Money and Finance

Bubbles, Jobs and Investment Tips: Jeremy Grantham visits Wharton

"Career risk and bubbles breaking, that is all that matters."

This was how Jeremy Grantham, cofounder, Chairman and active member of the asset allocation division of GMO, began his presentation to Wharton students on February 17, 2009.

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So how does Mr. Grantham feel about how most universities cover market efficiency? He began to address this topic by saying "science advances one funeral at a time," which was a famous statement made by Max Planck, the late German physicist. Mr. Grantham continued by commenting on how a University of Pennsylvania alumnus, Mr. Charles Kindleberger, once claimed that academics too often ignore the facts in defense of a theory. This makes sense given that Mr. Kindleberger was an economic historian. In fact in his book Manias, Panics, and Crashes, he relied on narrative exposition and knowledge of history rather than mathematical models to prove his point.

Like Mr. Kindleberger, Mr. Grantham also relies on history when trying to make sense of the markets, but he utilizes quantitative and statistical means to support his claims. One such claim, made about ten years ago, was that we were in a massive bubble. This claim was indeed accurate, as the tech boom ultimately came crashing down, but not to where GMO forecasted it would. It was only after the most recent crisis, the one we are all experiencing now, that their forecast came to pass. Mr. Grantham explained that all bubbles follow a similar path: they are all mean reverting. From his calculations, he found twenty seven "bubbles" in history. According to efficient market theory, this is completely valid, as this number coincides with what academics refer to as "random events".

Where Mr. Grantham and the academics differ, however, is how these bubbles act when they pop. According to the market efficiency theory, all movements in the market are random and thus when a bubble pops, the market should follow a random walk (i.e. sometimes the market will go up, while other times the market will go down). But from Mr. Grantham's calculations, each of the 27 bubbles he studied "nose-dived back to the mean". The one exception, as noted above, was the tech bubble. When this bubble popped it did not revert back to the mean in 2003. Mr. Grantham claimed that this was due to two historic events, 9/11 and Alan Greenspan's decision to lower interest rates to the point where real rates were negative, which ultimately led to increased borrowing (surprise, surprise!). According to Mr. Grantham, these two events helped create "the biggest sucker rally in history".

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Despite the harsh realities of the investment management industry, Mr. Grantham did leave us with some hope. His estimate of fair value for the S&P 500 is 900, so with today's closing value of 752.83 (on 2/26/09), we should all be cautiously returning to the markets. His forecast for real market returns is seven to ten percent. He also thinks that oil is a good investment in the thirty dollar range, and in the very long term, it might be a good idea to look to emerging markets. He did also tell us that the hedge fund industry will implode and the private equity industry is doomed, but for now, let's focus on the positives.

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Related book: Manias, Panics, and Crashes: A History of Financial Crises
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Related previous post: GMO - Jeremy Grantham's 4Q 2008 Letter (Parts 1 & 2)
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Other, bubble-related books:
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A Short History of Financial Euphoria
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Tulipmania
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Panic of 1819
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The Panic of 1907
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The Great Crash of 1929
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The Go-Go Years
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Bull: A History of the Boom and Bust, 1982-2004
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Speculative Contagion
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Mr. Market Miscalculates
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