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BULLS & BEARS: With bull market raging, investor advises caution

May 7, 2007

"It's Everywhere, In Everything: The First Truly Global Bubble." The title of this recent newsletter sounds a lot like one of those "doom and gloom" books out to make a quick buck playing on investor emotions.

The only thing is, those kinds of books only show up in bear markets, because that's when they sell-when investors are already depressed. Thus, their message is useless, for the damage has already been done to investors' portfolios-and, ironically, their appearance on bookshelves usually signals the makings of a market bottom.

However, when the warning is written by a respected Wall Street veteran-in the teeth of a bull market-investors of all stripes should sit up and at least hear what he has to say. The author is Jeremy Grantham, principal of the institutional investment firm GMO, and the letter should be on top of the reading pile of every board member of an institutional investor and their consulting firms. And surely any investor, large or small, can learn something from his April newsletter, which can be found at www.gmo.com.

The title itself is brazen, proclaiming a bubble in all assets around the world. For many investment professionals, such a declaration might be akin to professional suicide. After all, who would want to place money with anyone who is telling his clients they will not make much money for several years? But Grantham has the professional credibility to pull it off. GMO is a 30-yearold institutional investment firm managing nearly $150 billion and whose work in the field of asset allocation is nonpareil.

Grantham suggests that, for a bubble to form, two conditions are necessary: The economic conditions must look at least excellent (and perfect is better), and liquidity must be easy to obtain and cheap.

For the first, Grantham points out that not a single country out of 42 grew its gross domestic product by less than Switzerland's 2.2 percent-confirmation of how globalized and correlated economic fundamentals have become. As for the second ingredient, the availability of low-cost money to leverage assets couldn't be more obvious today. Grantham relates, "The more leverage you take, the better you do. The better you do, the more leverage you take."

With these conditions in place, bubbles form as human behavior stirs the "animal spirit," which is reinforced by the optimistic view from people around you. Here, Wall Street and the financial media supply the grease to keep the snowball rolling.

Grantham notes in a listing of his views that every bubble has burst, and that in this case, the bursting will be across all countries and all assets, perhaps with the exception of high-grade bonds. He suggests that the heart of the bubble, this time, is probably in private equity.

He readily admits that the tricky part in forecasting a bubble's burst is always timing. He notes that it will be difficult to identify any particular catalyst that will trigger a "revaluation" of asset classes. Instead, he simply suggests a few scenarios that will push asset values lower. Inflation will weaken asset values and raise borrowing costs. Also, the competitive grind of capitalism will serve to lower what are now historically high profit margins for businesses.

Grantham is, in effect, doing some of the "bell ringing" we were talking about a few articles ago. His letter deserves more discussion, so we will pick this up again.



Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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