JEREMY GRANTHAM, a 60-year-old partner of money managers Grantham,
Mayo, Van Otterloo & CO., is a bit woozy from borderline pneumonia, but he may just as well be suffering from bubble sickness, the dizzying impact of trying to apply well-honed reason to the stock market.

        There's a lot to give him vertigo: stock indexes driven upward by only a handful of companies (see chart); investors more attentive to a company's price appreciation than its earnings growth; risk defined as deviation from a statistical benchmark rather than potential for loss; valuations at double replacement cost.  Here's an important one: The earnings yield on the S&P 500 index, meaning the
composite earnings divided by the index price, is 2.9%. That is a good deal less than you can earn on a Treasury bill.
 
        "The miracle is how loony it is and how few will say the emperor has no
clothes," says Grantham.
 
 
 

        In 1978, when the mutual fund business was surviving, barely, on money markets, Grantham had just launched GMO and was presciently buying the out-of-favor stocks like Travelers Corp. and Chase Manhattan that funds were dumping.  A query in 1981 elicited a spectacularly correct call to buy bonds (Treasurys were then yielding over 14%); a visit in 1989, when value-based stock picking was a cult, found Grantham high on growth stocks like Abbott Labs and Lilly.  In short, Grantham is not a stopped clock, right just twice a century during market crashes. GMO'S performance record was consistently exceptional up until the last two years, when it turned bearish too soon.

        Grantham is unrepentant.  "We're right, just early," he says. If he has pulled out of stocks prematurely, it is because he wears the scars of overplaying a bull market.  In 1968, as a self-desctibed "gunslinging nitwit" just out of Harvard Business School, he jumped on enough winners to afford a Victorian home.  He lost it all a few years later buying garbage like American Raceways on margin.
Over the next several years he survived on his wife's salary (as an assistant editor for MIT Press) and a tight budget that allowed buying the Boston Globe only days after the Celtics played.  In 1971, while at Batterymarch Financial, he pioneered the idea of an index fund.  Brilliant, but early: It took two years to land the first client.
Unlike other indexers, though, Grantham never believed the market was consistently rational, nor efficient enough to preclude outperformance.  "Indexing in the long run is sensible," he says.  "In the short run it can be lethal, particularly now."

        Rather than making the market more rational, disciplined portfolio management has come to mean buying companies to match a narrow index, regardless of whether the valuation of the index makes any sense.

        Example: Large-growth stocks have been market leaders and continue to be regardless of price.  So today's crop of newly minted Harvard Business School graduates buy them mindlessly.

        Says Grantham: "All they care about is benchmark risk.  This will be a trivial issue in a collapse."

        Grantham remembers the first collapse of his career, which began with go-go stocks in 1970 and spread to the entire market by 1973.  In the years immediately after a crash, he explains, sobered investors keep a tight rein on prices.  Then, after a generational shift of about 20 years, emotion replaces business valuation as the driving force until the next, inevitable, shakeout.

        How does a rational investor justify owning the S&P at 1360, which means owning stocks at 34 times trailing earnings?  One theory is that, over the long pull, stocks are so sound they needn't carry a risk premium.  But even brushing aside the risk that P/E ratios just might be a lot lower 20 or 30 years from now (or whenever you get around to spending the money you are saving now), the 34 multiple strongly suggests that you can make a real return of only 2.9% on money you put into stocks today.  Will you be happy with this return?  It's less than half the real return stocks have averaged over the past century.

        Grantham's forecast for real total returns on the S&P 500 over the next decade is minus 1.5% a year.  He gets this figure by combining normal real earnings gains, a meager dividend yield and a steady unraveling of P/E ratios.  He's comparatively bullish about small-company shares- they should earn you 3% real per year over the next decade. (These and other return figures are pretax.)

        Where should we put our money?  Grantham's personal portfolio is short U.S. big-company stocks and long emerging market stocks (25%) and bonds (10%), REITS (25%), Treasurys (25%) and timber (10%).  From this strange mix, he expects a real return of 7% a year over the next decade.

        Grantham likes conventional Treasury bonds yielding 5.5%, but he likes the inflation-indexed Treasurys even more.  The one due in 2029 was issued on April 15 to yield 3.9% (real return) to maturity.  If, as Grantham expects, people come around to the view that this bond is something they want to have, then the price will climb and the yield over the next few years should drop to 3%.

        RElTs, very out of favor at the moment, should earn 7% real for today's buyer.  That's because they yield something close to that and have dividends that should keep up with inflation.  There's always the risk that they will do poorly for a time on Wall Street, but the business risk is not great because, says Grantham, the average lease was signed during a period of substantially lower rents.

        Timber, with an expected real return of 9% (and huge tax advantages), benefits from an illiquidity premium. Investors hate the idea that the return comes in decades, not day trades, and they tend to exaggerate the risk from fire and pests, which is only 0.5% annually, says Grantham.  He owns forest land in New Zealand, Tasmania and New England through private partnerships.  Small-time investors can own timber, albeit without the tax advantages, through stocks like Plum Creek and Deltic Timber.

        GMO doesn't take clients with less than $1 million, except into a timber partnership for $250,000, and it offers one retail mutual fund, the $5,000 minimum Pelican Fund.  Managed by Richard Mayo, Grantham's partner since 1970, it owns stocks like Waste Management and Kimberly-Clark.  Despite some bonds and small companies, ten-year old Pelican has kept up with the average value-oriented fund and performed far better during downturns.  The no-load fund's annual expense ratio is a below-average 0.95%.