History points to risky assets for October: Grantham

The old maxim, “sell in May and go away” appears to hold true again this year, but investors with a taste for risk might want to hold their cash until October, according to Jeremy Grantham, co-founder and chief investment strategist at GMO.

That’s when market enters the “year three boom” — marked by heightened speculation and gains — as seen in past cycles.

The current market travails are not unexpected, as the first and second year of a U.S. presidential cycle are historically marked by bear markets, he said. This should correct in 2011, as the third year of a presidency is historically the best.

The reasons for the “year three boom” are plain: Presidents spend their political capital on unpopular policies in the first two years, before embarking on job stimulation in the third in the run up to an election year. Employment hits cyclical highs about nine months before the election.

“Politicians are not completely dopey, they have discovered what moves the vote and what moves employment,” he said.

In the second year of a presidency, the excess real return for the S&P 500 has averaged -10.1%. That jumps to +15.3% (again, on average) in the third year.

“We have a very simple approach to asset allocation. We believe everything goes back to normal,” Grantham said at the CFA Institute’s 64rd Annual Conference. “If you believe that, then you’d better start with a pretty accurate ‘normal’. What we’re saying is that at the end of seven years, we’ll have normal P/E and we’ll have normal profit margins.”

Gains and gambles As with most of Grantham’s forecasts, there is a caveat. These gains are generated by the riskiest stocks in the index. The most volatile 25% of the index add 30 percentage points to that total return. In fact, the riskiest quarter of the market makes no money at all outside of year three.

“The Fed can say when it wants to, ‘go ahead and speculate, if anything goes wrong, I will do my best to help’,” he said. “In year one and two, traditionally, it said ‘if you speculate, and something goes wrong, kids, you’re on your own.’ Speculators being sensible people, speculate a whole lot more in year three.”

Year three begins in October 2010, and he expects Fed chairman Ben Bernanke will find “some ‘completely independent’ reason” to maintain current stimulative rate policy. If the S&P 500 doesn’t correct lower before that, it could be setting investors up for another U.S. equity bubble in 2011.

But Grantham sees a different scenario playing out.

“I think the candidates for leading the next bubbling phase are emerging [markets] and commodities,” he said.

“The last two great bubbles — in Japan and the NASDAQ tech bubble — they both went to three times the P/E of the rest of the world. Frankly, they were lousy arguments. The arguments for a bubble in emerging are strong as hell. The IMF just made a four-year forecast of 6% real GDP growth, and for us, 2.25%. The gap between 2.25 and 6% is something that I have no doubt that the world will use as a strong [and] simple argument for buying emerging.”

Emerging market equities will trade, he predicted, at a handsome 50% premium for the next couple of years; far short of the three-times valuation of the Japan and tech bubbles. Knowing that the bubble is inflating, Grantham is inclined to overweight the sector in an effort to capture some of that growth.

On the commodities front, he said the only one that is relatively straight-forward for investors to play is forestry. He’s staking 50% of his personal foundation’s assets on it, but he said this is simple as a means to protect the environment.

Still, he sees potential for 6% growth in the forestry sector, which he said will be a safer bet than sovereign debt, as the commodity is at least somewhat inflation protected. “It’s a nice counter-cyclical asset class.”

The value question He is less keen on a more traditional commodity hedge against inflation.

“I hate gold. It doesn’t pay a dividend, it has no value, you can’t work out what it should be,” he said. Depending on the valuation theory one accepts, gold could be worth anywhere between $800 and $6,500. That hasn’t stopped him from buying it, although he joked that his purchase would end its run. “It’s the last refuge of the desperate. I just got so sick of it going up that I thought I’d kill it.”

His fixed income outlook is “horrible,” with policymakers leaving retirees out in the cold. Normal real returns should be about 1.5% to 2%, he said, and not the current -1%. “That’s just a way of stuffing the pockets of banks and hedge funds.”

(06/09/10)