Jeremy Grantham has built a career on shouting down, and outlasting, asset bubbles. As far back as 1972, before he co-founded GMO, he was two years too soon in his bet that US small-caps were undervalued against the so-called ‘nifty-50’ companies leading the index. In 1986, three years before the Japanese market caved in from its all-time high of 65-times earnings, he sold all of his exposure to the original tiger market. He was deeply underweight technology companies two-and-a-half years before the dotcom crash, and railed against the US housing and leverage bubble that precipitated the financial crisis. As asset bubbles have come and gone, GMO’s undying adherence to mean-reversion has delivered a solid long-term performance record with less absolute volatility than most. However, temporary periods of painful underperformance mean that not all of the manager’s clients have enjoyed such gains. “We hero-worship regression to the mean,” Grantham said in a briefing with the financial media in Sydney last month.

“We’ve been on the other side of saying: ‘This time it’s different,’ and fighting the bull market when markets became overpriced.” “Every bull market is characterised by cries of a paradigm shift. It’s the [investment] institutions’ way of saying, ‘Everything’s fine, don’t get nervous’, as they make packs of dough out of it.” But now the global economy is undergoing its most crucial economic event since the industrial revolution, Grantham wrote in his latest quarterly letter, Time to wake up: Days of abundant resources and falling prices are over forever. GMO analysis has found the long-run trend of commodity price decline has dramatically reversed since 2002, marking a true paradigm shift, wrote Grantham. “From now on, price pressure and shortages of resources will be a permanent feature of our lives.” His reckoning also carried a stern warning: “If we maintain our desperate focus on growth, we will run out of everything and crash.” The GMO analysis of commodity prices in the last century concluded that the current high prices for oil, iron ore and grain have almost certainly bucked a trend of long-term decline. The manager built an index tracking the prices of 33 important and equal-weighted commodities from 1900 until 2010.

The index trended downwards – “in apparent defiance of the ultimately limited nature of these resources,” Grantham wrote – as the average price fell by 1.2 per cent each year, after inflation, to a collective nadir in 2002. In spite of the diminishing value of commodities, which amounted to a 70 per cent discount in real terms, on-going increases in annual productivity overcame the marginal cost of commodities. Over time, the wealth and wellbeing of civilisation soared. “The undeniable law of diminishing returns was overcome by technological progress – a real testimonial to human inventiveness and ingenuity.” But in the context of history, these favourable conditions were short-lived: since 2002, the decline in commodity prices has been retraced as markets recognise their finite nature. Strong demand from developing economies, especially China, has accelerated this shift. But if the current high commodity prices are just an aberration, and their downward trend in price hasn’t changed, they are in hyper-bubble territory, Grantham allowed. But this seemed implausible as GMO calculated that iron ore, the commodity which experiencing the most severe increase in price, had a 2.2 million: 1 probability that it remained on a downward price trajectory.

Leave a comment