Jeremy Grantham on long-term investing in short-term markets
Jeremy Grantham, originally from Yorkshire, is the co-founder and long-term investment strategist of asset management group GMO, based in Boston. Jeremy’s reputation is based on his long-standing ability to spot bubbles. He called the Japanese bubble in the late 1980s, and rightly refused to rush into the tech bubble in the late 1990s, a strategy that earned him notoriety as a permabear. But he also turned bullish in March 2009, just as the market bottomed after the crisis.
These episodes, and a great deal else, are chronicled in his memoir, The Making of a PermaBear: The Perils of Long-Term Investing in a Short-Term World, published earlier this year.
Andrew Van Sickle: Jeremy, we learn in your book that you weren’t always a patient value investor. I enjoyed the section about the late 1960s. You say you became a “gunslinging nitwit” in an expensive market, but you came a cropper with a couple of stocks. Will you tell us a bit about that episode and how it became a formative moment?
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Jeremy Grantham: Just after I got my first job in the investment business, I came up to Boston and joined this lunch club of gunslinging kids, fresh out of business school. Every time we met, someone would have a hot story. And typically these stocks would go up and come down very quickly. One was American Raceways, a motor-sports group that had Stirling Moss on the board. It was going to introduce Formula One to the US. I thought it would work. It seemed desperately American: power, noise, blood and death.
American Raceways bought one track in the middle of the country and everyone showed up. Expecting the races to catch on nationwide, I bought 300 shares at $7. I went to England and Germany for three weeks to get married; we came back and the stock was at $21. So I like to say that I did what any good value manager would do. I sold everything else I had and tripled up. I had 900 shares, a lot of them on borrowed money, at $21. And fate always teases you and wants to get you fully committed to a bull market, so the price was $100 by Christmas. All I had to do was sell and run. While my wife and were deciding whether to make a higher bid on a house we had our eye on, the market started to break and pretty soon American Raceways was slumping. And I scrambled out and got into another company equally far ahead of its time (Formula One is now doing well in the US).
This company was going to put a monitor on everyone’s desk, which back then was hugely high-tech. And on this little screen they were going to have the option price of individual stocks. But the idea, a forerunner of Bloomberg terminals and the internet, didn’t catch on at that stage, and the company never took off. It went belly up and I was lucky to scramble out with enough money to pay the banks back. From then on I thought I’d better revert to my Yorkshire instincts and be a cheapskate and a value manager.
Andrew Van Sickle: Having had your fingers quite badly burnt, you decided to take a very thorough look at stock market history and how human nature always ended up in these situations. And you constructed by hand, as part of your research, the first index for small-cap stocks?
Jeremy Grantham: Yes. We had to go back into the archives and put together an index going back to 1925. And what we saw were long periods of small-cap domination and long periods of large-cap domination. They ebbed and flowed in these multi-year cycles. And the interesting thing to me was that we were in a big “nifty-fifty” blue-chip cycle and small stocks’ valuations had become extremely depressed relative to the rest of the market. And so we put 100% of our money into small caps, which was so original as to be totally unique back in the day. Institutions didn’t dabble in small caps back then. They were beneath contempt.
And so we had a very strange portfolio that was difficult to sell. There were 99 rivals selling Coca Cola and there was one of us selling companies that no one had ever heard of. So it was at least entertaining. It amused the clients rather than anything else.
Andrew Van Sickle: So the idea was to seek out investments that people had overlooked, and you clearly enjoyed the number crunching – later your asset management group was one of the first to use a computer to keep doing so, wasn’t it?
Jeremy Grantham: Yes, it was painfully expensive, filled the whole room and created a lot of heat. But it did give us a little advantage for a year or two. And what we found, by the way, was that the numbers we’d hand-crunched were pretty accurate. And what was nice about hand-crunching numbers was that no one else did it. Whereas once we got a computer, everybody else did. Pretty soon, a computer was simply a cost of doing business.
And no one made a killing by having one, you just had to have it and pay for it, whether you liked it or not. This is, incidentally, getting ahead of myself, very analogous to AI. In five or ten years AI will be a cost of doing business. But it won’t be a way you get ahead. It will be a case of falling irretrievably behind rivals if you don’t use it. New technologies confer an advantage on the early adopters. And when it’s clear that they have an edge, everyone copies them and it goes away. But we’ll come to AI later.
Andrew Van Sickle: The notion of an early lead being eroded brings us to the issue of mean reversion, one of the principal themes to emerge from your research. What goes up must come down. This applies to corporate profits, which get competed away. Similarly, asset markets get euphoric, human nature being what it is; we overdo things on the way up and on the way down.
Bubbles blow up and burst, but one can never really tell when things will revert to the mean. What did it feel like in late Japan and late 1990s America, knowing that you were right to be bearish – because mean reversion is something unavoidable – but standing practically alone for years on end?
Jeremy Grantham: Well, it gave you lots of time to do more research, particularly in 1998 and 1999. We didn’t start to lighten up on US stocks until the end of 1997, when the trailing price/earnings (p/e) ratio reached 21, the same as at the peak in 1929. So it was an emotional point to reach. By the end of 1998, we were as light as we could get. And the p/e went all the way up to 35 by the peak. Japan was even worse, of course: the mother and father of all bubbles. The p/e had never eclipsed 25, and in 1989 it soared to 65.
Of course 35 wasn’t 65, thank heavens, or we would definitely have gone out of business. But conveniently at 35 the market beat a magnificent retreat and we were positioned for it, having doubled and redoubled our ante until there was nothing left to do, and we actually made good money.
To give you an example of how much of a bargain value stocks were around the market peak, consider real estate investment trusts (REITs). Properties were selling at a discount to replacement cost, and Reits were yielding 9.1%. The overall S&P 500 yielded just 1.5%, a record low. When the overall market slumped, Reits jumped by 30% amid a flight to safety and value.
Andrew Van Sickle: For your business it sounds like a race against time, with clients no doubt increasingly frustrated that you were sitting out the big technology-led gains of 1998 and 1999. They would have had the same perspective as Chuck Prince, CEO of Citigroup, in the credit bubble in 2007: “[As] long as the music is playing, you’ve got to get up and dance.” Do you think that if the bubble had burst a year later, you would have gone bust?
Jeremy Grantham: Yes, I think so. Incidentally, coming back to Mr Prince, George Soros’ take was that “Actually, the music had stopped, he just hadn’t noticed,” which was typically cruel.
Andrew Van Sickle: Did lots of people you spoke to at the time think it was a bubble, too, but just didn’t want to say so publicly?
Jeremy Grantham: That’s exactly right. We were a purely institutional firm dealing with lots of big pension funds. The hired guns in the pension funds usually had a lively understanding of how risky the market was. But their committees – made up of private equity and VC investors, and all manner of people who’d made lots of money and were very, very confident – insisted on going with the flow, and that anyone who didn’t was stuck in the past and should be fired.
The upshot is that the uncertainty surrounding the timing of bubbles is greater than the typical client’s patience. And that is all you need to know about institutional investing. Most of the engine-room players saw the bubble. It’s just that the marketing people and the bosses realised that scepticism was not a good business strategy.
If you are a big firm, you simply mustn’t bet on the bursting of a bubble. You have to go with everybody else, you have to be willing to run off the cliff, and you have to be willing to be professional and slick and quick, saving some money on the way down and redeploying it. If you do that, you will thrive. If you try to fight the bubble, well, you may get lucky, you may win one. We, in a sense, won the great financial crash. We explained it in quarterly letters. We prepared for it and we got out in a timely fashion and everything worked well. But if you get it wrong, watch out.
Keynes, just about my solitary hero in the economics business, said the key to investment life is never be wrong on your own. So you can be wrong in company and you don’t lose your job. Even being right on your own, he said, was dangerous in that they would pat you on the head if you won, but then describe you as an eccentric when you’d left the room. That’s not a great reputation to have. And he said that if you’re wrong on the downside, if the market doesn’t break and you were positioned for a bear market, “you will not receive much mercy”.
Andrew Van Sickle: Turning to the bubble of the moment, what is your take on AI and the market’s view of it?
Jeremy Grantham: In 100 years they’ll be writing about this point in stock market history as they write about the South Sea bubble. It is simply magnificent. The SpaceX prospectus was of the order of the famous South Sea bubble equivalent: “An undertaking of such profound importance but cannot at this time be revealed.” Just give us your money.
(Image credit: Spencer Platt/Getty Images)
Andrew Van Sickle: I was horrified to read that Isaac Newton went for the South Sea bubble. He should really have known that what goes up comes down.
Jeremy Grantham: He said something along the lines of: “I know a lot about the movements of heavenly bodies but nothing about human nature.” The SpaceX prospectus is unbelievable – mining asteroids and colonies on Mars and moving through space and a projection of revenue streams, 90% of which seem to relate to AI. And it’s not clear, of course, that SpaceX’s version of AI, which is at the moment having its bottom kicked around the block by Anthropic and the rest of the boys, is going to be around in the long term. Talk about tulips.
Andrew Van Sickle: You’ve said that you think excitement over the advent of AI essentially stopped the bubble of late 2021 deflating fully.
Jeremy Grantham: Yes, December 2021 met all the conditions of a bubble, we thought, and there was a slump in 2022. But for the first time in history, halfway through a bubble breaking, you come out with an idea that is so colossal and accompanied by so much capital expenditure that you change the game.
On that infamous day in late 2022, ChatGPT appeared and someone rang the bell and said: “All change.” And the rest of the market didn’t believe it for ten months, drifting down a bit. But by then the Magnificent Seven had doubled, and it dragged the rest of the market up.
I used ChatGPT, telling it to please summarise War and Peace in ten points, and then do it in German. And that was enough to make me realise that this was going to be impressive. It’s clearly better than anything else other than the railroads.
People don’t realise that the more obvious and important the idea, the more likely you are to attract too much capital and have a capital bust and a market bust. The railroads transformed our lives, they added enormous productivity, and yet they were so obviously going to do that, that everyone built too many railroads, and everybody lost their money. And that will happen in AI.
At present there are seven companies plus another 15 snapping at their heels. All are aiming at the same market, AI. The one that gets there first, they believe, has a licence to make more money than you could shake a stick at. More than anyone has ever made on anything. And they are all saying the main risk is not spending enough. We will spend our vast cash flows, they are saying.
They’re going to fight until someone survives. This could be the most vicious fight to the end that we have ever seen, starting now. In that sort of fight, they do not make lots of money and the stocks get crushed. And then they emerge out of the wreckage. Like the internet. Amazon declined 92% in the tech slump. And yet it then rose and inherited the Earth. The railroads rose from the ashes. And this will rise from the ashes.
Andrew Van Sickle: While investors take bets on who might survive, where are you finding value outside the US?
Jeremy Grantham: That was an easier question to answer at the beginning of last year. At that stage, valuations looked unremarkable and therefore priced to make a decent return. Since then, the S&P has gone up another 23% but that is nothing like the rest of the world, led by emerging markets. Emerging markets are up 60%. And value in Europe is up 45%. And these are very big gains over the S&P. The rest of the world now begins to look a tad overpriced, while the US has moved into “read all about it in 100 years” territory.
Andrew Van Sickle: We get the impression that Japan is certainly no longer cheap, although it’s probably reasonable.
Jeremy Grantham: Yes, reasonable, and it’s done very well. And again, it has handsomely beaten the S&P since the start of last year. The main thing that impresses a lot of people, however, is that even though the S&P may have been at the back of the pack in the last 18 months, it still went up handsomely, and so it’s created the impression that, therefore, it defies the pull of gravity.
And this feeling that it will go on forever is, of course, absolutely classic. That’s exactly how people wrote and thought in 1929 and how they wrote and thought in 2000. This time is not different.
Of course, people hate you if you say this. They are so involved in making money they loathe the notion that the whole thing is a mass delusion. Perhaps they hated me more in 2000, but it’s getting close. In the comment section of a recent podcast, three people said that my ears were big. And of course they are big. It’s just that people don’t usually say so after the age of seven or eight.
Andrew Van Sickle: I don’t suppose the boy pointing out the emperor was naked was very popular either.
Jeremy Grantham: I don’t know. The episode wasn’t recorded.
This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.
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