Huge Opportunity in "Anti-Risk"
Jeremy Grantham says he's spotted the third great investing opportunity of his career. The first was small caps in the 1970s. The second was real estate, Treasury Inflation-Protected Securities, and value stocks during the tech bubble in 2000. Before you get too excited, I should make clear that the main opportunity today, in Grantham's view, is getting out of the way and watching the markets plummet in what he calls a slow-motion train wreck. Grantham made this call in a report published July 25--a day before the Dow got 300 points sliced off the top (talk about instant gratification!).
Grantham's firm, GMO, runs mostly institutional mutual funds but also runs half of Vanguard U.S. Value and all of Evergreen Asset Allocation . Grantham has always had a bearish tilt, so I typically take his warnings with a grain of salt. Still, he has been very much on the money with his warnings about the S&P 500 in 2000 and recommendations of foreign small caps, emerging markets, and timber.
In Grantham's view, we are in a financial-debt-soaked bubble that he's labeled the Blackstone Peak. Real estate and bonds are wobbly, and equities may weaken in October 2008. Grantham is a big believer in election cycles, which essentially means that the government floods the economy with money to get itself re-elected and then the market has a big hangover the following year when the bill comes due.
Grantham says that the excesses of private equity, hedge funds, and subprime debt mean lots of the economy and markets are leveraged to the gills and the end won't be pretty. He posits that in five years half the hedge funds will be out of business and one major bank will go belly up. The first call isn't really that bold when you consider the survivorship rates of hedge funds, but the second is a whopper.
I asked him about that, and he explained that he expects big banks to get burned by loaning money to private equity for a low return. He figures they'll get stuck with a few of those loans and take a bath. Moreover, he points out that most financial crises take down at least one big player.
Grantham calls this new opportunity "anti-risk." He says the opportunity lies more in bonds than stocks. "The ideal way of playing this third great opportunity is perhaps to create a basket of a dozen or more different anti-risk bets, for to speak the truth, none of us can know how this unprecedented risk bubble with its new levels of leverage and new instruments will precisely deflate. Some components, like subprime and junk bonds, may go early, and some equity risk spreads may go later."
Grantham's quarterly letter doesn't go into a lot of detail on what those dozen anti-risk bets should be, but he does express a love for TIPS. Given the substantial risk of inflation over the next 10 years, Grantham figures a yield of 2.4% to 2.6% on TIPS would make them attractive. "So, in recent weeks with TIPS selling between 2.6% and 2.8%, we have that rarest of rare birds, a genuinely cheap asset. Needless to say, where appropriate we have been grateful buyers."
Grantham also says he plans to sell his emerging-markets stocks near the end of the year.
I asked Grantham what else individual investors could do to make some anti-risk bets of their own. The wagers he's making for clients are too complicated for individuals, but he did offer a few ideas in addition to buying TIPS.
* Hold a lot of cash so that you'll have plenty of dry powder to take advantage of cheaper markets in years to come.
* Regular bonds are not too bad to own. (This means core high-quality bonds, such as corporate or Treasury bonds.)
* Short the Russell 2000 and go long on the S&P 500.
The final notion reflects Grantham's view that low-quality small caps will be terrible after many years of outperformance and high-quality large caps will fare well after years of lagging. The S&P 500 isn't a perfect proxy for GMO's definition of high quality, but it's close. Grantham notes that 80% of the companies they consider high quality are in the United States. "If the economy weakens substantially, these stocks will be pure gold," he said. You can see the names GMO considers high quality in the portfolio of GMO U.S. Quality. Unfortunately, you can't buy that fund unless your name is CalPERS.
Grantham's view that real estate and junk bonds are a bad place to be isn't unique. Quite a few savvy investors have sounded the warning on these apparently overheated asset classes. In fact, Morningstar's own REIT analysts have a dim view of their prospects. However, Grantham stands out in his predictions for the breadth and depth of the sell-off. In addition, I haven't heard a lot of people pounding the table for TIPS.
It's an interesting argument and Grantham, like most thoughtful bears, provides a valuable service in challenging bullish assumptions. Will I bail out on everything but TIPS? No, though I already have gotten out of my high-yield and real-estate funds for some of the same reasons spelled out above. In addition, I already have lots of blue-chip exposure. I might raise my TIPS weighting a percentage point or two, though.
In fact, GMO's funds aren't entirely bailing on markets either, as they typically have tight constraints. The Evergreen Asset Allocation portfolio is instructive. It's out of small caps but has plenty of exposure to core bonds and stocks as well as TIPS and emerging markets.