Where This Bear Is Putting His Honey

Jeremy Grantham sees lots of alternatives to U.S. stocks

Here's a dreary forecast: The stock market will go nowhere for the next seven years. That's the word from Jeremy Grantham, chief investment strategist of Boston money management firm Grantham, Mayo, Van Otterloo (GMO), who is also known in investment circles as "the other Jeremy." While Wharton School finance professor Jeremy Siegel, author of Stocks For the Long Run, is famous for his bullishness, Grantham is renowned as a bear, often debating Siegel. Both men are so convincing that after their most recent debate in December, the moderator quipped: "Well, I agree with Jeremy."

Characterizing Grantham as simply a "bear" is misleading, however. Through most of the 1980s and early '90s he was bullish on U.S. stocks, and he still looks very favorably on other parts of the world. "People often think I'm bearish about everything, but I'm a raging bull on emerging-market stocks because they've been crushed," Grantham says. "I was a raging bull for U.S. stocks back in 1982, when they were cheap." His bullishness extends to other sorts of investments--foreign small-cap stocks, real estate investment trusts (REITs), inflation-protected bonds, and one unusual favorite, timber (chart).

Pay heed to Grantham. He has excellent credentials as an investment strategist. GMO, which runs $23 billion mainly for institutional investors, has been in business for nearly 25 years. (For individual investors, there are two funds: GMO Pelican and Vanguard U.S. Value.) The firm has 53 investment products that collectively have a 340-year track record. In two out of every three of those years, GMO's accounts have beaten their bogeys, such as the Standard & Poor's 500-stock index or the Russell 2000 index. In addition, over the 25-year period the accounts have beaten their benchmarks by an average of 2.4 percentage points, after fees.

Grantham is a fit 63-year-old from Doncaster, England, who still plays soccer every Sunday with a group of friends in Westport, Mass. "We'll play a pickup game with anyone who shows up," so long as they can kick, he says. He employs the same open-minded approach to investing, buying big-cap, small-cap, or foreign stocks or bonds--whatever his quantitative models determine to be the best values.

Behind all of Grantham's work is a belief that asset valuations always revert to their historical mean. "Throughout history, every asset bubble--from gold and oil in the 1970s to Japanese stocks 10 years ago to U.S. stocks in 1929--has fallen to its long-term historical trend," Grantham says. And since it usually take seven years for markets to get back to their means, his forecasts go out seven years.

By Grantham's standards, U.S. stocks still are way overpriced, so he's bearish. Look at the price-earnings ratio for the S&P 500. Its long-term average p-e over the past 75 years is 14, but the current number is 26.3, using the S&P 500's trailing 12-month operating earnings. (By using operating earnings instead of net earnings, Grantham eliminates the many writeoffs and one-time charges that occurred in the S&P 500 in 2001. Adding those in would raise the p-e ratio to over 50.) Grantham doesn't think stocks need to return all the way to the mean. Economic cycles are longer and recessions fewer, so stocks are less risky than they have been--and he figures stocks can sell above the mean and still be reasonably priced. His target p-e is 17.5.

To get to that number, either earnings have to rise or stock prices fall. But profit margins already are at historic highs with little room to grow, he believes, so earnings growth through margin expansion will be tough. And sales growth will still be only in the mid-single digits. That suggests downward pressure on share prices. Right now, his yearend 2008 target for the S&P 500 is 1,067, which is actually 7.5% below today's price. The only thing that makes the returns from stocks positive is the dividends. The bottom line: a 1.2% average annual return. Grantham's outlook on U.S. small caps is somewhat better, 4.4% per year. Small-cap p-e ratios are higher, but small companies have faster growth rates, and there's also a takeover premium.

Jeremy Siegel agrees that p-e ratios must fall, too, but not nearly as far. He figures the optimal p-e for the S&P 500 is in the low 20s. That translates into a better market outlook--roughly in the 7% to 9% a year range. Says Siegel: "Grantham is a very bright man, but I'm nowhere near as pessimistic as he is."

In Grantham's view, bonds--even at today's low rates--are more attractive than stocks. He expects them to deliver 5.1% per year. "They're priced to return about 3% after inflation. Not exciting, but not particularly dangerous," Grantham says. He thinks Treasury inflation-indexed securities (TIIS), which yield 3.5% above inflation, are an even better bet. "A 3.5% real yield protected against everything--no credit-quality or inflation problems--is simply not bad," he says.

Grantham reserves his greatest enthusiasm for off-beat investments. Emerging-market stocks--companies in Latin America, Eastern Europe, and most of Asia--have a cheap 12.9 average p-e. Because they are riskier than U.S. stocks, Grantham assumes they deserve only a 15 p-e, lower than his estimate for the S&P 500. Still, with such bargain prices, a 2.4% average dividend yield, and 5.2% average profit margins, he figures emerging-market stocks can deliver 11.6% per year through 2008. Emerging-market bonds should also deliver 9% per year, because of their hefty yields.

He's also bullish on REITs, publicly traded companies that invest in real estate, because of their high dividend yields, averaging about 7%, which compare well to the S&P 500's 1.4%. Those yields should be inflation-protected because the price of real estate often rises with consumer prices, Grantham says.

Grantham's "favorite asset class" is timber. Why? The price of wood has had an almost inverse relationship to stock prices during every major bear market of the past century, and it has grown at a 3% rate above inflation. But investing in timber is pretty much an institutional investor's game--and his firm does it.

Although Grantham does have a grim view of the U.S. stock market through 2008, he thinks stocks may continue to rally this year, as investors become enthusiastic about an economic recovery. "But then we'll run into the longer-term problems, such as the tremendous capital spending and debt buildups of the 1990s," he says. That excess will hurt profit margins and drive stocks back down. Siegel acknowledges these problems but still predicts high single-digit returns.

Who's right? Why Jeremy, of course.

By Lewis Braham

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