Jeremy Grantham of GMO is a must-read for all investors. He releases a quarterly update (drumroll, please!) 4 times a year. The link requires free registration. He hits on some great topics in this quarter’s update. I’ve included my favorite sections below with some random thoughts.

5. Small Arguments with Two Heroes

First, Warren Buffett. At about 950 on the S&P on October
16, he announced that he was a personal buyer of U.S.
stocks because they were cheap and their prices reflected
widespread fear. This is not typical for him, but he certainly
did it in 1974. When he said it back then, every stock in
our portfolio at Batterymarch yielded almost 10%! The
portfolio P/E was below 7.5x. Even with hindsight, if you value the market in 1974 using our current methodology it was very much cheaper than it is today at 950, which is what we calculate as almost precisely fair value.

His recent announcement made the market seem so much
more exciting than boring old fair value. So what are the
possibilities? Was he performing a civic duty? Certainly,
animal spirits are a critical component of any recovery,
so encouragement to take risk from an authoritative
source makes perfect sense. Does he believe that 1974-
type cheapness can never return, or is very unlikely
in this particular case? If that were the argument, we
would disagree; we suspect that cheaper prices are not
just possible but probable, although admittedly far from
certain. Has he perhaps a tactical market timing model
that produces his obvious excitement, despite these
ordinary values? Most unlikely, given his style. Or are our
numbers wrong? Perish the thought! In any case, it is all
an interesting conundrum.

Second, Nassim Taleb and the Black Swan logic,
which I have previously admired in public. Taleb is
completely dismissive – in a way only he can be – of any
near certainties. He implies that we have just suffered
from an outlier event crashing up against standard risk
modeling that only assumes that events will occur in an
approximately normal way. He argues that modeling the
95% or 99% normal range in Value at Risk (VaR) misses
the whole point: that the real game is played out in the final
1%. It’s hard to disagree with this criticism of VaR, but is
it relevant in this case? Was the recent breaking of our
credit and asset bubbles a totally unpredictable outlier?

We believe that we live in a world where bubbles routinely
form and where there are – in complete contrast to Nassim
Taleb’s belief – some near certainties. One is that bubbles
will break. Bernanke should not have said, “U.S. house
prices have never declined,” thus implying that they never
would. He should have said, “Never before has a three sigma,
1 in 100, U.S. housing bubble occurred, and be
advised that all such analogous bubbles in other asset
classes and in housing in other countries have always
burst.” (Robert Shiller for the Fed! He would have said
almost exactly that.) The bursting of the U.S. and U.K.
housing bubbles, the profit margins, and the risk premium
in global asset prices were all “near certainties.” This was
a White Swan, a particularly White Swan. Taleb’s work
will no doubt be correct when we have a genuine Black
Swan, but this was most definitely not it. (Okay, Nassim.
I can hear you thinking: this guy Grantham is a complete
loser who has obviously missed my entire point.)

Current Recommendations
Slowly and carefully invest your cash reserves into
global equities, preferring high quality U.S. blue chips
and emerging market equities. Imputed 7-year returns are
moderately above normal and much above the average of
the last 15 years. But be prepared for a decline to new lows
this year or next, for that would be the most likely historical
pattern, as markets love to overcorrect on the downside after
major bubbles. 600 or below on the S&P 500 would be a
more typical low than the 750 we reached for one day.

In fixed income, risk finally seems to be attractively
priced, in that most risk spreads seem attractively wide.
Long government bond rates, though, seem much too low.
They reflect the short-term fears of economic weakness
and the need for low short-term rates. We would be short
long government bonds in appropriate accounts.
As for commodities, who knows? There were a few
months where they looked like a high-confidence short,
but now they are half-price or less, and are much lower confidence
bets.

In currencies, we know even less. It is easy to find
currencies to dislike, and hard to find ones to like. There
are no high-confidence bets, in our opinion.
For the long term, research should be directed into
portfolios that would resist both inflationary problems
and potential dollar weakness. These are the two serious
problems that we may have to face as a consequence of
flooding the global financial system with government
bailouts and government debt.

Footnote on the January Rule and
the Presidential Cycle
In January 2008, I pointed out that the market had started
the year with the worst five days ever recorded, and that
the signal was “both impressive and bearish” in that down
Januaries materially increase the probability of a down
year. Well, that turned out to be a useful tidbit: “Worst ever
fi ve days predict worst-ever year! Read all about it!”
This year the fi ve-day return was up a bit (saved by the
last two hours), but the six-day return was down quite a
bit. Ho hum.

The Presidential Cycle, as written about previously, has
been completely ruined by Greenspan. He over-stimulated
during the fi rst two years, which are meant to be the
time for tightening up, not only in 1997 and 1998, but
also during this past cycle in 2005 and 2006. Both times
this caused an extra-speculative surge in the typically
stimulative Year 3s, in 1999 in the NASDAQ, and in 2007
in housing prices and ugly fi nancial instruments. Both
surges set off collapses during the critical election years,
which are meant to be stable. In the coming Year 1 of
the new cycle, we should be squeezing credit a little and
tightening budgets so that we can re-stimulate in 2011 for
the next election. What a joke! 2009 will be the greatest
stimulus year ever, let alone in a normally restrictive
year. So for the time being: Presidential Cycle – Rest In
Peace!

It’s interesting to note that neither Grantham nor Buffett have ever invested in a market like this.  As Richard Russell said in a recent Dow Theory Letter, Buffett is a spring chicken.  He’s “too young” to understand a market like this.  Russell, at the ripe young age of 84 actually lived through the Great Depression in New York and vividly remembers and recounts in his letters about the way things were.  It’s not surprising then, that there are very few investors who predicted or understand this market.  Russell, to his credit, became very bearish in November of 2007 (around the same time when I became very bearish).  Grantham, always a bit of a skeptic, had been predicting this mean reversion for years so saying he has been both wrong and right is not far off.

The Nassim Taleb commentary is particularly intriguing to me because it hits home.   I essentially agree with Grantham here.  Much of my market methodology is based on similar theories that Taleb uses, however, I have come to a much different conclusion. Essentially, Taleb will tell you that you can’t diversify risk out of a portfolio.  I find that to be a rather absurd comment and my performance throughout this bear market, although not as strong as Taleb’s,  gives credence to my side of the argument.

Complex dynamical systems are not predictable.  Taleb is 100% correct in this assertion, but that does not mean it is impossible to avoid black swans. As I often say, the money management business should really be called the risk management business.  Unfortunately, modern portfolio theory has led the sheep to the slaughter.  The inability of investors to think outside the box, understand the instruments they’re investing in, and more importantly, understand the complexities of the system in which they invest is often absurd.  95% of investors do not even understand what beta is yet they blindly invest 60% of their portfolio in stocks and 40% in bonds because that’s what the owner’s manual says (I am generalizing here of course, but you get the point).  And 95% of the 5% who do understand absolute return strategies do not know how to properly control and implement it in a portfolio.

The final section on the January Effect and the Presidential Cycle is also intriguing.  I often refer to such “strategies” as pure data mining.  No real statistician would take such a small data set and give it any credibility, but for some reason, these strategies are wildly popular among stock market investors.  Only in the stock market do such insane statistical strategies carry any weight.  Interestingly, understanding what the herd is thinking is an important element in markets so these “strategies” are important to understand, but not necessarily to use.   And I’m rambling….

Great stuff from Grantham.