Grantham’s Contradictions

by Cole Smead, Smead Capital Management

Dear fellow investors,

I thought it would be helpful to revisit Jeremy Grantham’s recent interview on Bloomberg UK’s Merryn Talks Money podcast. I’m a fan of Merryn, so I was inclined to give it a listen. You can find a link here.

Let me also start this missive by saying that we at Smead Capital Management believe Jeremy Grantham is doing a great job of telling people how high the likelihood of stock market failure is. He’s trying to scare people and that is prudent advice. We tip our cap to him. We want to go into a second-level thinking discussion of how to take advantage of Mr. Market right now using Jeremy’s comments as a benchmark.

Grantham: (Paraphrasing and transcribing) All the stimulus is gone. We’ve taken off the student loan moratorium. Leading indicators continue down. Availability of debt is increasingly difficult to get. The government level debt is huge and the interest rates increase, putting a real burden on the budget. Many things continue to deteriorate. My guess is that we will have a recession that will go deep into next year…every bubble has been greeted with a chorus of soft landing.

At Smead Capital Management, we are optimistic on humanity. This isn’t typical for most value investors like Grantham. They tend to be in the glass-is-half-empty camp. Some of the most foolish things we have seen in the past couple of years were early recession calls. The coming recession will be more like a unicorn spotting as everyone knows about it, but no one can find it.

Ultimately, it will be hard to find a recession as government stimulus has been massive and continues to be. During his interview he commented on the nasty recession following the 1970s, this obfuscates the truth. The economy rarely had nominal contraction in the 1970s as can be seen below.

Anyone looking for recessions should study history. Large government war (or war-like) spending always gets monetized into inflation. Any of the monarchs would recommend it as the best long-run tool for debt. This is what the US and the West have done. It hasn’t stopped. Anyone looking for economic contraction might go a long time without finding good evidence of one, but in real terms, problems would have been going on all along.

Grantham: If they think that, they are being historically rather literate because that is the pan. Something breaks and nobody seems to know what it is. You increase the pressure on a very complicated system until a few things snap. Each cycle is different, so each cycle something else happens. It’s always a surprise. The idea of a surprise is unsurprising…We did have a sneak preview with the regional banks in America where a couple just upped and went out of business in a flash.

To us, this is part of Grantham’s finest point in his interview. He points out that gravity showing up in interest rates increases the pressure as well. The question has been, on what? Investors thought the pressure would increase on the economy, hence the mythical recession. It wasn’t as expected (a surprise).

It has crushed asset prices in places like bonds, real estate and other interest rates sensitive investments. Stocks, however, think they are above this pressure as investors have pushed up the price of the S&P 500 index via seven companies.

We agree with Grantham that stocks won’t get past this pressure either. The confidence of the last decade in the S&P 500 will fade. When it does, bulls turn into bears. We as stock pickers will have to advocate for stocks as an asset class for long-term investment at some point again (Grantham would agree).

Grantham: (On profit margins mean reverting in the S&P 500 Index) If you want to further narrow the story to what they now call the magnificent seven. There has never been ever, ever such a divergence in favor of the US in total corporate earnings. Since 2010, so this is a recent event, the US has outperformed the rest of the developed world by about 70 percentage points. You could say well in that case they should do 70 percentage points better. They did more than that. The market always goes in for double counting. If you have unexpectedly good profit margins, you get an unexpected increase in price-to-earnings ratio, which also happened. If you go back to 70% outperformance and you take out the then so-called FANGS, you’d find that the 95% or more, the ordinary stocks, looked very much like the rest of the world…I would urge you to take a good look at quality. Quality has been the mispriced asset for 100 years.

We view these to be one of his two major contradictions. You can’t get a bad stock market today without quality doing poorly. The magnificent seven are owned by every quality large-cap manager and the S&P 500 index. Using Jeremy’s firm as a case in point, below are the top 10 holdings of the GMO Quality Fund. If Jeremy is right that the magnificent seven will underperform, quality won’t matter. It’s not that quality isn’t a factor. It’s just not a mutually exclusive factor. The value factor still holds. For another discussion on another day, like in 1972, there is a direct tradeoff between these two factors. Do you want to buy the “perceived” highest quality companies at the most expensive prices? His S&P 500 prediction will likely trump his quality call.

Grantham: (on energy transition) The thing about transitions is they are very tricky. They are characterized by more booms and busts than anywhere else. Oil and alternative energy will be a trickier area than most. Climate resources the same. The thing about climate investing is that they will have an enormous top line revenue advantage, other things being equal. The countries of the world have woken up. Maybe a few are in the process of still waking up to get behind the idea that climate is a big problem and needs to be addressed. They are beginning to address it and throw money at it. Subsidies mainly instead of a carbon tax.

We find this to be the strangest logical argument. Grantham believes the economy is in trouble. Their governments are becoming profligate. Yet, these two groups will unquestionably fund the subsidy to make the energy transition? This doesn’t add up. If the US government begins funding costs at 5% or more, the cost of interest will haunt the budget and things will get cut. The question is what? Social Security and Medicare/Medicaid are golden calves. The question will be at the size and scale that people like Grantham say we need, will the money be there? We don’t trust that the government does the right thing in spending. Our evidence? The past.

As we said earlier, governments inflate their way out of these problems. Funding costs moving higher hurts all assets. The S&P 500 Index, quality stocks and climate investments will feel this pressure like all securities. Remember, the future is bright. These problems will be solved in the long run. We know what to avoid. The question investors must ask is how they can make money, despite these risks. While we are always learning, the path we have chosen to go alone including in some of the places that Grantham dislikes.

Fear stock market failure,

Cole Smead, CFA

The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Cole Smead, CFA, CEO and Portfolio Manager, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

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