Most Popular ArticlesJune 2, 2009
P/E ratios and presidential election cycles
Understanding herding is central to forecasting price movements, but it is not the only cause of mispriced markets. Grantham closely monitors P/E ratios and profit margins which, in a rational world, would be inversely related – when margins are high, P/E ratios should be low, and vice versa. That has not been the case, as the two variables have a positive correlation of .32. “The market can’t even get the sign right,” Grantham said.
During the five years ending 2007, GDP grew at a faster rate than at almost any time previously, mostly driven by the BRIC economies. But P/E ratios remained elevated. Conversely, in 1982 profit margins were at their nadir, but so were P/E ratios.
Presidential election cycles strongly influence markets. Grantham showed that US markets have registered inflation-adjusted total performance of -3.4%, -10.1%, 15.3% and -0.3% in years one, two, three and four of presidential terms since 1932. His explanation is that by the third year in office, US presidents have figured out what is important and actually get it done. In tandem, the “completely independent” Fed makes money freer and rates lower, but this alone does not drive the 25 percent difference between years two and three. In addition, investors benefit from moral hazard; if they speculate in years one and two, they lose. But by year three, presidents will bail them out, even if inadvertently so.
Overall, Grantham respects the power of the Fed, which he said “rules the way everywhere and is the dominant force in the world.”
Seven lean years and the risks ahead
Where are we today? “Global equities are within noise levels of normal,” Grantham said, which is the case only about 20% of the time. But he is not willing to commit to normal equities allocations, because of a series of fears which he collectively labeled the “seven lean years” – “a series of long, slow burning negatives.”
Grantham’s concerns begin with the big imbalance between over-consuming countries, such as the U.S. and the U.K., and over-saving countries – Japan, China, and Germany. As a result, the great deficit created by the U.S. has flooded the market with dollars that have been monetized, creating deficits elsewhere around the world.
Grantham lamented that consumers are not as rich as they thought they were, as a result of the residential housing and stock market collapses, which he fears will be followed by a collapse in the commercial real estate market over the next six months. “We missed a decade of savings,” he said, which will not be recovered. “We just have to work longer and learn to have a more frugal retirement.” Frugality will be an important theme for investors, as he believes vendors like Wal-Mart are far better positioned than luxury providers like Mazeratti.
Our political and financial institutions have done a “disastrous” job of managing the crisis, and the loss of confidence in these institutions will erode growth. Grantham called out the Fed, Treasury and SEC for encouraging crime, such as when they beat back attempts by the Chicago Board of Trade to control subprime lending.
Grantham cited the adage that capitalism works best when there is a policeman on the corner, but the policeman was taken away when the Glass-Steagall Act was repealed in 1999. He faulted former Fed Chairman Alan Greenspan for encouraging this repeal, which Greenspan said would increase the safety of the financial system.
For Grantham, no failure was as great as that of political leadership during the peak of the housing bubble. “The housing market had been a flat plain that rose to a Himalayan peak,” Grantham said. While he and others warned of a bubble, Bernanke said that the U.S. housing market merely reflects strong demand. “I have no idea what he was thinking, other than the possibility that he believes so much in market efficiency that bubbles are impossible,” Grantham said.
As for former Treasury Secretary Henry Paulson, Grantham said he – more than anyone – understood the inferior quality of the securitized debt instruments. Paulson should have “done some arm-twisting” early on, before AIG ran into trouble, and forced institutions to raise capital. Paulson should have delivered an ultimatum: raise capital and be the government’s friend or else institutions would be on their own.
In April of 2007, when Paulson said “the subprime problem seems to be contained,” Grantham wrote in his quarterly commentary at the time that the container is likely to be Pandora’s.
“Our institutions have been incredibly badly led and it should make us nervous about the future,” he said.
Next on Grantham’s list of worries is a scarcity of resources, which include demographic shifts which are shrinking our workforce to the depletion of raw materials, all of which will squeeze profits.
“China and India together have caused us to enter a new era,” he said. Real prices of commodities are rising, following decades of decline. “We are running out of everything.” He believes there will be plenty of cheap energy, since higher prices spur the development of new sources. But supplies of every mineral, oil, coal and arable land will run out, after which “we will be on our own using our brains.”
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