Tuesday, November 29, 2011

Jeremy Grantham on Corporate Profits and Mean Reversion

Back in April we awarded Mr. Grantham the presigious CLoD in "Climateer Line of the Day: Jeremy Grantham on Profit Margins Edition":
“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” 
– Jeremy Grantham
That post had a half-dozen links to commentary on profit margins.
Here's Mr. Grantham's latest via Bloomberg:
U.S. companies are the most profitable in more than 40 years, and some of the best-known stock pickers are divided over how long that will last.

Bob Doll, chief equity strategist at BlackRock Inc. (BLK), said low labor costs and cost-saving technology will allow companies to keep up their profitability. Jeremy Grantham, chief investment strategist of Boston-based Grantham, Mayo, Van Otterloo & Co., said margins will send stock markets tumbling when they eventually revert to their mean.

“The implication for the stock market is ugly, because it means earnings are unsustainably high,” Grantham’s colleague Ben Inker, GMO’s director of asset allocation, said in a telephone interview. GMO, an investment manager that oversees $93 billion, puts the fair value of the Standard & Poor’s 500 Index at between 950 and 1,000, compared with the 1,158.67 level at which it closed last week....
...Grantham also believes in mean reversion, the notion that most measures drop back to their historical norms over time.

‘The Great Threat’
“Lower margins are the great threat to market performance,” he wrote in the August newsletter. Grantham is known for his bearish investment outlook and for his successful record in identifying stock-market bubbles.
Margins have been propped up by a “great surge” in government spending that fueled consumption, Grantham said. As political pressures force the U.S. to cut its budget deficit, the economy will suffer and margins will drop, Grantham predicted without laying out a timetable.

GMO expects U.S. large-capitalization stocks to return 1.8 percent a year above inflation over the next seven years, according to its website....MUCH MORE 
HT: Abnormal Returns

One area where Mr. Grantham is not looking for mean reversion is in commodities. In this he is at odds with SocGen's Dylan Grice, see:
Société Générale's Dylan Grice-"Commodities: ‘Their Expected Long-Run Real Return is 0%’"
Commodities: "The Case for Human Ingenuity"
Commodity Prices tend to be Mean-Reverting (cotton)

Back to GMO, here's our July 1, 2011 post "A Tip of the Cap to Jeremy Grantham on his Commodities Call":
That is not sarcasm.
When Mr. Grantham made his "paradigm shift" call back in April most analysts, pro and con, looked at the longer term comments. I did, although I also had a contrary gut feel. Our May 5 post:

Commodities: Did Jeremy Grantham's 'Paradigm Shift' Letter Call the Intermediate-term Top
Remember: A paradigm is only worth twenty cents.
Like a lot of blogs we relayed Mr. Grantham's commodities call.
Here's the Jeffries Global Commodity ETF chart via Finviz:

I'll be back with more. In the meantime here's the April 26 post that linked to FT Alphaville's Grantham story:
The End of Cheap Commodities (or not)
Later that day:
Commodities Have Reached a Permanantly High Plateau* (or not)
April 29:
Commodity Prices tend to be Mean-Reverting (cotton)
May 3:
Commodities: "The Case for Human Ingenuity"

You can probably guess that I tend toward the optimistic.
There was more to the story. From June 2:
Job Creation Disappears and Lord Rothschild Suggests You Panic, Sells Gold (and the Jeremy Grantham Commodity Call that Didn't Make the Headlines)
This didn't get a lot of play in late April and in fact I missed it on first reading GMO's letter. Most folks focused on the longer-term "paradigm shift" portion of what Grantham was saying and missed this because the shorter-tem negative bits were scattered throughout. Citywire wrapped it up in a neat package (note, this is not the Grantham piece linked in the article above) . 
Grantham predicts commodity crash on scale of financial collapse
GMO’s self confessed perma-bear Jeremy Grantham has rung the alarm bell on rising commodity prices predicting a crash ‘not unlike the financial collapse’.
In his latest quarterly letter titled Time to wake up: days of abundant resources and falling prices are over forever’, he argues that a combination of better than expected weather and a blip in China's 'warp speed' growth due to anything from wage increases, misappropriated capital in large, unnecessary projects, rising debt or a house price bubble, could drag commodity prices down dramatically.
He warned: ‘If the weather and China syndromes strike together, it will surely produce the second “once in a lifetime” event in three years.’

Elaborating, he said: 'Several of my smart colleagues agree with Jim Chanos that China’s structural imbalances will cause at least one wheel to come off of their economy within the next 12 months. This is painful when travelling at warp speed – 10% a year in GDP growth.'

'The significance here is that given China’s overwhelming influence on so many commodities, especially in terms of the percentage China represents of new growth in global demand, any general economic stutter in China can mean very big declines in some of their prices.'

'You can assess on your own the probabilities of a stumble in the next year or so. At the least, I would put it at 1 in 4, while some of my colleagues think the odds are much higher.'

'If China stumbles or if the weather is better than expected, a probability I would put at, say, 80%, then commodity prices will decline a lot. But if both events occur together, it will very probably break the commodity markets en masse. Not unlike the financial collapse.'...MORE
That is almost stunning in its simplicity. The guy is good.