Jeremy Grantham Letter - Q1 2016

The tone of the market commentators back in January, when I was writing my last quarterly letter, seemed much too pessimistic on global stock markets, particularly the U.S. market, and I said so.

This relative optimism was an unusual position for me and the snap-back in these markets has validated, to a modest degree, my thinking at the time. I still believe the following: 1) that we did not then, and do not today, have the necessary conditions to say that today’s world has a bubble in any of the most important asset classes; 
2) that we are unlikely, given the beliefs and practices of the U.S. Fed, to end this cycle without a bubble in the U.S. equity market or, perish the thought, in a repeat of the U.S. housing bubble; 
3) the threshold for a bubble level for the U.S. market is about 2300 on the S&P 500, about 10% above current levels, and would normally require a substantially more bullish tone on the part of both individual and institutional investors; 
4) it continues to seem unlikely to me that this current equity cycle will top out before the election and perhaps it will last considerably longer; and 
5) the U.S. housing market, although well below 2006 highs, is nonetheless approaching a one and one-half-sigma level based on its previous history. Given the intensity of the pain we felt so recently, we might expect that such a bubble would be psychologically impossible, but the data in Exhibit 1 speaks for itself. This is a classic echo bubble – i.e., driven partly by the feeling that the substantially higher prices in 2006 (with its three-sigma bubble) somehow justify today’s merely one and one-half-sigma prices. Prices have been rising rapidly recently and at this rate will reach one and three-quarters-sigma this summer. Thus, unlikely as it may sound, in 12 to 24 months U.S. house prices – much more dangerous than inflated stock prices in my opinion – might beat the U.S. equity market in the race to cause the next financial crisis.

In the meantime, however, we continue to have the typical equity overpricing that has characterized the great majority of time since the Greenspan regime introduced the policy of generally pushing down on short-term rates. At current prices it is very close to impossible for the mass of pension funds or other institutions to realize longer-term targets of 5% a year, let alone 7%. A 60% stock/40% bond portfolio would be lucky to deliver 3% even if we were to lock in current high P/Es and above-normal margins. Prudent managers will just have to grin and bear it. The worst argument is always that extra risk has to be taken because the need to deliver higher returns is desperate. The market does not care what your targets are! And, in any case, there is a very wobbly relationship between risk and return, as the 50-year underperformance of high-risk equities to lower-risk equities attests. (And this underperformance applies to a varied definition of risk: Table 1 shows the gap between the top and bottom 20% in the U.S. equity market for volatility, beta, and fundamental quality – stability of high return and low debt.) My point over the last two years has been to emphasize how long and painful the grinning and bearing can be, and I firmly believe that investors should be prepared for considerably more pain (of overpriced assets becoming yet more overpriced) without throwing in the towel 1999-style at the worst time possible time.

Oil

As with stock prices, I am encouraged by the rise in oil prices since my unusual bullishness of last quarter. My belief remains that a multi-year clearing price for oil would be the cost of finding a material amount of new oil. This appears to be about $65 a barrel today, and costs are drifting steadily higher as the cheapest old oil is pumped. My guess is that the price of oil will indeed be as high as $100 a barrel again within five years and, perversely, I feel encouraged by the growing host of longer-term pessimists. Much as I would love as an environmentalist to have oil for transportation almost disappear in 10 years, it simply isn’t going to happen. However, there will be dramatic technological improvements in non-oil based transportation well before 10 years is out, and after 10 years… well, the oil companies will wish they had taken Ted Levitt’s advice in 1960 in his then groundbreaking “Marketing Myopia” article and defined themselves as energy and chemical companies and not defended their narrower definition of “oil companies.”

New technologies for energy and transportation

The new discoveries and engineering insights in these fields keep coming. The Grantham Foundation’s attraction to venture capital, described last quarter, plays conveniently into this and we are investing 20% of our total capital in “mission-driven” projects, mainly in venture capital. One investment is aiming at doubling the power-to-weight ratio of lithium ion batteries and another at a 200-second charge time for some types of lithium ion. Vehicle development we see includes ultra-light and ultra-streamlined electric-powered people movers, suitable for commuting and shopping in developed countries, and as a first cheap yet state-of-the-art vehicle everywhere, very fast and with a long range. (Better make hay soon, Tesla!) But, you never know. And venture investing is particularly full of disappointments. So, just in case, I am one of the 400,000 preorders for the $35,000 Tesla Model 3, likely to be the cheapest electric car per mile of range at least for a while. The mission component on some of our investments is so on target that even if they fail they represent attempts that will have deserved some of our non-profit making grants. As it is, we hope that at least one of the several game-changing projects driving these CO2-reducing technologies forward will simultaneously make our foundation a fortune!

Global warming accelerates: “so much for the pause”

Because 1998 was an outlier warm year due to a large El Niño effect in the Pacific, many subsequent years, including 2013, had lower global temperatures and led some to believe, or claim to believe, that global warming had ceased. But it turned out to be, after all, just another series like that of the S&P 500 in real terms with a little steady signal often obscured by a very great deal of noise. As it turned out, the below-trend 2013 was followed immediately by a modest new record in 2014. And then came the real test as a new powerful El Niño started to build up in 2015. Ten of the twelve months of 2015 set new all-time records, an unheard of event, and 2015 in total became a monster, not only the warmest year in recent millennia but by a record increment. Yet, the early months of 2016, still under the influence of what had become one of the most powerful El Niño effects, showed temperature increases that were even more remarkable.

This current El Niño has accelerated underlying warming caused by increasing CO2 – as all El Niños do – but this time the combined effect has been far ahead of scientific forecasts that in general remain dangerously conservative. January 2016 was the hottest January ever on the NASA series and by a new record amount. It was a full 0.22 degrees Celsius above the previous high for January. Then February became the new shocker, washing away that record by being 0.33 degrees Celsius above the previous February record. Most recently, March was once again the warmest ever March, although not quite by a record amount (see Exhibit 2). The exhibit makes the scary point clear: global temperature is not just increasing, but accelerating. The average increase from 1900 to 1958 was about 0.007 degrees Celsius per year. From 1958 to 2015 it doubled to 0.015 degrees Celsius per year, and from February 1998 to February 2016 it rose by an average of 0.025 degrees Celsius per year! Time is truly running out.

Sadly, it has become obvious that the recent talk in Paris of limiting warming to 1.5 degrees Celsius is toast, as it were. And the dreaded 2 degrees Celsius is highly unlikely to be the limit of our warming. If you line up the previous El Niño outlier of 1998 with this March 2016 El Niño (as we might do in lining up bull market highs) it gives an idea of when 2 degrees Celsius might first be broached in a future El Niño effect: just 17 years! Meanwhile, the most obvious effect to watch for in destabilizing weather patterns is an increase in record breaking, intense rainfall, such as occurred last month in Houston. Three inches an hour1 fell and kept falling hour after hour, delivering four months’ average rain in under 24 hours (unprecedented without a major hurricane), flooding major parts of the city under several feet of water.

Let me just make the point here that those who still think climate problems are off topic and not a major economic and financial issue are dead wrong. Dealing with the increasing damage from climate extremes and, just as important, the growing economic potential in activities to overcome it will increasingly dominate entrepreneurial efforts in future decades. As investors we should try to be prepared for this.

Jeremy Grantam focuses on Venture Capital

Venture capital has always been a high-risk, high-reward  proposition. Its current surge is finding an unlikely proponent in legendary investor Jeremy Grantham. 

The billionaire has a worthy cause in mind: his Grantham Foundation for the Protection of the Environment. My foundation is aspiring to an extremely large 40 percent allocation to venture capital, because that is where I see the greatest potential, and we certainly need all the money we can
make trying to protect the environment, Grantham says in his office at the Boston headquarters.

The U.K. native launched his $617 million foundation in 1997 to concentrate on Climate Change and Agriculture. In February it announced its involvement in a new $430 million fund with Boulder,
Colorado based Vision Ridge Partners and Capricorn Investment Group of New York that will focus on clean-energy companies and other sustainable assets.

Venture capital is uniquely suited for mission-driven, or impact, investing because investors can give early support to companies that share their values and help to bring those businesses and values to market, says the slender, sharply dressed Grantham.