The following is an excerpt from the quarterly newsletter of Jeremy Grantham, Chairman of the Board of Grantham Mayo Van Otterloo LLC. To read the full newsletter, please click here.
In 2010, value purists will have to struggle increasingly with the Fed's continued juicing
of the markets. In order to control real risk – the risk of losing money – they will be forced to take the increasing career and business risk of lagging a rising market.
Our choice – by no means a “solution” – is to only very slightly underweight global equities on the grounds that, when tilted to quality, they are still adequate in terms of return potential. We also have to swallow our distaste for parking the rest in unattractive fixed income.
And if the equity markets are indeed driven higher in the next six months, which, unlike my view of last summer, now looks to be at least 50/50, we will very slowly withdraw equities: eight times bitten, once shy, so to speak, for in these situations we typically beat a much too rapid and enthusiastic retreat. If we do see a substantially higher market in the next few months, we will probably underperform, but likely not by much.
There is perhaps, though, one saving grace: the risky stocks have already been driven to extreme overpricing. Further attempts to drive the market higher (they may not be deliberate attempts, but does it matter?) will probably result in a much broader advance in which high quality stocks should hold their own or even outperform.
Believe it or not, they can outperform on the upside, and these times tend to be: later in bull markets, or when they are relatively cheaper than the rest of the market, or both. (More quantitatively, high quality stocks have outperformed in more than 40% of up months and approximately 60% of the time when they were relatively very cheap, as they are now.) For the record, they also outperformed in 1929 and 1972, at the end of the first two great bull markets of the 20th century, and held level in 1999. In a continuing rally, even level pegging for quality would be a great improvement over 2009. And, if the market surprises me and goes into an early setback in 2010, then quality stocks should outperform by a lot. What could cause an early setback would be some random bunching up of unpleasant seven-lean-years data: two or three bad news items in a week or two might do the trick. This would suit me – cheaper is always better – but given the Fed's intractability, it seems less likely than some further gains.
For the longer term, the outperformance of high quality U.S. blue chips compared with the rest of U.S. stocks is, in my opinion, “nearly certain” (which phrase we at GMO traditionally define as more than a 90% probability).
