Inside The Mind of a Legend
Famed value investor Jeremy Grantham talks about the price of oil, paradigm shifts, and the power of the presidential cycle.
(FORTUNE Magazine) - Jeremy Grantham, chairman of the $120 billion money-management firm GMO, is known among investing pros as both a master trend spotter and an unparalleled decoder of data. He makes money by buying undervalued assets and waiting for them to bounce back. That's a discipline that requires tremendous patience as well as the ability to sift through reams of figures and spot the ones that matter. Grantham shared his thoughts on the market, the oil spike and other urgent issues with FORTUNE's Corey Hajim.
You've been saying that the price of oil may be establishing a new, higher, base level. What's the evidence?
As a value manager you live in dread of a paradigm shift--something changes and leaves you high and dry forever. And that's what we may be seeing in oil. If you look at the charts, you see that for 100 years, from about 1870 to 1974, the prices fall in a remarkably normal distribution around the trend line, which is $16 a barrel in today's dollars. But late last year it began to dawn on me that oil wasn't really mean-reverting around its old central tendency anymore. Since the OPEC crisis of the '70s, it seems to have been mean-reverting on a new trend that has jumped to $36 a barrel. And the bad news is that the price may have jumped again; we won't know for 40 years, but my fear is it may have gone to $45 or so. From either level, $36 or $45, by the way, the price can easily go to $100 or back down to $22. That's what oil does. It's an extremely volatile commodity.
For someone who believes in fundamental valuation, you seem to put a lot of faith in the "presidential cycle"--the idea that the market follows a distinct pattern during a President's term.
We've looked at the data since 1964, and--very briefly--in the first year of a President's term, starting with the election, the S&P gains 1.3%, in the second year you lose 8.4%, the third year you make 24.1%, and the last year you make a totally average 7.4%.
Why is year three so big?
With the election looming, you stimulate the economy like mad to generate an increase in jobs. We tested everything--the S&P, GNP, etc., and employment is the thing that moves the vote. So some of the best data we have say that regardless of value, regardless of anything, the market goes up in the 15 months starting in October [of the second year]. That was true even in 1999. It was the most overpriced market that had ever existed, way over 1929 and 1965, but it was a third year. It went straight up. So come October, we will have terrible creative tension between our need to play pure value, which is a discipline of the firm, and the presidential data, which say that over-priced speculative stocks are going to do very well. Thank God we have between now and Oct. 1 to decide what to do.
Where are you finding value today?
Growth stocks are merely badly overpriced--down from legendary levels--but value stocks, which were only a tiny bit overpriced, are now at least as badly overpriced as growth stocks. Small caps are now worse than large caps; emerging and international are now almost as bad; bonds that were brilliant are now badly overpriced. The only opportunity we see is high-quality stocks vs. junk [stocks]. My definition of quality is a high and stable return and low debt. If you have a low and volatile return and high debt, you are at the junky end. Modern portfolio theory says the highest-quality stocks, like Microsoft (Research), will underperform the market because they are boring and stable. In real life they have outperformed by 30% over 35 years. Despite that, they are about the best value they've ever been relative to low-quality stocks.
You're worried that Americans aren't saving enough for retirement.
People have not been saving, under the delusion that they are rich because of paper profits. The savings rate in the past ten years has averaged 3%. It used to be 8%. That's a five-point gap for ten years. That's 50% of a year's salary that should have been compounding over the past ten years that simply does not exist and will never be replaced. So the retirees are, in a nutshell, screwed.