“History is a guide to navigation in perilous times. History is who we are and why we are the way we are.” – David Mccullough, Historian and Author
You won’t see him on TV or writing an editorial piece for a major newspaper. Most retail investors have never heard of him, but he has one of the best long-term track records of any investment manager in the world.
His investment style is based completely on history. He lives and breathes the “It’s never different this time” ideology that’s necessary for success as a long-term investor.
Even to the detriment of his own firm and career, he’ll never jump on the hot trend or latest bubble. He lost loads of clients during the tech-bubble because he just didn’t get “the new era” of investing. Then he called the Dow hitting 14,000 a little over a year ago, part of the “greatest sucker’s rally in history.”
Over the past year though, he has certainly been rewarded for his unwavering belief in “it is not different this time.” And a lot of his investors must be pleased. While hedge fund investors (institutions and investors who must have at least $1 million net worth) have been asking for their money back at record rates, his clients of extremely high net worth individuals and institutions still entrust him with the care of more than $106 billion.
Over the past decade, Jeremy Grantham, has considered stocks overvalued. Before the tech bubble really got going and the housing bubble was years away, Grantham was simply waiting for the asset bubbles to burst.
Then this week, in a very rare interview (view interview here – it takes a little while to load), Grantham is speaking out about what investors should be concerned about today and offers takes on corporate earnings, inflation (gold), China, and how low the market can go.
Inflation: “Don’t Worry About It”
It’s no secret all of the Federal loan guarantees, multi-billion dollar stimulus packages, and rock-bottom interest rates have put a lot more dollars into circulation. Some estimates for the total cost of all government intervention and bailouts have already surpassed $8.5 trillion.
With all those extra dollars floating around, inflation fears are starting to pickup. Despite the fear of inflation, we are clearly in a deflationary period.
Grantham agrees. He says, “Don’t worry at all about inflation. We can all save up our worries there for a couple of years from now and then really worry!”
Yes, there are more dollars in circulation and they’re chasing fewer goods as production falls (the recipe for inflation), but the price of everything is falling. Gasoline prices are back below $2 a gallon, oil is hanging around $50 a barrel, and natural gas is 60% off its highs too.
The price of everything is dropping. Just take a look at what happened this holiday shopping season. Normally, yesterday is the big shopping day and all stores hold off offering the very enticing deals to get you in the door. This year, however, the race to undercut each other and unload excess inventory at any price started weeks ago.
So the price of everything is dropping, but the money supply keeps increasing? By some counts as much as $3 trillion. Clearly inflation has to come, it must, right?
All I can say is not anytime soon. There has been $3 trillion created, but that’s a drop in the bucket compared to the $10 trillion in stock market losses, the trillions of dollars of lost wealth in the housing market, and the sharp decline in available credit. It’s the reverse wealth effect (Read our previous warning of the impact of the wealth effect in reverse here) and the only concern right now is deflation.
On the good side, deflation is a necessary evil. It’s a part of contraction. Eventually though, costs to produce goods and services will get much lower and the price of those goods and services will get too cheap.
More Trouble Ahead for China
In his quarterly letter to shareholders, Grantham defines the biggest problem facing the Chinese economy. While most of the investment community has focused on the impact of declining exports on the Chinese economy, there’s a much, much bigger problem facing China. And it’s part of the structural nature of China’s economy.
You see, China is built for booms. Over the past decade it has become accustomed to the double-digit GDP growth. It has one of the highest savings rates in the world. And those savings have allowed the country to expand its capital base at a tremendous rate.
Therein lays the problem. It is going to have too much capacity.
So when factories are shutting down, steel demand has plummeted, and GDP growth is decelerating rapidly, you know China’s economy is in big trouble. The world may be focusing on export demand, but they’re missing out on a much bigger and highly leveraged part of the Chinese economy, the capital spending portion.
About 39% of China’s GDP is capital spending. That means a huge portion of China’s economy is building new factories, steel mills, mines, etc. With the economy slowing down, you really can’t justify building a new factory while 10 others are getting shut down. Economies just don’t work like that. And that’s why I’m very concerned about the optimistic growth expectations many investors have for a recovery in China.
How bad is it? Just look at the drastic action China has taken. The industrial nation has cut rates four times in three months, reduced the reserve requirement for its banks, and issued the largest bailout package (as a percentage of GDP) of any country during this downturn.
There appears to be a lot more problems in China than the market is currently anticipating. Granted, China stocks are down, but with the China Xinhua FTSE 25 (NYSE:FXI) up about 40% in the last month, there could be a lot more downside to come. After all, great expectations usually lead to great disappointments.
More Trouble Ahead for Corporate Earnings
China is not the only place the market is expecting to hold up, expectations are still pretty high for corporate earnings next year. Expectations for profits on the S&P 500 next year range between $60 and $90. To me, $90 in earnings (which would give the index a P/E ratio of about 10), is just a bit too optimistic.
Grantham says, “The ridiculous bullishness of bottom-up earnings forecasts has long been a joke among serious investors, but we still see them everywhere.”
But we’ve been through this before. When I issued my first warning the agriculture boom was about to go bust back in July (view “Agriculture Boom Goes Bust” here), the outpouring of animosity was extreme.
While the bubble was bursting and formerly high-flying shares of companies like Mosaic (NYSE:MOSE) and Potash Corp (NYSE:POT) were in steady decline, investors who decided to hold on became focused on P/E ratios. As the stocks declined, P/E ratios were falling to lows of 3 or 4.
Those P/E ratios, although quite low, were based on the earnings forecasts Grantham describes as “ridiculous.” The coming drop-off in corporate earnings (as unemployment continues to climb, 8.5% will have a huge impact on earnings) will be big. So, stocks might seem cheap relative to future earnings estimates, but in a lot of cases the future estimates are just too high.
Since share values are based on earnings, in a rational market, there could be another sizable drop ahead.
How Low Can the Markets Go?
This is the $64,000 question. The short answer is the markets can go a lot lower.
Grantham notes the markets can still go significantly lower. But it’s not due to a collapsing financial system or an ominous depression; it’s because of an impending decline in earnings.
Grantham puts the current fair value of the S&P 500 at around 975, but in the interview caveats the statement with one very important point about market swings. His main concern is markets overshoot to the high side during good times. And they overshoot to the low side during tough times.
We’ve already watched some overshooting to the low side, but if history is any indication, there could be more to come.
Grantham states the markets typically overshoot to the low side by 30% to 50%. If that happens, S&P 500 hitting new lows of 700 or a bit lower is not out of the question.
Despite all the bad news, there is a silver lining. The markets are moving more violently than ever. As we discussed the other day, 25 years worth of market volatility has been crammed into the past two months. It can be pretty stressful. But if you pick your buying spots, develop a plan, and don’t have overly optimistic expectations, you will be rewarded handsomely at the end of it all.
Grantham agrees. In the interview, Grantham went on to agree with what we’ve been saying for months now.
At the Prosperity Dispatch, we’ve been repeating, “Yes, stocks are cheap. This is the buying opportunity of a decade. But we’ve got to be prepared for the buying opportunity of a lifetime.”
Grantham said, “Stocks are reasonably cheap, not spectacularly cheap.”
Anyway you look at it, ensuring you have plenty of cash on hand to be able to “buy lower” is a prudent move to make right now. If history is any indication, there will likely be a chance to buy stocks even lower.
By Andrew Mickey