Here comes the crash
Boston sage Jeremy Grantham thinks investors are facing two tough years ahead. About $70 billion of smart money says the guy is no Chicken Little.
By David Stires

(FORTUNE Magazine) – Talk to Jeremy Grantham about the stock market, and you get the impression the sky is about to fall. For years the chairman and chief strategist of money-management firm Grantham Mayo Van Otterloo has been gleefully rattling listeners' nerves with his claim that the excesses of the dot-com bubble still haven't been unwound and that the market is headed for another precipitous drop. About a year ago his prediction became alarmingly specific. Shortly after this year's election, he says, the market will sink into a "black hole," losing about a third of its value over the next two to three years. He sounded this warning most publicly at the annual Morningstar investment conference in July. In late October, speaking from his elegant Boston townhouse, he told FORTUNE, "We're still in the unraveling of the greatest bull market in American history."

Grantham, 66, clearly relishes his role as stock market Cassandra. But it's not as though he's some madman who just broke out of the asylum. A Britisher who graduated from Harvard Business School in 1966, Grantham co-founded Batterymarch Financial Management before launching GMO with Dick Mayo and Eyk Van Otterloo in 1978. Using GMO's computer models, he has made several well-timed calls. In 1982, with stocks selling at fire-sale prices and the economy recovering, he predicted the market was ripe for a "major rally." That year the U.S. market kicked off its longest bull run ever. He also called the top of the Japanese bubble in 1989, the resurgence of U.S. large caps in 1991, and the rallies in U.S. small-cap and value stocks in 2000. Some veteran market watchers consider him one of the top strategists in the game. "Jeremy has great ideas," says longtime client Jack Meyer, who oversees the $23 billion endowment of Harvard University. "And he's usually right, which is a true rarity in the investment business."

It's hard to argue with Grantham's results. Since inception, GMO's two dozen funds have beaten their respective benchmarks by an average of three percentage points a year after fees. In recent years, as Grantham's value-oriented investment style has come back into fashion, his firm's assets under management have swelled to $70 billion, up from $20 billion in October 2001. GMO manages money for some 800 institutions, including the endowments of nearly every Ivy League school, the World Bank, and the pension funds of Exxon Mobil, Verizon, and International Paper. Grantham also has 50 or so individual clients, who each pony up at least $5 million to get into one of his funds. The list includes Dick Cheney and John Kerry.

What to make of Grantham's latest call? Unlike some doomsayers, he has done plenty of homework. Grantham and his team searched for every historical bubble worldwide in stock markets, currencies, and commodities; they documented 27. They found that in every correction, all the gains from the bubble were completely wiped out before a new bull market began. "It's an impeccable record," he says.

The first problem with today's market, as Grantham sees it, is that we still haven't given back all the gains from the bubble of the late 1990s. After it burst, the market hit a low of 19.5 times his estimate of trailing normalized earnings, in September 2002. Grantham says that wasn't nearly low enough. To wipe out the gains, he says, the market would have to revert to 16 times earnings, by his calculation the average multiple of the S&P 500 since 1900. Today the market trades at 20.4 times earnings. At 16, the S&P 500 would be valued at 725, about 35% lower than its current value of 1,100. The second problem, Grantham says, is that great bear markets always overcorrect. "The low will come two or three years from now, at a level below 700 on the S&P," he says. "How much it overruns, and for how long, is in the lap of the gods."

Grantham speaks with conviction that's unmatched in the investment community. But is he right? His call is certainly contrarian. Most investment pros are bullish on U.S. stocks for the year ahead. And Grantham has blown calls before. He turned bearish on U.S. equities in the mid-1990s, prompting clients to shift money to other firms. "He's way too bearish," says Jeremy Siegel, a professor of finance at Wharton and author of Stocks for the Long Run. Siegel doesn't dispute Grantham's theory that stocks will revert to their average valuations, but he figures the market's P/E ratio deserves to be higher today, somewhere between 18 and 20 times earnings. That's because more people than ever are investing in stocks, and interest rates and transaction costs are below their historical averages. Siegel thinks the fair value of the S&P 500 is roughly where it is now.

Grantham dismisses such views as "wishful thinking." As for the timing of his call, he says that has to do with the presidential cycle, which he considers the "most powerful predictive tool" for making one-year market forecasts in the U.S. Historically, Grantham says, stocks tend to do poorly during the first two years of a presidential term regardless of which party is in office. He says this is largely because the President and his administration typically dispense tough fiscal medicine during those years--raising taxes and cutting deficits--so they can stimulate the economy in year three and hopefully keep their party in office in year four. Grantham believes the next two years will go by the book. "This has been a weak recovery that hasn't addressed the major issues of excess capacity or excess debt," he says. "All we're doing is postponing the pain."

How does Grantham recommend investors survive the coming meltdown? "Panic," he says. (He's serious.) Surveying everything from stocks to bonds to commodities, he says, "It's the most broadly overpriced set of asset classes I have seen in my 35-year career." Grantham suggests investors seek shelter in select areas of the market--safeguarding wealth for what could ultimately be the buying opportunity of a lifetime. "The trick to this business is having money to invest and having the will to do it when things are cheap again."

Here's what he recommends:

Avoid U.S. stocks. "Don't try to get blood out of stones," he says. Grantham believes U.S. stocks will take the brunt of the hit over the next few years.

Buy some bonds. High-quality government bonds with short durations and treasury inflation-protected securities (TIPS) are good ways to protect assets.

Buy stocks in emerging markets. Grantham expects stocks in developed nations to tumble with their U.S. counterparts, but he believes emerging-market issues won't suffer as much because they're so much cheaper. GMO's seven-year forecast calls for emerging-market stocks to gain 6.6% a year after inflation.

Buy conservative hedge funds. "If you have access to conservative hedge funds, for heaven's sake, take them!" he says. "The ability to short has become a huge advantage."

Carefully consider commodities. Metals, oil, and timber have rallied dramatically in recent months, so the easy money is gone. Still, they can help diversify a portfolio. Grantham is particularly bullish on timber, his favorite asset class.

Hold cash. Your mattress may be the safest haven of all.

The Grantham Makeover

Call it Jeremy's eye for the bullish guy: Here are six fund that let you invest in market areas he thinks will best survive a meltdown.