Trader’s Narrative

Jeremy Grantham declares most of the easy money made in his latest quarterly letter from GMO. I respect Grantham as one of the few ‘elder statesmen’ of the stock market because he approaches it with an impressive amount of perspective and discipline. No doubt, a result of having survived many market cycles.

He was one of the few who warned that the bubble was everywhere in 2007 and then surprising to many who were accustomed to his jeremiads against the market, he turned bullish in March 2009: Reinvesting When Terrified.

Here are a few choice excerpts from his latest missive on the US equity market:

Fair value on the S&P is now about 860 … This places today’s market at almost 25% overpriced

Having reinvested back in March to be almost neutral in equities, we have recently taken just a few chips off the table and recommend that anyone who was neutral weighted in equities or even overweighted (lucky you!) do the same.

Quality stocks (high, stable return and low debt) simply look cheap and have gotten painfully cheaper as the Fed beats investors into buying junk and other risky assets

As many have already done before him, Grantham compares the spring rally to the ‘last hurrah’ which saw the Dow Jones counter rally in the aftermath of the 1929 crash:

As mentioned six months ago, in the third year of the Presidential Cycle, a tiny fraction of the current level of moral hazard and easy money has done its typically great job of driving equity markets and speculation higher.

Price, however, does matter eventually, and what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors. First, the disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems, particularly pressure on profi t margins as the quick fix of short-term labor cuts fades away. Second, the slow gravitational pull of value as U.S. stocks reach +30-35% overpricing in the face of an extended difficult environment.

But, like Doug Kass of Seabreeze Partners, Grantham doesn’t believe that we break the 666 low on the S&P 500 but that it will last as a long term inflection point. Turning to other markets, Grantham continues to favor emerging markets, even as their valuation pushes against his own value instinct. Finally, he finishes off with an special comment on the question of redesigning the financial system in the aftermath of the 2008 meltdown. The whole thing is longer than his usual quarterly updates but well worth the read.

Follow this link to download GMO latest quarterly letter. If that doesn’t work, you can also find it in the Free Trading Resource section in the Reports & Articles folder.

No, there is no free lunch. But for my US readers, there is a free trading magazine subscription in their future.. For a limited time, you can get a complimentary subscription to SFO magazine (Stocks, Futures, and Options).

It takes less than a minute to sign up and you need to provide some basic information. But as I mentioned, you need to be a resident of the US (because you need to provide a US address). Enjoy!

One of the sophisticated investors I track is Jeremy Grantham of GMO. Back in 2007 he warned that the financial world was full of bubbles. The only asset class he liked then was an alternative one: timber.

He was right of course. Bubbles popped in the credit market, mortgages, real estate, the stock market, etc. Then in early 2009 just in time for the March rally he began to soften his staunchly bearish stance and then ultimately became bullish at those valuations: Reinvesting When Terrified.

Setting aside these two calls, Grantham is a long term market timer. He’s not interested in catching short term fluctuations nor would he be able to exploit them since he manages billions in assets as an institutional money manager. With that in mind, here is a chart - released today - of GMO’s most recent 7 year asset class return forecast:

To download the full reports, register then login at GMO’s website. To sum up, they predict that:

• the S&P 500 will return less than 5% annually over the next 7 years.
• international equities are expected to perform better, but not by that much
• US government bonds are among the lowest return asset class (1.7%)
• once again, timber makes an appearance with a 7.5% expected return

In comparison, GMO’s prediction of asset class returns just before the financial markets went into a tailspin in 2007 looked quite different:

• the S&P 500 forecast was -2%
• US ‘low quality’ stocks were expected to return -10%
• US government bond returns were forecast at just 3%
• and timber was still high, at 6.5% annual return

Clearly, GMO is signaling that they expect the US equity market to recover. Their ‘highest quality’ US equity forecast was 4.2% in October 2007 while it currently stands at 11.8%. Time will tell if they will continue to be correct.

While the US market has been incredibly strong, the Chinese stock market, by comparison, makes it look downright flaccid.

A few months back we looked at the Shanghai Stock Exchange Composite and noticed that the Chinese equivalent of the Coppock Curve had turned positive. As well, just a few weeks before this long term signal was given, we had another important positive development: a golden cross. Since then prices have climbed in what can only be described as a trend followers dream.

That was a good place to go long Chinese equities (green up arrow). Since then the Shanghai Composite has climbed by 37%. But if you were reading this blog way back in early November 2008, I wrote about the extremely negative sentiment in China towards stocks and how this was a great contrarian indicator.

Back in November 2008, the Shanghai Composite was trading around 1700 - pretty much nailing the exact bottom (green up arrow). With the Shanghai Composite now trading at 3438, that’s 100%+ in 9 months.

So obviously, everyone all of a sudden loves Chinese stocks now. Their IPOs are popping like crazy. Just today China State Construction Engineering opened at 6.70 yuan, well above its initial public offering price of 4.18 yuan and closed on heavy volume at 7.30 yuan. It is telling about where the future global epicenter will be when the largest global IPO so far this year is Chinese.

A good old IPO frenzy is a sure sign of a sentiment extreme, just like billboards lampooning the stock market are a contrarian indicator at the bottom. But there are other signs of caution.

The last time the Shanghai Composite closed this far from its simple 50 moving day average was way back in October 2007… just as the market was making its top at slightly under 6100. And the last time the index closed this far above its 200 day simple moving average was in November 2007. Again, not a good time to be long this market.

Also, notice that simple support and resistance highlights this level as congestion going back to the spring of 2008. As prices were falling last year, they were met with strong support around this area. The Shanghai Composite thrashed about as prices disturbed their smooth downtrend. So this same area is now resistance as it acted as support before.

There is no question that things are really stretched at this point in Chinese equities. Of course, price can always continue but if you’re sitting on nice gains, it doesn’t make sense to continue to ride them as the odds are now totally skewed against you. The time to go long Chinese stocks was when no one wanted them, late last year as I pointed out back then.

From a long term perspective, having being blessed with both the “golden cross” and the Coppock Guide upturn, the best is yet to come. But not before we have a pull-back to shake out the weak hands. So unless you are ready to ride so major turbulence, it would be smart to lighten up here and ring the cash register.

If you’re not going to listen to me, consider Jeremy Grantham; who was correctly pessimistic and called the bear market as well as the spring rally this year. In his recent report, the chief investment strategist at Boston-based institutional money manager GMO writes:

Deciphering the strength of the Chinese economy will also play a major role in formulating our view of any future relative strength of emerging. My colleague, Edward Chancellor, strongly suspects that the Chinese economy is dangerously unbalanced and very likely to come unhinged in the next few quarters, surprising the pants off investors. On the other hand, the strong longer-term case that I outlined in “The Emerging Emerging Bubble” 15 months ago seems intact. I suggested then that emerging equities would sell within fi ve years or so at a distinct P/E premium to celebrate their obviously superior GDP growth compared with that of an aging developed world. Emerging market equities are already selling at a modest premium to EAFE and the higher quality half of the U.S. equity market.

Being pro-emerging yet anti-China is a dilemma for us; we are working to resolve it. Meanwhile, emerging equities, like most risky asset components, are moderately overpriced. We in asset allocation may, however, push our luck in emerging – particularly ex-China emerging – using inertia to reduce our current modest overweight. If we do this, it will be out of respect for the high probability that emerging equities will sustain and increase their overpriced level relative to the rest of the world.

You can download the complete report from Jeremy Grantham from the FREE Trading Resource Section (in the Reports folder). There is a lot of other stuff you might like as well, so take a look around.

Book Giveaway
If you haven’t already, throw your name into the hat for a giveaway of:
Hedge Fund Operational Due Diligence (follow link and submit comment)

Jeremy Grantham, Chairman of Grantham Mayo Van Otterloo, is one of the few that saw the financial crisis coming. In 2007 he wrote, warning that we were caught in “The First Truly Global Bubble“. There was only one asset class that liked back then, and even that didn’t fully escape unscathed.

But Grantham isn’t a perma-bear. Since the brutal bear market, his views have changed completely. Here’s a preview of his newest letter to GMO clients:

In his letter, written before last week’s gains, he says that the market is fully valued at appx. the 900 level:

For the record, we now believe the S&P is worth 900 at fair value or 30% above today’s price. Global equities are even cheaper. (Our estimates of current value are based on the assumption of normal P/Es being applied to normal profit margins.) Our 7-year estimated returns for the various equity categories are in the +10 to +13% range after inflation based on an assumption of a 7-year move from today’s environment back to normal conditions. This compares to a year ago when they were all negative!

Then he discusses briefly how GMO is handling the dilemma of either moving too early, and having to endure further losses, or moving too late and giving up gains as the market moves up:

… you absolutely must have a battle plan for reinvestment and stick to it. Since every action must overcome paralysis, what I recommend is a few large steps, not many small ones. A single giant step at the low would be nice, but without holding a signed contract with the devil, several big moves would be safer.This is what we have been doing at GMO. We made one very large reinvestment move in October, taking us to about half way between neutral and minimum equities, and we have a schedule for further moves contingent on future market declines.

Of course, he is an institutional investor, having to position billions of assets. But the lesson is the same no matter the size of your account. You must have a battle plan laid out before hand so that when the market reveals itself, you know exactly what to do and aren’t caught off guard.

You can read the whole March 2009 letter from GMO in the Free Trading Resource section - in the Reports & Articles folder, where you’ll also find other interesting reports, articles and even complete trading books.

Book Giveaway
If you haven’t already, throw your name into the hat for a giveaway of:
Hedge Fund Operational Due Diligence (follow link and submit comment)

In late November 2008, the S&P 500 index was trading at 850, when we looked at a chart of the 10 year rolling returns. The 10 year return back then was -23% - although horrendous, not one of the worst we’ve seen in history. It still made me consider that it was reason enough Why Long Term Investors Should Consider Buying:

Flash forward a few months to take into account the continued erosion of the S&P 500 and we have the updated chart above. Using the most current data, we have a rolling 10 year return of -45.67% (not including dividends).

How bad is that? There are only a few months that were worse. And they were all around the 10 year anniversary of the 1920’s top:

• 8/1/1939 -61.66%
• 9/1/1939 -59.20%
• 7/1/1939 -58.88%
• 4/1/1939 -57.16%
• 6/1/1939 -56.29%
• 5/1/1939 -56.24%
• 5/1/1940 -55.81%
• 6/1/1940 -55.07%
• 10/1/1939 -53.91%
• 7/1/1940 -52.56%
• 4/1/1940 -51.81%
• 3/1/1939 -51.28%
• 8/1/1940 -50.94%
• 2/1/1939 -50.38%
• 1/1/1939 -49.72%
• 3/1/1940 -49.25%
• 9/1/1940 -48.85%
• 2/1/1940 -47.03%

The monthly data I used went from January 1st 1910 to present (March 1st 2009) so what we are saw as a 10 year simple rolling return is in the worst 1.5% of months for almost 100 years.

Just imagine the stories you’ll tell your grandchildren about the Great Decession. And all the major players: Madoff, Bernanke, Bush, Obama, Greenspan, etc. These are truly historic times we are living through.

Some have written me and questioned the validity of the original market call back in November 25th, 2008. As way of explanation, let me say first, that unlike a loud TV personality, I don’t pretend to know what the market will do - nor am I claiming that you should in me trust (cough Cramer cough). You should base market decisions on your own due diligence. Taking into account something I write is fine, as long as you do your own thinking afterward.

In any case, I made it clear that this was intended for long term investors. Not traders. Long term investors can still make a killing even if they are off a bit. You are either going to get in early, and share in the continued decline of the market, or you’re going to get in late, and pay opportunity costs. But if your time horizon is 25+ years, you don’t really care about a few percentage points here or there, your aim is to catch the big wave.

Even if you disregard the chart above and the fact that we are going through a rare and magnificent opportunity, you have to sit up and take notice when great market timers like Barry Ritholtz, Doug Kass, Jeremy Grantham, Warren Buffett, etc. turn bullish en masse.