The Last Bubble? Finding Value in a World on Fire | Jeremy Grantham & Edward Chancellor

0:00Demetri Kofinas:What's up, everybody? My name is Demetri Kofinas, and you're listening to Hidden Forces, a podcast that inspires investors, entrepreneurs, and everyday citizens to challenge consensus narratives and learn how to think critically about the systems of power shaping our world. My guests in this episode of Hidden Forces are co-founder and chief investment strategist of asset management firm GMO, Jeremy Grantham, and financial historian, journalist, and investment strategist, Edward Chancellor. Together, they have collaborated on Jeremy's autobiography titled The Making of a Permabear, which chronicles Grantham's evolution as a value investor and the valuable lessons that can be learned from his six-decade career in investment management.

0:45Demetri Kofinas:We spend the first hour of our conversation discussing the collaboration behind the book, Jeremy's formative experiences in finance, the principles that have guided his investment philosophy, the role of mean reversion in asset markets, and why they both believe that US equities are more overvalued today than at almost any point in history, with critically important implications for where returns will come from over the next decade. The second hour is devoted into a conversation about the mechanics of financial bubbles, the relationship between ultra low interest rates and asset price inflation, Jeremy's framework for navigating overvalued markets by shifting capital to international and emerging market equities, the challenges of selecting investment managers, and Jeremy's deep concerns about existential risks to humanity, including climate change, resource scarcity, and the toxic assault on human fertility that he believes poses an underappreciated threat to our species' long-term survival.

1:43Demetri Kofinas:If you want access to all of this conversation, go to hiddenforces.io slash subscribe and join our premium feed, which you can listen to on your mobile device using your favorite podcast app, just like you're listening to this episode right now. If you want to join in on the conversation and become a member of the Hidden Forces Genius community, which includes Q &A calls with guests, discounted access to third-party research and analysis, and in-person events like our intimate dinners and weekend retreats. You can also do that on our subscriber page. If you still have questions, feel free to send an email to info at hiddenforces.io, and I or someone from our team will get right back to you.

2:26Demetri Kofinas:Lastly, because this conversation deals with investing, nothing we say on this podcast can or should be viewed as financial advice. All opinions expressed by me and my guests are solely our own opinions and should not be relied upon as the basis for financial decisions. And with that, please enjoy this incredibly thoughtful and valuable conversation with two of the most brilliant and seasoned minds in finance, Jeremy Grantham and Edward Chancellor.

2:57Demetri Kofinas:Jeremy Grantham and Edward Chancellor, welcome to Hidden Forces. Nice to see you, Dimitri. Hi. So you both collaborated in the writing of Jeremy's biography or autobiography. What was the nature of that collaboration? How did it begin? And Jeremy, more to the point, what led you to want to write this book and to tell your life story to begin with? I'm a lazy bum, and I pretty well knew I'd never get a book written, even though I was full of grandiose plans for at least half a dozen in my life. And I knew Edward was a real professional. He wrote to deadlines, and he'd written a couple of excellent books.

3:43So if we wanted to get a book written, he was a natural candidate to write Heard on Me and keep me under control, all of which he did.

3:54Demetri Kofinas:What was it in Edward's style that resonated with you? Actually, Edward has a different style and much more elegant, elaborate. Mine is unusual in the sense that I write exactly the way I speak, and it's best described as hopefully high-quality bullshit. and Edward is a professional writer. So it's a very different style and puts a real challenge for Edward to try and manage that difference. So the way I see it is, as Jeremy says, he was never going to quite get round to writing the book himself. My view was that, Jeremy, as you're aware, had this big volume of investment letters, of investment letters going back to 2000, some of which were really, to my mind, and anyone who read about the investment in the last 25 years thought they were first rate.

4:51So my view was, anyhow, that there was a lot of material there that deserved to be preserved in book form, leaving aside the ups and downs of Jeremy's career. With regard to my own role, I have thought about it. I thought for a while, perhaps I was like one of these surrogate mothers, which actually is a sort of unpleasant metaphor but then actually I thought... That mother, I think. Then actually, Jeremy, the way I see it now is that I'm more of a tailor is that Jeremy provides both the model, the figure and he also actually provided me with the material, the cloth and my job really was to cut the cloth to fit the model And to have, because Jeremy and my voices are so different, it's actually have as little of my voice in there as possible.

5:44And when Jeremy was going through the drafts, whenever he saw my voice creep in, out would come his red pen and it would go, which is how I think it should be. On the other hand, because Edward was the boss, he determined what, in the end, what would go in and what would go out. And so he molded the presentation. So there are, like most people, there are several aspects to everybody. We all have different currents running inside. And Edward decided which of those would be presented to the public, which would be useful for GMO, my firm, and which would be kind of expensive sidetracks for which I'm infamous.

6:34and the financial world doesn't really need to hear too much about climate change and toxicity and the deficiencies of capitalism. Ironically, the things for which I became well-known, they want to hear about the stock market. We know this to be a case because we've had some amazing controlled experiments where we did half an hour on the stock market bubble and half an hour on investing in climate change or something like that. And the title would be as good as it could get, Investing in Climate Change. And then the results would come in on YouTube and it would be a record 180 ,000 views for the stock market and not even 10 % for the climate change version.

7:26Yeah, and that book in a way, actually, it's true. I decided what went in and actually Jeremy decided what went out. And how I composed the book was to give really 80 % weighting to the investment financial side and the 20 % to Jeremy's green activities, ideas and philanthropy. That's the balance. And I think it's fair enough. It sort of roughly matches the decades that Jeremy, the proportion of his career he's spent in those different times. And has the virtue of being at least as much as the financial people can stand. And I get that now more than I did at the time.

8:07Demetri Kofinas:So before we get into the book where I'm going to put you on the hot seat, Jeremy, I'm going to put you on the hot seat for a second here, Edward, and ask you, what was it that made you say yes to this project? And how did you go about thinking about Jeremy's life, what was interesting, and how to mold and balance what it was that maybe he thought was important with what you thought was both more objectively interesting that audiences as an author and a historian would find interesting and would sell books? First of all, I'd finished that big book, The Price of Time, that took me six years to do.

8:45And my batteries were a bit low, so I didn't really want to embark on another six-year project immediately. When one of Jeremy's, you know, one of our former colleagues, Peg McGettrick, wrote me a, you know, who's director of GMO, said, you know, they were thinking about this project and would I be prepared to do it. As I said earlier, I thought there was enough of Jeremy's material from his letters and so on that were worth preserving. Also, Jeremy offered me a job and I worked several years with Jeremy. So obviously, I know, you know, I sort of know the ins and outs of how Jeremy thinks as well as anyone.

9:23And so I thought I was probably in a good position to do it. And frankly, because Jeremy offered me work, I was able to save more and go back to a life of writing. So I felt I owed Jeremy one anyhow. So those are sort of various reasons for doing it. I certainly would not do this project. I would not dream of doing it for anyone else, for sure. David Steinberg You're a financial world historian. And my 60 years goes back to the Neanderthals. I mean, there was no financial investment management industry back in the day. When I started, there was very little talent, very few ideas, not even an options model.

10:07I mean, there were the failed younger sons of rich families who would hold hands at lunch for a Morgan Guaranteed Trust and buy their client an occasional few shares of Coca-Cola or Exxon. That was it. That was the investment.

10:26Demetri Kofinas:So let's get into the book. The title of the book is The Making of a Perma Bear. I'm curious about the thought process that went to this title because I've never really thought of you as a perma bear. And I'm kind of curious, what was the thinking behind the titling of this book? Was it meant to be somewhat tongue in cheek? I voted for having inverted commas around perma bear to make it clear. But I was outvoted by Edward. To me, in the first chapter, and talking about Jeremy's thought processes, he mentions the way he's always approached thinking of the investment world, which is to say what is going on here and I think that was the way when I was talking to Jeremy and putting together the book I thought that that was really the mark of the way Jeremy approached things is that if you go into the world investment world or any world for that matter and say to yourself it doesn't matter what the conventional view is what do I think with fresh eyes is going on here is, I think, a very interesting way of looking at the world.

11:33Anyhow, so that was my preferred title. But the publisher was adamant against it, that title. And so somewhere or other, it came around to the making of a perma bear, which, as you say, is tongue-in-cheek, because, you know, as is made pretty clear, Jeremy's reputation of a perma bear is really formed during those periods when the markets are at extremely high valuation levels compared to their history. So yes, I think Puma Berry is tongue-in-cheek. But let me just add, one of the things I think we agree on is that the world is ludicrously optimistic. Homo sapiens is ludicrously optimistic, hates bad news, very good at putting the head in the sand.

12:21This is revealed just as much in climate change, toxicity and all the bad things. We just don't want to deal with them. We want to have happy thoughts. And if you're a contrarian, and if you're trying to see reality, that means that the mainstream is overwhelmingly, in terms of time, on the wrong side of fair value. They're all going to be believing that the market is going up all the time. And any value-based contrarian is going to think they're overdoing it the great majority of the time. And if you end, as we do, at the end of the longest bull market run in history, or nearly so, then you are going to look like a perma bear.

13:06If you merely make the point that reasonable value is what it is, that is going to seem awfully pessimistic. And in the late stages of a bull market, people develop something close to a hatred for bears. anything that interferes with the rising market and their rapidly growing portfolio's value, they loathe.

13:31Demetri Kofinas:So I suppose your experience of maybe falling out of favor is a topping signal in and of itself. We'll have a chance to dig more into your investment philosophy throughout the course of this conversation, Jeremy, but I'd like to ask you a question first about the book's dedication. The book was dedicated to your grandfather, Joseph Cook, who you write had an outsized impact on your life. He was, in some real sense, a father figure to you. Can you tell me a little bit more about him and why he was so important in your life? Yes. He was as important as most father figures are. And he was the man in the family.

14:06He was kind, thoughtful. We would sit on his knee and he would declaim poetry in the way that old grandfathers born in the 19th century tended to do. Tennyson and how heroic the British Empire was and other things. And brought up a Quaker as he was. He was thoroughly brainwashed by Quaker principles and never said a bad thing about anybody, never did a bad thing as far as we can construe history. And it was easy to admire him. And I did.

14:42Demetri Kofinas:Well, in the book, you say that even to this day, when you go to a restaurant, which I find somewhat hard to believe, but I take it at face value that you still look for what is a bargain on the menu before you decide what to order. Is that really true? It's not only is it true, but I am shocked that you find it hard to believe. There are quite a few of us who do that, by the way. And it doesn't matter whether we're in the money or out of the money. It is a reflex and it has more to do with waste. I don't approve of spending large sums of money on superficial things like eating and drinking. All right.

15:17Demetri Kofinas:So you eventually, you made your way to the United States and you began to apply your skills to the world of finance. And in the book, you highlight a few of the important formative experiences you had as an investor, notably investments in American raceways and market monitor. What made you choose these examples to highlight and how did these experiences inform your evolution as a value investor? Because I had this rather brief 18-month window into how much more optimistic other people can be, I was deep into momentum and wishful thinking and kind of to the moon, to the moon. And we didn't really pretend that they had serious value.

16:01We bought them because we thought they'd go up a lot in a hurry, we would make money. And for a long time, they did. For a while, they did. And they went up rapidly. They double in three months, that kind of thing, as the equivalent does today. And then they blew up. So we paid quite a price in terms of lifestyle postponed, living as cheaply as we could to save money to go back to England or Germany. and then I blew it all in about six months. And that was a wonderful lesson that you can be cynical, you can be doing it because you're confident you're going to get out quicker than the enemy and then you can still be surprised by the sheer speed with which they implode when they go.

16:49That was the thing. It wasn't that they went. I knew in a way they'd go sooner or later but I didn't think they'd just blow up and in a few weeks go to nothing.

16:59Demetri Kofinas:Edward, when you were interviewing Jeremy for this book and you were exploring this particular period of his life, and I imagine there are just hours and hours of interviews that you've done, what made you want to focus on these formative experiences? And more generally speaking, how important is the role of personal experience, especially the experience of loss in the course of financial speculation to one's development as an investor in your view? Jeremy's descriptions of losing money in market monitor and American raceways, these are the sort of go-go stocks of the 1960s. And that's, you know, it's not a very well-known period of speculative euphoria compared to, say, the dot-com boom of the late 90s, or even the meme stock boom of 2020-21.

17:49But yeah, it's a nice episode. I think, you know, Jeremy somewhere says that in investment, there are some things that you really have to learn through personal experience. Someone can tell you to keep away from super specs, or they might tell you to keep away from stock tips from your friends or whatever. But it does actually help to, yeah, it helps to lose money. I often think, as you know, Dimitri, if you work for an investment firm, when you're pitching to clients, they always put the years of experience underneath. I used to think this was a bit ridiculous. Some might have a lot of experience and many years, but not may learn much from it.

18:33But I think the point is that Jeremy got very severely burnt very early on. And at that moment, would seem to have turned more or less overnight into what we'd call a conventional value investor. So I think probably, as I say, it's good to get those lessons out of the way quite quickly in your career.

18:56Demetri Kofinas:Well, reflections on mean reversion, I think reflections on mean reversion and also career risk, and that comes up quite a bit in the book. But at what point, Jeremy, in your career, did you come to the firm conclusion that everything in markets is mean reverting? And what led to this realization? I guess I always thought it was intuitively obvious that history counted. And anything that had happened pretty consistently for 100 years or so was probably happening for some reason. And the other thing was mean reversion has this idea of replacement cost, that something is substantially worth what it costs to replace.

19:37And brand image plays a role in changing that a bit. But how much would it cost to replace Coca-Cola's brand? It's hard to calculate, maybe impossible. But that idea that the brand replacement, which took scores and scores of years, as a measure of value is a pretty good one. And so you look at assets, which include intangibles, and you think that's the replacement cost. And you would imagine that prices optimistically would move upwards from there and pessimistically downwards from there, but they would be sucked back to the real value or the cost of replacing it.

20:22Demetri Kofinas:So you say in the book that price to book is junk, I think is the term you use to describe it as a heuristic for determining value. Why is that not a great way to determine whether a company is a bargain or not? What I say is that it's the market's boat on what are the least valuable assets at book value per dollar. And that's exactly what it is. So you have to be aware that when you're paying 20 cents on book, the real replacement value of that asset has probably really shrunk. And it has. That's all that that thought tries to get at. Can I interject something about Jeremy's early work on mean reversion?

21:06Because if you remember in the book, what Jeremy does in the early 1970s, and you have to bear in mind, this is a period when there's no historical electronic data on performance of different factors or strategies, as you might call them. And what Jeremy does, as we describe in the book, is he works out by hand, taking the data from 1926 to 1970, and works out by hand the performance of an equally weighted index relative to a market-weighted index, to show, and what he discovers from that, and this is an empirical discovery rather than a sort of theoretical idea on the nature of mean version. What he discovers from that is the ebb and flow of small cap relative to the broader market.

22:04And I think it's this, what they used to call ebb and flow, what we would call cyclical movements. And that is this ebb and flow that you see generally applying to small cap, later to value, later to international stocks, later to emerging markets, and then to the broader markets themselves, to the broader stock markets, to see the ebb and flow around valuations. Now, in a way, we all take that pretty much for granted now. But in the era when there was no data readily accessible, everything had to be calculated by hand. I think that the discovery of the ebb and flow and the mean-reverting nature of the market is actually pretty significant.

22:50We looked at the rate of regression to the mean of return on equity. We took samples, big companies, little companies, high return, low return, and we worked out, did they in fact regress? And if so, how much? And the answer came back, you bet they regressed. They regressed faster than we imagined. 15 % of the gap between normal or average and their return would disappear in a single year. So if you were 4 % and the average was 12, 15 % of that eight points would go in a single year. And if you're only earning four points, that's enough to give you a real kicker on earnings and make it very difficult to work out whether the 4 % returning companies would have stronger earnings growth than the 20 % earnings companies.

23:44And in fact, it was very difficult. and they weren't nearly as different as you thought, because the guys earning a preposterous 40 % return would be so busy regressing that they would regress by five or six percentage points in a single year, and that would knock 15 % or 20 % off their potential earnings. On the other hand, of course, they would be retaining such a large amount that that would be offset. So the war of attrition between a tendency for poor returning companies to regress upwards and for large returning companies to have an enormous amount to reinvest each year was a very closely run battle.

24:24Some years, the high return guys would win, and some years, the low return people regressing would win. And value would win two out of three years for 100 years ending in 2000. For the 20th century, value beat the socks off growth stocks. Low return companies beat the socks off high return companies. Why? Because the rate of regression was underestimated. And it persistently and reliably regressed. And as we know, that's a pattern became much less clear after about 2000.

24:57Demetri Kofinas:So in natural systems, ecological, geological, climate, et cetera, There are certain generally recognized dynamics or attractors like gravity, the ratio of predators to prey, the carrying capacity of the land that we can point to as clear drivers of mean reversion. What have you identified or what would you point to as the equivalent primary drivers in financial markets? Not so much in financial markets, by the way. When I arrived, it was what does it in a typical capitalist enterprise, in an industrial company, making chemicals, making machines. What drives it is very, very simple. If you make abnormally high profits, you suck in competition.

25:43If you make 4 % return, you frighten competition far away. After a while, having had no new capital flow into that industry, there's a capital shortage and the returns begin to move upwards, hence regression. So it's a very, very straightforward enterprise. And if regression doesn't work, I would say, cast some doubt on how healthy capitalism is. If obscenely high returns do not drown you in competition, there is something wrong. And since about 2000, that something wrong has been increasingly obvious to everybody. And that is a growing element of monopoly and protection for these high return companies.

26:27Demetri Kofinas:So I feel like since the 08 crisis, there have been a few periods where one would have expected prices to mean revert, were it not for policymakers extending the window. The most recent obvious example is the COVID-19 pandemic. If you think that valuations are high, but policymakers can intervene to keep them higher for longer. How does one balance the empirical time series of mean regression with the objective evidence that governments have the power and incentive to keep the game going every time that it looks like it's going to stop? I think it falls clearly into the category of this time is different.

27:05If you had very little political interference, commercial interference into the laws of the land and so on in the 20th century, you might expect capitalism to work more effectively and quicker. And as you get into the 21st century, I think, for lack of a better description, the rich and powerful have more influence. Rich companies start to outpoint poorer companies. Big companies outpoint smaller companies. And the gap in all of these is concentrated. So the concentration by industry has gone up in every industry. In some, it's quite small. In some, it's monstrous. And the average is quite a lot.