Why Jeremy Grantham changed his mind

If people had paid attention to veteran investor Jeremy Grantham over the past two years, their investment portfolios would be looking much better than they likely are. While many investors were caught up in bull-market euphoria in 2007, Grantham, who oversees $85 billion for Boston-based institutional money-management firm GMO, told anyone who would listen there was a global bubble: ?It?s everywhere, in everything.? Then, in early March of this year, when the market looked its worst, he wrote that people needed to get over their fears and invest, because U.S. stocks were cheap and foreign stocks even cheaper.

Grantham?s disregard for the conventional wisdom has brought him grief at nearly every point of his 40-plus-year investing career. But more often than not, the often grumpy Grantham, 70, has been right over the long term. The irony of all his remarkable forecasting is that few ordinary investors can invest with him. The funds GMO runs are mostly geared toward institutions, such as pension funds or school endowments, although the Evergreen Asset Allocation fund invests exclusively in funds managed by GMO. GMO investors lost money last year because many of its funds dictate a substantial degree of stock holdings even when the boss is decrying the market. Still, GMO?s U.S. stock funds lost only about half what the S&P did during the crash, and some other GMO funds did much better.

Grantham has an opinion for everyone about the best investment strategies in these uncertain times. Sitting in his office lined with giant Buddhas and relics of civilizations long gone, Grantham talked with us about the stock market and the current financial mess.

Q: In 2007 you were worried the global financial market could fall apart, and you said a market downturn was probably coming. OK, say it: ?I told you so.?

A: That seems so long ago. I felt like saying that a few months ago, but now onward and upward, and wait for the next unexpected twist.

Q: Why were you so certain things were going to get so ugly?

A: There wasn?t a whole lot of doubt where I was coming from. I thought the fair value of the S&P was 925; the S&P went to 1500. And by 2006 the housing bubble was at a 100-year peak. This was the 32nd asset bubble that we?ve tracked, and all but the U.K. housing bubble have popped.

Q: Why didn?t you just put all the money in GMO?s funds into cash?

A: Every quarter, we do our best to tell our clients the truth. We were comfortable with telling our clients there was a major bubble in every asset class, everywhere. Then they go to investment committees and decide what to do with their money. They don?t want to do anything that looks eccentric and costs them their jobs. It?s a miracle that any of our advice perks up the pipeline.

Q: Why did your own funds lose so much money when you were confident the market would fall apart?

A: Most of our mandates require us to be nearly 100 percent invested. But even when you had to be at least 45 percent equity, then you couldn?t help but to go down. There was nowhere to hide. Everywhere and everything got hit.

Q: Yet now, for the first time in years, you like U.S. stocks.

A: We think a fair price for the S&P 500 index is 900. By sheer divine intervention we bought into the market on March 6, the day it hit the recent low of 666. It?s likely, but far from certain, that we?ll go back and make a new low. You aren?t going to get to buy at the absolute low unless you have a time machine.

Q: Anything else besides U.S. stocks?

A: U.S. stocks were nicely cheap, and frankly, the rest of the world was even cheaper. In early March, when we bought, we invested only in stocks we thought would have a 10 to 14 percent average annual return after inflation. That?s magnificent. We haven?t seen anything like that in 20? years. It was somewhat disappointing that prices moved up so fast in just a couple of weeks. The odds are a bit more than 50-50 that we will go back and test that low.

Q: So you?ve made a quick buck. Now what?

A: You have a set of possibilities. First, if the market nosedives, it?s easy: You buy. The second is confusing, when the market just goes sideways, between 700 and 800. The market is irritatingly cheap then, but not supercheap. The longer that goes on, the less probability we will set a new low, so we?ll ultimately put money each month into the market.

Q: What if stocks keep rallying?

A: If the market goes higher, above 950, and then starts moving sideways, between 950 and 1050, we probably do very little. Then the market is moderately overpriced.

Q: Over the long haul, is there any particular industry or sector you like?

A: The people who move quickly in this market can make money. The people who invest in energy alternatives will make more. Alternative energies and combating climate change are the single most important economic initiatives over the next 10 years ? really over the next 50 years. It will be a very exciting next 50 years.

Q: That?s the future. But why did so many supposedly smart people miss this disaster over the past two years?

A: The ultimate villain of this is the belief in rational expectations ? that the market tends to be efficient. People who have anything to do with investing either believe it a bit or believe it a lot. There are only a few of us ornery disbelievers who don?t believe that the market is efficient at all.

Q: What?s wrong with believing that the market is efficient?

A: If you believe in it, then you don?t see asset bubbles. And there?s nothing as dangerous as an asset bubble. If you even slightly believe in it, you believe in (former Federal Reserve Chairman) Alan Greenspan?s idea that markets can control themselves. You believe that you should buy and hold the market. You believe you should have a fixed asset mix and you should never change it, because why would you? The market is efficient! When you believe in market efficiency, it?s like being on the railroad watching the locomotive coming toward you. Then you just stand your ground just for the discipline of not moving. It?s ruinously expensive.

Q: Will we get out of this mess?

A: The stimulus is so great in the United States, China and the United Kingdom, it will kick the economy up. GDP will go back positive for two to three quarters. They?ll assume everything is settled, that throwing money at it has worked. But the long-term imbalance between overproducers (like China) and overspenders (like the U.S.) will continue. It?ll be a multiyear drag on growth.

Q: We?re just throwing money at the problems?

A: If the problem is that we consume too much and borrow too much, does it make sense to borrow more and spend more? It doesn?t make sense to solve alcoholism by giving an alcoholic a quart of whiskey, but everyone believes that we must stimulate. So that?s why we feel this is a temporary cure. This is like when you revive the drunk, he staggers down a few blocks, then falls down again.

Q: That does not sound promising.

A: We?re not rich, and we?re undersaved and underpensioned. Those will be a real brake on economic growth. This will be a pretty long recovery period, longer than we?re used to, but hopefully not as long as Japan took. It will not be as long as the Depression, but it will be several years, and not just two. Lord knows we have had several fat years.

Q: Won?t our leaders help?

A: President Obama is not doing the right thing. I admired his appointments in many areas, certainly in the environmental area. But then he got these tired old retreads from the financial area that notoriously didn?t blow a whistle over the last few years. They?ve all been Rubin-ized (influenced by former Treasury Secretary Robert Rubin).

Q: So why are these life-size Buddhas and other statues in your office?

A: I?m a history freak. I find old civilizations fascinating. Great empires all rise and fall. It?s sad that we don?t know how the future will work out. A time machine would be a wonderful device, even if you couldn?t use it for investing.

2009 Copyright The New York Times Syndicate