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Playing with Fire (A Possible Race to the Old Highs) at Trader’s Narrative





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GMO Quarterly Letter Apr 2010

Jeremy Grantham’s most recent GMO quarterly report is a jeremiad against the reckless Federal Reserve policies and what they will ultimately lead to for the US economy and the stock market:

Speculators are not stupid. They see that after each crash, a long, artificial period of low rates and easy financial borrowing has been delivered. They see that Bernanke is an unreconstructed Greenspanite in that he refuses to address bubbles, but will leap to help ease the pain should a bubble break. With symmetry like that, why not speculate? And so another bubble appears and then another

Because of the disconnect between the still anemic US economy and the US stock market and because of Bernanke’s willingness to disregard asset bubbles and to target the economy, Grantham believes that the stock market could very well overshoot on the upside and result in yet another bubble.

Grantham also points to the upcoming sweet spot in the presidential cycle starting in October 2010. Historically the Fed has helped the incumbent president (the only exception being Volcker) and this year looks to be no different. The consequence has been that the stock market has an incredibly positive return over the 3rd year of a presidency.

According to Grantham, the future will unfold with two major scenarios: either the US economy does recover or it limps along. Grantham believes there is only a 30% chance it will recover, leaving a 70% chance for continued weakness. The best scenario would be an economic recovery because then interest rates will rise and forestall any ensuing bubble.

The worst final scenario - which Grantham gives a 49% chance of occurring - is if we avoid any shocks (no sovereign default, no commercial real estate implosion, no competitive devaluations, etc.) and allow the abnormally low interest rates to foment another stock market bubble which collapses under its own weight.

The second worst case scenario is a if an economic shock does occur to break the speculative frenzy and bring the stock market in line with fundamentals. Grantham believes this has a 21% chance of occurring.

The reason why Grantham believes that Bernanake is playing with fire is that in the worst case scenario, the US is left with very little or no monetary or fiscal reserves. Where will the money come from for another bailout? where do you take rates when they are already at zero?

The letter is only a few pages long and deserves the attention of any serious student of the market. There is also an added bonus in this Quarterly report: Grantham’s views on the disadvantages of Graham and Dodd, value investing. You can download the complete report here.

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