Monday, November 29, 2010

Jeremy Grantham and me

I don't know Jeremy Grantham personally, but we both worked at Batterymarch Financial Management, which was the firm he was at just before he left to found Grantham Mayo Van Otterloo (GMO), an asset management firm with over $100 billion in assets.

I finally got around to watching the recent Grantham interview with Maria Bartiromo of CNBC outlining his outlook, which is well worth the 29 minutes of your time. I was surprised to see how much my outlook agreed with Grantham's. While there were some minor points of disagreement, they were minor.

Inner investor vs. inner trader
Grantham's views sound a lot my inner investor vs. inner trader debate. Despite his reservations about equity valuations and macro risks, he seems to be resigned that the S+P 500 may be frothy enough to rally to as high as 1500, before falling to GMO's fair value estimate of about 900 on the index.

I agree with Grantham's belief, which I have written about before, that there is significant macro risk in the financial system. The Federal Reserve has undertanken to blow serial asset bubbles, the latest being QE2, which will lead to rolling boom-bust cycles. The Fed balance sheet is already precarious in the wake of QE2. While they may be able to rescue the situation right now, at some point it will all come down like a house of cards. When that happens, the fallout is going to be really, really ugly.

What's more, QE2 is a form of currency depreciation, which is upsetting America's trading partners and risking currency wars. Its effects are showing up, not so much in the FX markets, but in commodity prices.
On the other hand, just as my inner trader told me not to worry and enjoy the party that the Fed was throwing. Grantham reluctantly allowed that the stock market could rise even further from current levels.

Our differences are one of approach
So far I have outlined the points where we agree. Our differences are few and relatively minor:
  • We are both long-term commodity bulls but for different reasons. Grantham's bullishness stems from his belief that the supply-demand equation has shifted from commodity consumers to producers. Emerging market countries are growing a lot faster and their rising resource intensity is putting upward pressure on demand. Where I differ: I am a little bit more skeptical about the commodity bullish supply-demand story. I am a long-term commodity bull because I believe that the pressures from overly accommodative global fiscal and monetary policy are likely to manifest themselves in higher commodity prices.
  • Grantham believes that the biggest macro risk is a full-blown currency war, which would have similar effects as the Smoot-Hawley tariffs had during the Great Depression. Where I differ: I just worry about tail risk, which can be either inflationary or deflationary. In no particular order, here are some of the events that may set off another crisis: China slows into a hard landing, more deflationary pressures in Europe, e.g. Spanish real estate falls another 30%, or the Germans balk at supporting their EU brethrens, the fragile US economy slips into a double-dip recession. Should any one of these time bombs blow up, how will the authorities respond?
  • GMO's assets of choice are high quality US stocks and emerging market equities. These are reasonable investment solutions for institutional investors who are constrained largely to a buy-and-hold discipline. In some ways, the high quality stock approach is a close cousin of David Rosenberg's SIRP (Safety and Income at a Reasonable Price) strategy. Where I differ: Given the backdrop of low returns and a volatile economic outlook (i.e. a rolling series of financial crises), I believe that investors should employ more dynamic asset allocation strategies to play the swings, such as my Inflation-Deflation Timer Model.
In summary, we both agree that there are significant macro risks. We just differ on how investors should address the situation.

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