Thursday, May 19, 2011

Grantham's Bear Case - Ari Paul


Shortly after I posted Siegel's bullish narrative last week, a friend (thanks Alejandro) sent me a recent essay by Jeremy Grantham that serves as the perfect counterpoint to Siegel's bullish narrative. Grantham runs GMO and manages about $110 billion in assets. He is known for his long-term approach to predicting asset returns (latest 7 year forecast) and his bearishness over much of the last decade. In the essay (part 1 here, part 2 here), Grantham argues that the entirety of Jeremy Siegel's bull case is really just a 200 year hydrocarbon bubble. Grantham believes that global GDP growth has been above trend for two centuries because of the discovery of incredibly cheap energy...and that the age of cheap energy is over.

Grantham's argument:
The recent boom in commodity prices has reversed the downward trend of the last century. Even as the population increased more than fourfold over the past one hundred years, commodities produced negative returns because we were discovering and innovating even faster than we were consuming. The recent supply fundamentals suggest we're entering a new era. Productivity growth in agriculture has fallen from 3.5% a year to 1.5% a year. Growth in the oil supply has nearly stagnated and the average cost per barrel has more than doubled in real terms in the last 10 years, after staying roughly steady for 60 years. Every extra barrel of oil, ounce of copper, and bushel of wheat is becoming exponentially more expensive.

Economists generally believe that every $10 increase in the price of oil reduces US GDP growth by about 0.25%. The demand for oil by emerging economies (especially China), continues to rise at a dramatic rate, while supply growth stagnates. What will keep oil from climbing over $140 and eliminating US GDP growth? Optimists hope for sudden innovation in alternatives like solar or wind, but any transition will require at least 10 years to have a meaningful impact, and probably more like 20 years.

Grantham also focuses on the impossibility of sustained compound growth. As a colorful example, he asks us to imagine what would have happened if the Ancient Egyptians started with a cubic meter of physical wealth (say gold) and compounded it at a rate of 4.5% a year. How much would they have today? Their gold would completely fill more than one thousand solar systems. His point - if our demand for resources rises at all with our growth in GDP, then indefinite compound growth is impossible, and will catch up to us sooner than most realize.
Speaking practically, Grantham believes that bets on resource production and resource efficiency will pay off over the long-term. However, over the next 18 months he thinks there is a significant risk of commodity prices falling sharply because of a "blip" in Chinese growth, better weather, and the end of QE2.

To paraphrase Warren Buffett, it's never paid to bet against American ingenuity. Malthus predicted that we'd all die from famine because the world couldn't support a population of more than a billion people. Today we have nearly 7 billion with less famine than in Malthus' time. Who knows what innovations and discoveries tomorrow will bring?

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