Jeremy Grantham On Financial Crisis And Where To Next
This morning, a piece appeared on the CNNMoney.com website in which Money Magazine reporter Joe Light and senior writer Janice Revell spoke with legendary investment investor Jeremy Grantham. The conversation took place back in mid-September, at which time the GMO chairman answered a number of their questions:
In retrospect, there were plenty of signs pointing to the serious and growing problems in the financial system before everything seemed to fall apart at once. Why didn’t anyone, on Wall Street or in Washington, take action sooner?
Jeremy Grantham: We got so good at denial. The Fed was in denial, the Treasury was in denial, the bosses of Merrill Lynch and Lehman were in denial. And yet this crisis was the most widely heralded “surprise” in the history of finance - there were plenty of people warning that it was going to happen long before it did.
You were one of them. What did you see that bothered you?
Grantham: All you had to do was open a history book and see what happens when you have a bubble. In this case, there was a bubble in housing and there was a magnificent bubble in risk taking. People were just shoveling their money into risk on the pathetic idea that risk is always rewarded.
That is completely misguided. You don’t get rewarded for taking risk; you get rewarded for buying cheap assets. And if the assets you bought got pushed up in price simply because they were risky, then you are not going to be rewarded for taking a risk; you are going to be punished for it.
You can lay the evidence in front of everybody, but they will yawn and ignore it. It’s that denial that’s impressive. It’s what happens in bubbles.
How much at risk were the financial institutions involved? That is, was this degree of intervention really necessary?
Grantham: Leverage is the ultimate demonstration of risk, and we never had system-wide leverage like this before. Ever. We had several firms that were leveraged 30 to 1. [For every $30 of assets on their books, they put up $1 of equity and borrowed the other $29.] At leverage of 30 to 1, you have to lose only about 3% on your $30 worth of assets and your dollar of equity gets wiped out. You’re bankrupt.
Why would those financial firms take on such extreme risk?
Grantham: They believed their risk models, which said they had a diversified portfolio, so their investments couldn’t all go down together. And the potential rewards were out of whack with the risk.
Say you’re in the hedge fund division of some investment bank and you have a billion dollars to invest. You hit the ball out of the park, make 120% on that billion and probably walk away with a $45 million bonus. If you lose the billion dollars, you’re fired. Hey, that’s not bad! If I thought the odds of success were fifty-fifty, I’d be a fool not to try.
What can the past tell us about where the stock market is going next?
Grantham: Historically, when a market bubble has popped, it has almost always overcorrected. But after the tech bubble burst in 2000, the stock market didn’t hit the lows it should have.
Before it could, the housing bubble and tax cuts that followed 9/11 kicked off the biggest sucker rally in history, from 2002 to 2006. So I think the market isn’t cheap yet. There is more pain coming. I don’t think we’ll hit the low until 2010.
What’s your advice to investors now?
Grantham: Understand that the market may recover for a while and then go to a new low. One of the lessons I have learned over the years is that things can get a whole lot more extreme, both up and down, than you ever dreamed of. So we may drop another 30% before we hit bottom.
Keep telling yourself every night that you’re a long-term investor and don’t look at daily stock prices. And it’s not too late to shift some of your money to high-quality blue chips. Emerging markets are probably no longer too expensive either. If you had 80% of your stockholdings in blue chips and 20% in emerging markets, you’d have a pretty reasonable portfolio to ride out the bad times.
Source:
“A little perspective, please”
Joe Light, Janice Revell
CNN Money, October 10, 2008
