  Now when looking across global equities for shares to buy, emerging markets come to mind.  And Grantham is generally pretty bullish here.  However, a key note of caution comes on China.

My colleague, Edward Chancellor, strongly suspects that the Chinese economy is dangerously unbalanced and very likely to come unhinged in the next few quarters, surprising the pants off investors. On the other hand, the strong longer-term case that I outlined in “The Emerging Emerging Bubble” 15 months ago seems intact. I suggested then that emerging equities would sell within five years or so at a distinct P/E premium to celebrate their obviously superior GDP growth compared with that of an aging developed world. Emerging market equities are already selling at a modest premium to EAFE and the higher quality half of the U.S. equity market. Being pro-emerging yet anti-China is a dilemma for us; we are working to resolve it. Meanwhile, emerging equities, like most risky asset components, are moderately overpriced. We in asset allocation may, however, push our luck in emerging – particularly ex-China emerging – using inertia to reduce our current modest overweight. If we do this, it will be out of respect for the high probability that emerging equities will sustain and increase their overpriced level relative to the rest of the world.

Translation: Emerging markets have rallied way too much.  China is looking dangerous in particular.  However, we are holding positions ex China and not yet selling as these markets still may outperform.

Bottom line for me: this is NOT a bull market, and as such asset allocation decisions are fraught with risk. Running with a buy and hold strategy in this environment may not be the best strategy. Grantham has a ton more to say and it is a very good read.  I do suggest you read the entirety of his piece, which is linked below as well as being available here.

Jgletter All 2q09


GMO Quarterly Letter July 2009 (PDF) – Jeremy Grantham

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