GMO

1
We have met the enemy and he is us. Pogo
Jeremy Grantham
GMO
February 6, 2007
North America Europe Asia-Pacific
2
The Great Bubble Where Were the Investment
Professionals? Price/10-year real earnings of SP
500
Did anyone really miss this?
Price/10-Yr Earnings
Price/10-Year Real Earnings
Source Standard and Poors, GMO As of
12/31/06
3
The Way the Investment World Goes Around
Career Risk
Herding Momentum Extrapolation
Timing Uncertainty
Market Inefficiency Prices Move Away from Fair
Value
Arbitrage or Mean Reversion Risk / Return
Pulls Prices Back to Fair Value
4
The Power of Herding or Momentum Fama and Malkiel
bite the dust
Decile Run by Previous 12-Month Performance
Random Walk Down Wall St. or There is no
information in pricing alone.
Relative Value Added per Year
i.e., next years outperformance of the best 10
last year
Source GMO. Top 600 U.S. stocks by market cap
Data 1960-2006
5
The Power of Mean Reversion or Value
Decile Run by Value (Price to Normalized Earnings)
Relative Value Added per Year
i.e., next years outperformance of the cheapest
10
Source GMO. Top 600 U.S. stocks by market cap
Data 1960-2006
6
Yes, Mean Reversion Is Certain But Timing Is a
Little Problem
Stocks
3 Years
18 Years

Currencies
Commodities
3 Minutes
Detrended Real Price is the price index divided
by CPI2, since the long-term trend increase in
the price of the SP 500 has been on the order of
2 real. Note For SP charts, trend is 2 real
price appreciation per year Source GMO Data
through 9/30/06
7
Quintiles of Price/10-Year Earnings To Predict
10-Year Returns 20 of the time, stocks return
approximately 0 real over 10 years
Replacement Cost (Tobins Q) is even more
predictive (see Matthew Harney and Edward Tower,
The Journal of Investing, Fall 2003) Source
GMO, Standard Poors Data 1926 9/2006
8
Overrun How Low Will We Go?
-51
-63
-53
Source GMO As of 9/30/02
9
United States Median House Prices as a Multiple
of Household Income
Sources National Association of Realtors, US
Census Bureau, GMO As of 2/28/05
10
P/Es and Profit Margins Double-Counting at its
Worst (Why Shiller Is Right)
P/E Ratio of U.S. Stock Market
Record Margins High PE
Record Margins High PE
Record Margins High PE
Depressed Margins Low P/E
Depressed Margins Low P/E
Actual correlation between profit margins and
P/Es is positive 31.8
Source GMO, Standard Poors As of
3/31/04
11
Long-Term Bond Yields Extrapolation at its Best
Nominal Yield of U.S. 30-Year Treasury Bond vs.
Inflation
14 Bond Rate Extrapolates 11 Inflation for 30
Years
5 Bond Rate Extrapolates 2 Inflation for 30
Years
Source GMO As of 9/30/04
12
GDP is Very Stable and Seems to Offer Little
Long-Term Risk Real SP price vs. perfect
foresight fair value 1882 2005
Volatility 2/3 of the Time GDP 1
Shiller model Source GMO,
Standard Poors, Federal Reserve As of
12/31/05
13
GDP is Very Stable and Seems to Offer Little
Long-Term Risk Real SP price vs. perfect
foresight fair value 1882 2005
Shiller model Source GMO,
Standard Poors, Federal Reserve As of
12/31/05
14
GDP is Very Stable and Seems to Offer Little
Long-Term Risk Real SP price vs. perfect
foresight fair value 1882 2005
Shiller model Source GMO,
Standard Poors, Federal Reserve As of
12/31/05
15
G.K. Chesterton Says
The real trouble with this world of ours is not
that it is an unreasonable world, nor even that
it is a reasonable one. The commonest kind of
trouble is that it is nearly reasonable, but not
quite. Life is not an illogicality yet it is a
trap for logicians. It looks just a little more
mathematical and regular than it is its
exactitude is obvious, but its inexactitude is
hidden its wildness lies in wait.
Mandelbrot Says
The whole world of economics is enormously more
complex than the world of physics. And therefore
the teaching of business schools, including
Yales, is unrealistic. Even though economics is
a very old subject, it has not truly come to
grips with the main difficulty, which is the
inordinate practical importance of a few extreme
events.
16
The Wildness Lies in Wait Distribution of daily
SP 500 returns (1928 present)
11 std. dev. event Oct. 28, 1929
14 std. dev. event March 15, 1933
9 std. dev. event Oct. 29, 1929
18 std. dev. event Oct. 19, 1987
Source Standard Poors, Global Financial Data
17
The Wildness Lies in Wait Overresponse at 1
Year Distribution of yearly SP 500 returns
In real life, the most important events lie
outside a normal distribution in the short term.
3.0 std. dev. event 1 in 1,000 year event (1932)
3.4 std. dev. event 1 in 3,000 year event (1931)
Source Standard Poors, Global Financial Data
(1900 present)
18
But, at 30-Year Horizons the 1-Year Overresponse
Looks Silly Distribution of 30-year returns is
normal
Source Standard Poors, Global Financial Data
(1875 present)
19
So, Career Risk and Inefficiencies
Dominate. What About CAPM and Beta?
Capital Asset Pricing Model
20
The Real World Is Merely an Inconvenient
Special Case Volatility works backwards!
Luckily they dont take Nobel Prizes back!
Source GMO Data 12/71 -10/05
21
Amazingly, Almost All Stock Risk Factors Work
Backwards For 40 years, risk and return have been
negatively correlated
Safer Characteristics Tend to Outperform
Leverage, volatility and profit Source
GMO monthly data from 1/65 12/31/06
22
Only Liquidity Has a Logical Response Probably
because it reduces Career Risk
Historical trading volume divided by price
volatility Source GMO Data 12/71 -10/06
23
And CAPM Misses the Risk of Overvaluation With
Its Long and Unforgiving Memory Buying at a
market peak
Real Returns to SP 500
18 years to approximate break-even!
Source Standard Poors As of 12/31/05
24
And CAPM Also Misses Fundamental Quality Quality
(unlike Book and Small) was huge in the Great
Depression
Assuming an excess return of 1 per year, time
required by Low Quality to catch up with High
Quality 165 years
Source GMO
25
And Quality Saved a Lot of Bacon in Japans
Bust Quality stocks relative to the market
96 Outperformance
Source GMO, MSCI As of 10/31/2005
26
But Fama and French Did Get Something Right
Small Cap Is a Risk Factor Small stocks in the
Great Depression
Assuming an excess return of 1.3 per year, time
required by Small to catch up with Large 48
years
Source GMO
27
And Book Is Even Worse Who Do You Think Goes
Bankrupt? Price/book in the Great Depression
Assuming an excess return of 2 per year, time
required by Cheap to catch up with Expensive 41
years
Source GMO
28
And Now for Forecasts! Equilibrium Returns vs.
GMO Forecasts
U.S. Large Caps
U.S. Small Caps
Intl.Large Caps
Intl.Small Caps
Emerging Equities
U.S.Bonds
Real Returns at Equilibrium Prices (Fair Value)
Real Return Holding Today's Valuation Constant
Immediate Gain or Loss from Hitting Fair Value
Tomorrow
Expected Real Return from Hitting Fair Value in
7 Years
Source GMO As of 12/31/06
29
GMO 7-Year Asset Class Return Forecasts As of
December 31, 2006
Stocks
Bonds
Other
6.5 Long-term Historical U.S. Equity Return
2
4
3
3
Estimated Range of 7-Year Annualized Returns
6.5
7.0
6.0
7.0
10.5
2.0
2.0
8.5
1.5
1.5
5.5
6.5
The chart represents real return forecasts1 for
several asset classes and an estimate of value
expected to be added from active management.
These forecasts are forward-looking statements
based upon the reasonable beliefs of GMO and are
not a guarantee of future performance.
1 Long-term inflation assumption 2.5 per
year. 2 Alpha transported from management of
global equities.
3 Return forecasts for international equities are
ex-Japan. 4 Alpha transported from management of
global bonds.
Source GMO
30
GMO 7-Year Global Equity Forecasts1 Value and
growth within large and small stocks, and REITs,
as of December 31, 2006
U.S. Large
Intl. Large2
Intl. Small2
U.S. Small
REITs
Annual Real Return Over 7 Years
1 Real returns long-term inflation
assumption 2.5 2 Return forecasts for
international equities are ex-Japan.
Note The chart represents real return
forecasts1 for several asset classes and an
estimate of value expected to be added from
active management. These forecasts are
forward-looking statements based upon the
reasonable beliefs of GMO and are not a guarantee
of future performance.
Source GMO
31
Whats Wrong with U.S. Equities? A Toxic
Combination SP 500 P/E and profit margins
P/E Ratio of SP 500
SP 500 Profit Margins
Post-WWII Cyclical Peak
Price / Earnings Ratio
Long-Term Trend
Post-WWII Average
Geometric Average 14.7
The result? Excluding sales growth and
dividends, a -6.1 real return for 7 years
Source Standard Poors, Global Financial Data
As of 9/30/06
32
SP 500 Building a 7-Year Estimate Components
of annual return of SP 500, with regression over
7 years




Note The assumptions needed to produce a 7
real return would be an increase in the P/E to
29.0, OR an increase in the profit margin to
10.4, OR an increase in real sales per share
growth to 11.2.
Source GMO As of 12/31/06
33
The Revolution in Asset Allocation and Asset
Pricing I The Lets All Look Like Yale Effect
(leading institutions)
U.S. Blue Chips Was 53, Now 16
U.S. Bonds Was 33, Now 11
17
4
16
22
U.S. Small Cap
Foreign Emerging
Alternatives
Source Here There Data 1988 to present
34
The Revolution in Asset Allocation and Asset
Pricing II The Goldilocks Decade

• Record global GNP growth combined with economic
  stability
• Record low global inflation
• Moral hazard generous money low rates
  (Greenspan Bernanke)
• Record low credit standards
• Rapidly increasing global leverage especially
  U.S.
• Increasing purchases of risky assets, leading to
  their outperformance
• and low- or no-risk premiums

35
The Revolution in Asset Allocation and Asset
Pricing III Consequences

• General overpricing of assets
• Particular overpricing of risky assets (and
  illiquid exotics)
• Massive expansion of hedge funds, private equity,
  etc.
• Increased competition for alpha more leverage,
  more risk
• Increase in average fees equal decrease in
  return
• Greater competition for talented people
• GMO response greater efforts on recruiting

36
What Happened to the Risk Premium?
Emerging Debt Spreads
CBOE Volatility Index
Domestic Defaults
Risk Cheap
Risk Expensive
Conditions perfect
Conditionsreally perfect
Conditions perfect
Conditions perfect
Source JPMorgan As of 12/31/06
Source GMO, JPMorgan As of 12/31/06
Source Bloomberg As of 12/31/06
37
All Measures of Risk Premiums Are Currently
Expensive
Risk Cheap
Risk Cheap
Risk Cheap
84th Percentile
70th Percentile
87th Percentile
Risk Expensive
Risk Expensive
Risk Expensive
Source GMO, Lehman Brothers As of 12/31/06
38
Absolute Return Portfolios Over Time The return
to risk is shrinking
Higher Risk Portfolios(more Emerging and
International)
12.5
9/2002 Frontier
9.7
Lower Risk Portfolios(more Fixed Income)
6.1
Note Based on GMOs 7-year asset class return
forecasts. These forecasts were forward-looking
statements based upon the reasonable beliefs of
GMO.
Source GMO As of 9/30/02
39
Absolute Return Portfolios Over Time The return
to risk is shrinking
Higher Risk Portfolios(more Emerging and
International)
12.5
9/2002 Frontier
9.7
Lower Risk Portfolios(more Fixed Income)
6/2004 Frontier
7.6
6.6
6.1
5.2
Note Based on GMOs 7-year asset class return
forecasts. These forecasts were forward-looking
statements based upon the reasonable beliefs of
GMO.
Source GMO As of 6/30/04
40
Absolute Return Portfolios Over Time The return
to risk is shrinking
Higher Risk Portfolios(more Emerging and
International)
12.5
9/2002 Frontier
9.7
Lower Risk Portfolios(more Fixed Income)
6/2004 Frontier
7.6
6.6
6.1
5.2
5/7/2006 Frontier
5.1
4.8
4.4
Note Based on GMOs 7-year asset class return
forecasts. These forecasts were forward-looking
statements based upon the reasonable beliefs of
GMO.
Source GMO As of 5/7/06
41
But Dont Fight the Tape in Year 3 Unless You
Have To October to October returns by
presidential cycle
Really the Federal Reserve cycle

Source GMO Returns from 1964
42
World Wide Reverberations of U.S. Presidential
Cycle Third year of local market relative to
their average 1974-2002
Source GMO
43
GMO Global Balanced Allocation Strategy
Expected Absolute (in real terms) Return
-0.3 Volatility 10.8 Beta on SP 500 0.61
Expected Absolute (in real terms) Return
(net of fees) 2.8 Volatility 8.3 Beta on
SP 500 0.43
Benchmark65 Global Equities 35 Bonds
GMO ActiveWeighting Decisions
Strategy
U.S. Equities 23.7
International Equities 11.1
Traditional Bonds 12.3
OtherFixed Income 24.8
48.75 SP 500 / 16.25 MSCI AC World ex-U.S. /
35 Lehman Aggregate Bond. Equity range 45
75. Based on a representative account.
Weightings are subject to change without notice.
This information is based on GMO's 7-year
forecasts and an estimate of value expected to be
added from active management. These forecasts
are forward-looking statements based upon the
reasonable beliefs of GMO and are not a guarantee
of future performance.
As of 12/31/06
44
Mean Reversion Strategy Current portfolio
Long Positions
Short Positions
Egypt/Saudi Index Swap
Japanese Yen
ASX 200 Futures
Copper Futures
Euro
U.S. High Quality
Russell 2000 Futures
Japanese 10-Year Bond
British Pound
Australian Equities
International Large Cap
UK 50-Yr Gilts
SP 500 Futures
Variance Swap
U.S. Low Quality
Emerging Equities
Based on a representative account.
Weightings are subject to change without notice.
Source GMO As of 12/31/06
45
At Last, a Paradigm Shift Oil in 1974
Jan-
1875
1883
1891
1899
1907
1915
1923
1931
1939
1947
1955
1963
1971
1979
1987
1995
2003
Source GMO, Global Financial Data. As of
12/31/06
46
GMO
North America Europe Asia-Pacific
40 Rowes Wharf Boston, Massachusetts
02110 [phone] www.gmo.com