GMO
Quarterly Letter
Jeremy Grantham, Chairman
Stocks Have Rallied And Will Now Return Less.
Hip Hip Hooray! But Now What?
The Strangely Different Responses to Higher Prices
by Stock and Bond Investors
The second quarter was a good one for bonds, especially
junk and emerging country debt, and a sensational one for
global equities, with the S&P 500 up 15%, EAFE up 19%
and emerging countries up 23%! It was a good time to
compare how bond and equity investors react to price
increases.
The strong rally in bond prices, on one hand, has been
greeted with justifiable dismay by bond and asset
allocation investors as it lowered the available yields and
took away reasonable long-term investment options and
replaced them with fears of the capital losses that will
occur when yields move higher at some uncertain future
date. At GMO, for example, we loved inflation protected
government bonds (TIPS) in early 2000 when they
yielded 4.2%. We argued that 4.2% was so attractive at
zero risk that we were highly likely to see a capital gain
as the yields came down to the 2.7% to 3.0% range that
we saw as reasonable in the long term. Not only did this
yield reduction happen, but the yields kept on falling
right through our view of fair value to today’s much less
satisfactory return of 2.0%. (Efficient market believers
please explain.) Ben Inker and I, and most proponents of
investing in TIPS, are heart broken to lose this wonderful
investment and are only partially consoled by having
made so much money in them by overstaying our
legitimate welcome. This pushing of our luck in TIPS
was partly because of the increasing lack of fairly priced
alternatives and partly because of the inertia we built long
ago into our asset allocation moves. The same logic
applied in a lesser degree to all fixed income, but both
these factors have their limits, and late last year and early
this year, metaphysically cursing and swearing
(sentiments that seem to be broadly shared by fixed
income professionals), we eliminated our huge
overweight in now overpriced fixed income.
July 2003
The regret at lost opportunities and the resulting
reduction in the size of the asset class bet seem absolutely
normal to me. An asset class rallies in price and the
imbedded return drops. A wonderful feature of bonds is
you have to try very, very hard to miss this point. Not
only did the real (after inflation) return drop by 60%, but
the near certainty of a substantial capital gain was
replaced by the near certainty of a capital loss.
What then are we supposed to make of the response to a
25% rally in the U.S. market? Far from being seen as an
increasing risk or even as a lost or reduced investment
opportunity, it is seen, nearly universally, as an
unmitigated good. Individuals, net sellers of mutual
funds at 775 on the S&P in October, are now heavy
buyers at 1000. Newsletters and other advisers are at a
multi-year high in optimism about future equity prices.
(Yet stocks, like bonds and indeed every other asset class,
share the characteristic that at higher prices you get a
lower return.)
Why does this disparity exist between the dismay of bond
investors to higher prices and the joy of stock investors to
higher prices? Partly, I believe, it is an after effect of the
great bull market in stocks and Greenspan’s logic that
permanently high productivity might justify permanently
higher p/e ratios, not yet by any means out of our
collective system. More particularly, the math is so
simple and compelling for bonds that no reasonable
person can miss it. For stocks, the logic of growth versus
yield is not so clear.
The Economy
The economy, however, has continued to take my last
eight quarterly letters to heart by being intermittently
disappointing. It has continued to move up, but on a path
that varies from perfectly adequate in some quarters to
obviously sluggish in others, such as the first quarter this
 year at 1.4% GNP growth. In total, as suspected, the
economy is still suffering from the overhang of debt that
is too high everywhere, personal savings that are too low,
and the previous capital spending boom.
This is in fact the worst recovery from a recession in at
least three ways. Excess capacity, for the first time, is
greater today than when the recession appeared to end
and in fact lower than all but 5 quarters in the last 25
years. The number of jobs has dropped since the
recession ‘ended’ for the first time and real wages have
been flat. Capital spending is still falling on a year over
year basis. With these pressures, it is not surprising that
profits have been disappointing when compared to what
was expected a year ago for the first half of 2003. Indeed,
it is remarkable, and I believe suspicious, that the S&P
500 companies are claiming that today’s profit margins
are normal on a percentage of sales basis. (The profit
margins declared to the IRS remain very subnormal. The
estimate of total corporate earnings from the national
income accounts also remains below average, and the
gaps between the claimed corporate operating earnings
and the other two series remain at record wide levels.)
So on one hand, we have a classic third year presidential
effect: a rising stock and bond market supported by
stimulus, particularly low rates, and plentiful availability
of funds, with little competition for funds from
corporations facing weak sales and excess capacity, with
a resulting flow of money to financial assets. On the
other hand, we have a sluggish and disappointing
economy and earnings that typically follow a major
economic and stock market bubble, combined with an
overpriced market. The net effect is that we expect a
continuation of intermittently disappointing GNP
growth and earnings, but not disastrously so: remember,
last week’s average GNP estimate – by 50 economists in
The Wall Street Journal for the next 12 months – was
3.7% real growth. There is plenty of room there for
muddling through okay while still being disappointing.
Asset Allocation: Fortune Favors the Virtuous
Prompted by the extraordinarily good performance of
fixed income and its cousin, the REITs, in the 3-year bear
market, we sold our overweighted fixed income positions
down to parity late in the fourth quarter and early in the
first quarter, having held the maximum overweight
possible for 6 years, typically 15% points overweight.
REITs were also reduced to 1/3 of their peak overweight.
Impressed by the uniquely wide gap in value between
U.S. equities and non U.S. equities (the widest in at least
GMO Quarterly Letter – July 2003
50 years), we moved all of the 15% to non-U.S. equities
with a twin emphasis on emerging countries and small
cap developed.
Almost uniquely, in our experience, non-U.S. equities
outperformed the S&P 500 even as the S&P rallied 15%
in a quarter. The normal experience would be to have
foreign stocks deliver 1/3 to 2/3 of the U.S. performance
in a very strong quarter like this one for the U.S. This
time, the S&P 500 lost to EAFE by 4% and emerging by
8%. This extremely favorable outcome for GMO and its
clients generally allowed our allocation accounts to win
in a rally despite having won in three consecutive down
years. Partly, this was the fortunate timing of our rapid
sale of fixed income (unfortunately, asset allocation is
simply not that precise a business usually) and, more
importantly, it was due to a spectacular weakness in the
dollar that favored our foreign accounts by over 8% this
year and over 15% since early December last year. Yes,
we budgeted for 15%—2% a year for 7 years was in our
budget. We just did not expect this entire 7-year forecast
to occur in 7 months!
There is usually a worm in any apple this good and the
bad news now is that all of the best investment ideas have
performed the best and have lost all or some of their
attractiveness. There has probably not been a time in
my 35-year career when asset classes in the U.S. were
so broadly unattractive. This is typically the case in a
great bull market but was wonderfully not the case this
time. In March 2000 there were many places to hide with
many cheap asset classes in which to make money. Now,
bonds globally are expensive and value and small in the
global markets have done their job and are now in line
with the rest of their markets. Our beloved REITs have
gone from extraordinarily cheap to slightly above fair
price and their near-term fundamentals look awful. Only
foreign stocks look reasonable, at or close to fair value.
And the usual reflex to fill a portfolio in this situation,
which is to hold cash, is met by most of us with a cold
shudder at the thought of knowingly investing at a
negative real return.
What Is Left, if Anything?
Exhibit 1 shows our relatively new exhibit on our 7-year
asset class forecasts. The top line shows the real returns
(after inflation) that we expect from each asset class at
fair value. The numbers are unusually uncontroversial,
agreeing with most consultants and other sources, plus or
minus a few basis points: 5.7% real from stocks and 3.0%
real from bonds giving a “risk premium” of 2.7%. The
2
Exhibit 1. Equilibrium Returns versus GMO Forecasts

US US Int’l Int’l
Large Small Large Small Emerging US
Caps Caps Caps Caps Equities Bonds
8%
Real Returns at Equilibrium 6.7% 6.7%
6.2%
Prices (Fair Value) 5.7% 5.7%
6%

4% 3.0%

2%

0%

10% 5%
Immediate Gain or Loss from 3%
0%
Hitting Fair Value Tomorrow 0%

-10%
-9%
-20%

-30% -25%
-31%
-40%

8% 7.4%
Expected Real Return From 6.7%
5.7%
Hitting Fair Value in 7 Years 6%

4%

2% 1.4% 1.2%

0%
-0.6%
-2%
As of 6/30/2003

incremental return from owning riskier small caps and
emerging country stocks is a reasonable extra 1% a year.
The problems start in row two which shows the move that
would have to occur tomorrow, in our opinion, to move
mispriced asset classes to normal fair value (or trend line
price).
Row three amortizes the pain of being overpriced and the
pleasure of being cheap evenly over 7 years and is our
usual 7-year forecast. Seven years is picked because
market asset prices have historically passed through fair
value every 6¼ years and we wanted to be conservative.
The bad news is that bubbles breaking take about the
same time to deflate as they took to move above trend,
which was mentioned in my December 2002 letter. This
means that it is very likely that U.S. stocks will move
back to the trend line (and fair value) of just under 700 on
the S&P 500 sooner than 7 years: 1 to 3 years from now
would be a much better guess historically than 7 years.
But, staying with our more conservative 7-year forecast,
it is readily apparent from rows two and three that U.S.
stocks and bonds are badly overpriced and foreign
developed and emerging country equities are priced at
fair value. This is the biggest deviation between the two
equity blocks in history and is the backbone of our
current asset allocation positioning.
What this all boils down to is that the best we can
recommend to investors is to own as much foreign and
emerging as you dare within equities and own as much
cash as you can stand within fixed income, or where
possible own conservative or market neutral type hedge
funds designed to outperform cash by a few percentage
points or more. Finally, consider forestry as a different
and defensive investment.
A Good Time to Consider Forestry
Exhibit 2 shows the updated version of my favorite
forestry exhibit. First, it shows that for 92 years the price
of timber beat the price of a share of the S&P 500 in a fair
fight. But highlighted in this exhibit are the timber prices
in the great market declines. We have used this exhibit
for several years to make the point that in the three great
bear markets of the 20th century, the price of timber,

3 Quarterly Letter – July 2003 GMO

 Exhibit 2. Real Growth in Stumpage Price vs. S&P 500 in Bear Markets
100.0
Southern Pine
S&P 500 Index
Price Index (1910 = 1), Log Scale
10.0
1.0
0.1
1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
according to the U.S. Forestry Service, rose. When the
stock market rose in the past, timber happily had a
slightly positive correlation, rising a little. But in these
three great declines, it had a strongly negative correlation,
actually rising in all three of these over 50% U.S. equity
declines. Now we have the first great bear market of the
21st century and once again the price of timber stayed
steady in a 50% equity decline!
In addition to the price, there is also yield. The yield on
the S&P 500 averaged 4.5% over 75 years but is currently
below 2%. The yield on forestry averaged 6.5% and is
currently about 6.5%.
The reasons for the outperformance of a very
conservative asset class relative to the risk in equities are,
I believe, very straight forward. It is a non-traditional
investment that most of your peers will not be using,
giving it substantial career risk. It is also illiquid, needing
to be locked up for 10 years. These are probably the two
pet hates of institutional investors (even though it seems
a bit irrational), and each of these characteristics is worth
a couple of extra points of return. So an asset class with
highly desirable portfolio attributes yields 8% or 9% real
instead of the 4% to 5% real that finance 101 (which
notoriously cares little about behavioralism) would
GMO Quarterly Letter – July 2003
As of 12/31/2002. Source: U.S. Forest Service and Standard & Poors
suggest. So for those with both a long time horizon and
a willingness to have some illiquidity, it seems as close to
a free lunch as exists. At a time when the alternatives are
so wretched on a 7 year horizon, it seems a particularly
good time to consider a timber investment.
The Third Year of the Presidential Cycle: an Update
I described the third year of the Presidential Cycle in my
December 2002 letter, "Predictive ‘Entrails’ and the Case
for a Time-out in the Great Bear Market" as a very bad
year for short sellers to try to be heroes. The third year
has an average of 17.2% real return since 1932 (compared
to an average below 3% for the first 2 years) and has only
two small declines. It can be described as the King Kong
of bullish factors. The Godzilla factor of bear market
factors, however, is the aftermath of a major bubble
breaking, which has historically made it difficult to
sustain a major rally until the market is very cheap, which
in January it clearly was not.
The Presidential third year is bullish because of the
amount of fiscal and monetary stimulus that the
administration of the time attempts to pack into it. This
year has been a doozy for stimulus with the rate cuts to
40-year lows, strongly negative real rates, and a large (if
4
inefficient) second round of tax cuts. The Fed also made
as blatant a promise as has ever been made to uphold the
principle of moral hazard, suggesting last week that it
would keep interest rates low for a long time. This, in
turn, offered the hope that investors could leverage
portfolios without too much risk. So determined is the
language and action of the Fed to keep rates low and
money flowing that Stephen Roach of Morgan Stanley
suggests that Greenspan is in the business of producing
“chain linked bubbles” (a mixed metaphor if ever there
was one, but one that still works beautifully). The future
possible bubbles we are risking are in long bonds and
housing. But for now, despite reservations about the
future, King Kong has won, the market has done well,
and although the year is far from over, an up year seems
very likely.
It is interesting to note that the U.S. Presidential Cycle is
so powerful that it exists in Europe. In the U.K. it is
particularly powerful: since 1932 the average of the first
2 years of the American presidents’ terms has been 3.9%
and the average for the third year an astonishing 19.0%!
The Prime Ministerial Cycle, on the other hand, is
completely non-existent. The only thing left is to become
the 51st state. In the whole of Europe, since 1970, the
comparable numbers are 4.6% and 16.8%. It’s a strange
world in which U.S. politically driven stimulus programs
would have such a broad impact, but that’s the way it is.
As a longer-term bear it is probably appropriate for me to
admit how ‘healthy’, in a traditional sense, this second
quarter rally felt. Each of the three prior rallies were
classic bear market rallies in that they were dominated by
the favorites from the late, great bull market, tech and
growth stocks in particular, with value stocks left far
behind. This turned in the second quarter as value stocks
outperformed growth by 3% and the Russell 2000
outperformed the S&P 500 by over 8%. A rally this broad
led by a different type of company is what you look for in
a new bull market. In this sense, any market historian has
to treat this rally with respect. For historians, though, it
lacks just one, unfortunately cosmically important
characteristic: this rally emphatically did not start from a
cheap level, bottoming at 19 times adjusted trailing
earnings compared to a trend line 16 times. The animal
spirits and unrealistic high hopes of the great bubble had
been substantially reduced but had not been by any means
totally crushed. This rally is driven by Greenspan and
Bush, by availability of cash at give away rates, and tax
stimulus. It is unusual, but not amazing in these
circumstances, that this rally has felt so impressive. But
5 Quarterly Letter – July 2003
for a major and sustained rally to start lacking cheapness
following the breaking of a major bubble would rewrite
the history books. (With a hit rate of 27 out of 27 major
bubbles retreating all the way to trend and below, we
recognize the possibility of a new bull market, but only as
a very remote possibility.)
The fourth year of the presidential cycle is also strong up
to the election, although it does not have the same heroic
success rate as the third year. The strength of this year’s
stimulus and the strong historic record of the fourth year
make me believe that for the next 15 months, predictions
are unwise and that anything can happen, including the
U.S. stock market holding or adding to its gains. This
would make this rally one of the best bear market rallies
in history and perhaps the very best, but one with good
reasons to explain it. However, I would also not be
totally surprised to see a substantial decline from current
levels in this 15-month period in the face of overpricing.
The greatest short-term danger would be if the
intermittent disappointments in GNP growth,
employment, wage rates, and corporate earnings were to
take an unexpectedly severe decline, which is quite
possible. So, a toss up.
The Cliff and the Lemmings?
2005 and 2006, however, are a completely different story,
and the odds are far longer against a decent stock market.
In the first 2 years the administration typically looks to
put its house in order and this particular house is pretty
disorderly and very overpriced. That the bear market
should take this kind of time may seem unusual, but it
absolutely is not. Quite the reverse is true as, after a great
bull market, taking 6 or 7 years to hit the low for the cycle
would be very normal. If the market p/e is still up at these
levels towards the end of next year, it will present a
glorious opportunity indeed to take evasive action – for
us lemmings to stop at or near the cliff edge and to think
better of it.
GMO Second Quarter Performance
This was definitely one of our best (and luckiest) quarters
in 25 years, with broad based outperformance in
individual U.S. and foreign equity funds, asset allocation,
fixed income, and hedge funds, all in the face of a 15%
move in the S&P 500 and the usual GMO bear market
bias that exists in everything we do. It doesn’t get much
better than this and if we made any Faustian bargain with
the devil, I’m happy to say it wasn’t me who signed the
contract!
GMO