Bulls Eye Investmentment Chapter 2

CHAPTER 3: THE TREND IS YOUR FRIEND

Jeremy Grantham (money manager), his theory is that over time investment classes come back to the average. When asset classes are well above trend he avoids them, and when they are well below trends he buys them. Grantham has been very successful at simply investing for the long term using history as his guide. You will miss bubble tops and get in too soon on irrational bottoms, but patience and time will see you rewarded.

In an interview in Barrons Grantham notes that his firm researched every bubble for which they could find data, including stocks, bonds, commodities and currencies, 28 bubbles in all. They defined a bubble as a 40-year event in which statistics went well beyond the norm a 2-standar-deviation current.

According to Grantham, every one of the 28 went back to trend, no exceptions, no new eras, not a single one that we can find in history. The broad U.S. market today is still in bubble territory at 26 times earnings.

“Bubbles and markets will come back to trend”

He turns that research on the recent stock market bubble. He notes that the long term average P/E for the stock market is 14. Prior to 9/11, he thought the markets would come back to about 17.5, rather than the historic average, in recognition that the world was seen as a safer place at that time.

If the P/E trends down gracefully, as Grantham asserts, then that means 10 years from the market will essentially be where it is today; that is exactly what Robert Shiller said in his book; he points out that no stock market at the P/E levels we have seen for the past few years has ever returned anything to buy-and-hold index investors after 10 years. Grantham´s contention is that we are still in a bubble.

Mark Yusko from the University of North Carolina, noted that most consultants and managers have a strong incentive to not take risks, where risk is defined as doing something different than the herd of other consultants. If you suggest something different and you are wrong, you lose your job. If you suggest sticking with the standard line, you can blame the market and point out that everybody else had problems as well: you keep your job.

The second point What Yusko means is that the more important decision for large and small investors to make about their portfolios is in which asset classes to be positioned. How Much in real estate? Gold? Bonds? Stocks? Hedge Funds?

Grantham notes that many markets and bubbles not only come back to trend, but go down right on past the trend line. What is trend for U.S. markets? He gives us four measures: Based on dividend yield, the market is overvalued by 50%. Based upon Tobin´s Q (the market value of a firm´s asset divided by their replacement value) the market is too high by 31%. The price of stocks to the 10-year average of real earnings is too high by 31% and as a function of market cap to GNP the market would need to come down by 45% to get back to trend.

Grantham breaks down historic P/R ratios into five levels, or quintiles, from level 1, which represents the 20% of years with the cheapest values (lowest P/E ratios) in history right on through the fifth quintile, which represents the 20% of years with the most expensive values.

What kind of returns can you expect 10 years after these periods, on average? Interestingly, the two quintiles, or cheapest periods, have identical returns: 11%. That means when stocks are cheap, you should get 10% over the next 10 years. The last, or most expensive period, sees a return over 10 years of zero percent. We are in period that would easily rank among the most expensive periods.

Gratham likes Treasuryinflation-protected securities (TIP), REIT´s, emerging market debt, market neutral hedge-fund strategies, and international small cap value and small cap growth stocks, which show historical signs of being undervalued. He is willing

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