GMO

Quarterly Letter July 2003

Jeremy Grantham, Chairman

Stocks Have Rallied And Will Now Return Less.

Hip Hip Hooray! But Now What?
The Strangely Different Responses to Higher Prices The regret at lost opportunities and the resulting
by Stock and Bond Investors reduction in the size of the asset class bet seem absolutely
The second quarter was a good one for bonds, especially normal to me. An asset class rallies in price and the
junk and emerging country debt, and a sensational one for imbedded return drops. A wonderful feature of bonds is
global equities, with the S&P 500 up 15%, EAFE up 19% you have to try very, very hard to miss this point. Not
and emerging countries up 23%! It was a good time to only did the real (after inflation) return drop by 60%, but
compare how bond and equity investors react to price the near certainty of a substantial capital gain was
increases. replaced by the near certainty of a capital loss.

The strong rally in bond prices, on one hand, has been What then are we supposed to make of the response to a
greeted with justifiable dismay by bond and asset 25% rally in the U.S. market? Far from being seen as an
allocation investors as it lowered the available yields and increasing risk or even as a lost or reduced investment
took away reasonable long-term investment options and opportunity, it is seen, nearly universally, as an
replaced them with fears of the capital losses that will unmitigated good. Individuals, net sellers of mutual
occur when yields move higher at some uncertain future funds at 775 on the S&P in October, are now heavy
date. At GMO, for example, we loved inflation protected buyers at 1000. Newsletters and other advisers are at a
government bonds (TIPS) in early 2000 when they multi-year high in optimism about future equity prices.
yielded 4.2%. We argued that 4.2% was so attractive at (Yet stocks, like bonds and indeed every other asset class,
zero risk that we were highly likely to see a capital gain share the characteristic that at higher prices you get a
as the yields came down to the 2.7% to 3.0% range that lower return.)
we saw as reasonable in the long term. Not only did this
yield reduction happen, but the yields kept on falling Why does this disparity exist between the dismay of bond
right through our view of fair value to today’s much less investors to higher prices and the joy of stock investors to
satisfactory return of 2.0%. (Efficient market believers higher prices? Partly, I believe, it is an after effect of the
please explain.) Ben Inker and I, and most proponents of great bull market in stocks and Greenspan’s logic that
investing in TIPS, are heart broken to lose this wonderful permanently high productivity might justify permanently
investment and are only partially consoled by having higher p/e ratios, not yet by any means out of our
made so much money in them by overstaying our collective system. More particularly, the math is so
legitimate welcome. This pushing of our luck in TIPS simple and compelling for bonds that no reasonable
was partly because of the increasing lack of fairly priced person can miss it. For stocks, the logic of growth versus
alternatives and partly because of the inertia we built long yield is not so clear.
ago into our asset allocation moves. The same logic
applied in a lesser degree to all fixed income, but both The Economy
these factors have their limits, and late last year and early The economy, however, has continued to take my last
this year, metaphysically cursing and swearing eight quarterly letters to heart by being intermittently
(sentiments that seem to be broadly shared by fixed disappointing. It has continued to move up, but on a path
income professionals), we eliminated our huge that varies from perfectly adequate in some quarters to
overweight in now overpriced fixed income. obviously sluggish in others, such as the first quarter this
 year at 1.4% GNP growth. In total, as suspected, the 50 years), we moved all of the 15% to non-U.S. equities
economy is still suffering from the overhang of debt that with a twin emphasis on emerging countries and small
is too high everywhere, personal savings that are too low, cap developed.
and the previous capital spending boom.
Almost uniquely, in our experience, non-U.S. equities
This is in fact the worst recovery from a recession in at outperformed the S&P 500 even as the S&P rallied 15%
least three ways. Excess capacity, for the first time, is in a quarter. The normal experience would be to have
greater today than when the recession appeared to end foreign stocks deliver 1/3 to 2/3 of the U.S. performance
and in fact lower than all but 5 quarters in the last 25 in a very strong quarter like this one for the U.S. This
years. The number of jobs has dropped since the time, the S&P 500 lost to EAFE by 4% and emerging by
recession ‘ended’ for the first time and real wages have 8%. This extremely favorable outcome for GMO and its
been flat. Capital spending is still falling on a year over clients generally allowed our allocation accounts to win
year basis. With these pressures, it is not surprising that in a rally despite having won in three consecutive down
profits have been disappointing when compared to what years. Partly, this was the fortunate timing of our rapid
was expected a year ago for the first half of 2003. Indeed, sale of fixed income (unfortunately, asset allocation is
it is remarkable, and I believe suspicious, that the S&P simply not that precise a business usually) and, more
500 companies are claiming that today’s profit margins importantly, it was due to a spectacular weakness in the
are normal on a percentage of sales basis. (The profit dollar that favored our foreign accounts by over 8% this
margins declared to the IRS remain very subnormal. The year and over 15% since early December last year. Yes,
estimate of total corporate earnings from the national we budgeted for 15%—2% a year for 7 years was in our
income accounts also remains below average, and the budget. We just did not expect this entire 7-year forecast
gaps between the claimed corporate operating earnings to occur in 7 months!
and the other two series remain at record wide levels.)
There is usually a worm in any apple this good and the
So on one hand, we have a classic third year presidential bad news now is that all of the best investment ideas have
effect: a rising stock and bond market supported by performed the best and have lost all or some of their
stimulus, particularly low rates, and plentiful availability attractiveness. There has probably not been a time in
of funds, with little competition for funds from my 35-year career when asset classes in the U.S. were
corporations facing weak sales and excess capacity, with so broadly unattractive. This is typically the case in a
a resulting flow of money to financial assets. On the great bull market but was wonderfully not the case this
other hand, we have a sluggish and disappointing time. In March 2000 there were many places to hide with
economy and earnings that typically follow a major many cheap asset classes in which to make money. Now,
economic and stock market bubble, combined with an bonds globally are expensive and value and small in the
overpriced market. The net effect is that we expect a global markets have done their job and are now in line
continuation of intermittently disappointing GNP with the rest of their markets. Our beloved REITs have
growth and earnings, but not disastrously so: remember, gone from extraordinarily cheap to slightly above fair
last week’s average GNP estimate – by 50 economists in price and their near-term fundamentals look awful. Only
The Wall Street Journal for the next 12 months – was foreign stocks look reasonable, at or close to fair value.
3.7% real growth. There is plenty of room there for And the usual reflex to fill a portfolio in this situation,
muddling through okay while still being disappointing. which is to hold cash, is met by most of us with a cold
shudder at the thought of knowingly investing at a
Asset Allocation: Fortune Favors the Virtuous negative real return.
Prompted by the extraordinarily good performance of
fixed income and its cousin, the REITs, in the 3-year bear
What Is Left, if Anything?
market, we sold our overweighted fixed income positions
down to parity late in the fourth quarter and early in the Exhibit 1 shows our relatively new exhibit on our 7-year
first quarter, having held the maximum overweight asset class forecasts. The top line shows the real returns
possible for 6 years, typically 15% points overweight. (after inflation) that we expect from each asset class at
REITs were also reduced to 1/3 of their peak overweight. fair value. The numbers are unusually uncontroversial,
agreeing with most consultants and other sources, plus or
Impressed by the uniquely wide gap in value between minus a few basis points: 5.7% real from stocks and 3.0%
U.S. equities and non U.S. equities (the widest in at least real from bonds giving a “risk premium” of 2.7%. The

GMO Quarterly Letter – July 2003 2

Exhibit 1. Equilibrium Returns versus GMO Forecasts

US US Int’l Int’l
Large Small Large Small Emerging US
Caps Caps Caps Caps Equities Bonds
8%
Real Returns at Equilibrium 6.7% 6.7%
6.2%
Prices (Fair Value) 5.7% 5.7%
6%

4% 3.0%

2%

0%

10% 5%
Immediate Gain or Loss from 3%
0%
Hitting Fair Value Tomorrow 0%

-10%
-9%
-20%

-30% -25%
-31%
-40%

8% 7.4%
Expected Real Return From 6.7%
5.7%
Hitting Fair Value in 7 Years 6%

4%

2% 1.4% 1.2%

0%
-0.6%
-2%
As of 6/30/2003

incremental return from owning riskier small caps and stocks and bonds are badly overpriced and foreign
emerging country stocks is a reasonable extra 1% a year. developed and emerging country equities are priced at
fair value. This is the biggest deviation between the two
The problems start in row two which shows the move that equity blocks in history and is the backbone of our
would have to occur tomorrow, in our opinion, to move current asset allocation positioning.
mispriced asset classes to normal fair value (or trend line
price). What this all boils down to is that the best we can
recommend to investors is to own as much foreign and
Row three amortizes the pain of being overpriced and the emerging as you dare within equities and own as much
pleasure of being cheap evenly over 7 years and is our cash as you can stand within fixed income, or where
usual 7-year forecast. Seven years is picked because possible own conservative or market neutral type hedge
market asset prices have historically passed through fair funds designed to outperform cash by a few percentage
value every 6¼ years and we wanted to be conservative. points or more. Finally, consider forestry as a different
and defensive investment.
The bad news is that bubbles breaking take about the
same time to deflate as they took to move above trend,
which was mentioned in my December 2002 letter. This A Good Time to Consider Forestry
means that it is very likely that U.S. stocks will move Exhibit 2 shows the updated version of my favorite
back to the trend line (and fair value) of just under 700 on forestry exhibit. First, it shows that for 92 years the price
the S&P 500 sooner than 7 years: 1 to 3 years from now of timber beat the price of a share of the S&P 500 in a fair
would be a much better guess historically than 7 years. fight. But highlighted in this exhibit are the timber prices
in the great market declines. We have used this exhibit
But, staying with our more conservative 7-year forecast, for several years to make the point that in the three great
it is readily apparent from rows two and three that U.S. bear markets of the 20th century, the price of timber,

3 Quarterly Letter – July 2003 GMO

 Exhibit 2. Real Growth in Stumpage Price vs. S&P 500 in Bear Markets
100.0

Southern Pine

S&P 500 Index

Price Index (1910 = 1), Log Scale

10.0

1.0

As of 12/31/2002. Source: U.S. Forest Service and Standard & Poors

0.1
1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

according to the U.S. Forestry Service, rose. When the suggest. So for those with both a long time horizon and
stock market rose in the past, timber happily had a a willingness to have some illiquidity, it seems as close to
slightly positive correlation, rising a little. But in these a free lunch as exists. At a time when the alternatives are
three great declines, it had a strongly negative correlation, so wretched on a 7 year horizon, it seems a particularly
actually rising in all three of these over 50% U.S. equity good time to consider a timber investment.
declines. Now we have the first great bear market of the
21st century and once again the price of timber stayed
steady in a 50% equity decline! The Third Year of the Presidential Cycle: an Update
I described the third year of the Presidential Cycle in my
In addition to the price, there is also yield. The yield on December 2002 letter, "Predictive ‘Entrails’ and the Case
the S&P 500 averaged 4.5% over 75 years but is currently for a Time-out in the Great Bear Market" as a very bad
below 2%. The yield on forestry averaged 6.5% and is year for short sellers to try to be heroes. The third year
currently about 6.5%. has an average of 17.2% real return since 1932 (compared
to an average below 3% for the first 2 years) and has only
The reasons for the outperformance of a very two small declines. It can be described as the King Kong
conservative asset class relative to the risk in equities are, of bullish factors. The Godzilla factor of bear market
I believe, very straight forward. It is a non-traditional factors, however, is the aftermath of a major bubble
investment that most of your peers will not be using, breaking, which has historically made it difficult to
giving it substantial career risk. It is also illiquid, needing sustain a major rally until the market is very cheap, which
to be locked up for 10 years. These are probably the two in January it clearly was not.
pet hates of institutional investors (even though it seems
a bit irrational), and each of these characteristics is worth The Presidential third year is bullish because of the
a couple of extra points of return. So an asset class with amount of fiscal and monetary stimulus that the
highly desirable portfolio attributes yields 8% or 9% real administration of the time attempts to pack into it. This
instead of the 4% to 5% real that finance 101 (which year has been a doozy for stimulus with the rate cuts to
notoriously cares little about behavioralism) would 40-year lows, strongly negative real rates, and a large (if

GMO Quarterly Letter – July 2003 4

inefficient) second round of tax cuts. The Fed also made for a major and sustained rally to start lacking cheapness
as blatant a promise as has ever been made to uphold the following the breaking of a major bubble would rewrite
principle of moral hazard, suggesting last week that it the history books. (With a hit rate of 27 out of 27 major
would keep interest rates low for a long time. This, in bubbles retreating all the way to trend and below, we
turn, offered the hope that investors could leverage recognize the possibility of a new bull market, but only as
portfolios without too much risk. So determined is the a very remote possibility.)
language and action of the Fed to keep rates low and
money flowing that Stephen Roach of Morgan Stanley The fourth year of the presidential cycle is also strong up
suggests that Greenspan is in the business of producing to the election, although it does not have the same heroic
“chain linked bubbles” (a mixed metaphor if ever there success rate as the third year. The strength of this year’s
was one, but one that still works beautifully). The future stimulus and the strong historic record of the fourth year
possible bubbles we are risking are in long bonds and make me believe that for the next 15 months, predictions
housing. But for now, despite reservations about the are unwise and that anything can happen, including the
future, King Kong has won, the market has done well, U.S. stock market holding or adding to its gains. This
and although the year is far from over, an up year seems would make this rally one of the best bear market rallies
very likely. in history and perhaps the very best, but one with good
reasons to explain it. However, I would also not be
It is interesting to note that the U.S. Presidential Cycle is totally surprised to see a substantial decline from current
so powerful that it exists in Europe. In the U.K. it is levels in this 15-month period in the face of overpricing.
particularly powerful: since 1932 the average of the first The greatest short-term danger would be if the
2 years of the American presidents’ terms has been 3.9% intermittent disappointments in GNP growth,
and the average for the third year an astonishing 19.0%! employment, wage rates, and corporate earnings were to
The Prime Ministerial Cycle, on the other hand, is take an unexpectedly severe decline, which is quite
completely non-existent. The only thing left is to become possible. So, a toss up.
the 51st state. In the whole of Europe, since 1970, the
comparable numbers are 4.6% and 16.8%. It’s a strange The Cliff and the Lemmings?
world in which U.S. politically driven stimulus programs 2005 and 2006, however, are a completely different story,
would have such a broad impact, but that’s the way it is. and the odds are far longer against a decent stock market.
In the first 2 years the administration typically looks to
As a longer-term bear it is probably appropriate for me to
put its house in order and this particular house is pretty
admit how ‘healthy’, in a traditional sense, this second
disorderly and very overpriced. That the bear market
quarter rally felt. Each of the three prior rallies were
should take this kind of time may seem unusual, but it
classic bear market rallies in that they were dominated by
absolutely is not. Quite the reverse is true as, after a great
the favorites from the late, great bull market, tech and
bull market, taking 6 or 7 years to hit the low for the cycle
growth stocks in particular, with value stocks left far
would be very normal. If the market p/e is still up at these
behind. This turned in the second quarter as value stocks
levels towards the end of next year, it will present a
outperformed growth by 3% and the Russell 2000
glorious opportunity indeed to take evasive action – for
outperformed the S&P 500 by over 8%. A rally this broad
us lemmings to stop at or near the cliff edge and to think
led by a different type of company is what you look for in
better of it.
a new bull market. In this sense, any market historian has
to treat this rally with respect. For historians, though, it
lacks just one, unfortunately cosmically important GMO Second Quarter Performance
characteristic: this rally emphatically did not start from a This was definitely one of our best (and luckiest) quarters
cheap level, bottoming at 19 times adjusted trailing in 25 years, with broad based outperformance in
earnings compared to a trend line 16 times. The animal individual U.S. and foreign equity funds, asset allocation,
spirits and unrealistic high hopes of the great bubble had fixed income, and hedge funds, all in the face of a 15%
been substantially reduced but had not been by any means move in the S&P 500 and the usual GMO bear market
totally crushed. This rally is driven by Greenspan and bias that exists in everything we do. It doesn’t get much
Bush, by availability of cash at give away rates, and tax better than this and if we made any Faustian bargain with
stimulus. It is unusual, but not amazing in these the devil, I’m happy to say it wasn’t me who signed the
circumstances, that this rally has felt so impressive. But contract!

5 Quarterly Letter – July 2003 GMO