The four horsemen of the market

Heed the sobering investment advice of these veteran money managers

SAN FRANCISCO - As investors, they fly solo. As market observers, they don't lead or follow as much as go their own way. It's tempting to dismiss their Cassandra-like warnings as overly pessimistic and hopelessly out of step, but their track records show that can be a costly mistake.

Jeremy Grantham, Bob Rodriguez, John Hussman and Steve Leuthold are contrarian-minded investors and opinionated commentators who share one thing in common: Those who buy into their funds never know exactly where their money will be parked. It could be emerging markets or alternative energy, high-yield debt or Treasurys. And if these risk-conscious money managers don't see compelling values, they might hedge their portfolios against unruly markets or even stash a good chunk of shareholders' assets in cash until better bargains appear.

You might call them the Four Horsemen of the Market, riding ahead of the predictable approaches and traditional thinking that defines most of the mutual-fund business. While these strategists display individualistic tailoring and design, what they have to say about stock and bond markets and economic conditions should get investors' collective attention.

Jeremy Grantham: 'Officially scared'

Jeremy Grantham is not given to false alarms. The chief investment strategist at GMO, the highly regarded Boston-based manager of institutional and high-net-worth accounts, makes buy and sell decisions with a combination of computerized technical analysis and old-fashioned spadework. But nowadays, his digging for attractively valued stocks is mostly hitting rocks, and that has Grantham deeply concerned.

"The fundamentals have turned out to be worse than I had thought," Grantham said. "My advice would be, don't take any risk."

What he means is that in this market, don't be a hero; live to fight another day. Here's why: Global economic growth is slowing under the weight of increasingly illiquid credit markets and inflationary pressures. Weaker growth slashes corporate earnings, and since stock prices are tied to earnings, the outlook for equities worldwide, as Grantham sees it, is poor to middling.

"I don't consider myself a 'perma-bear,'" Grantham said. "Merely a realist."

It's a grim reality, to be sure. In Grantham's world view, stocks in both developed and emerging markets are "substantially overpriced," with the possible exception of high-quality blue-chip companies that have strong, defensible global franchises.

"I underestimated in almost every way how badly economic and financial fundamentals would turn out," Grantham wrote shareholders in a July letter. "Events must now be disturbing to everyone, and I for one am officially scared!"

One of his biggest fears, he added in an interview, is that "the whole global economy will be weaker than the market expects for quite a considerable time." How long? "I would guess at least two years of sustained disappointment."

Notably, just a few weeks ago Grantham turned negative on his "beloved" emerging markets, which had been a spot-on bullish call. "If the global economy is going to disappoint, the cost of holding them just seemed too high," he said.

Grantham is particularly uneasy about China, a leading engine of world growth that seems to be sputtering. "I worry on behalf of the global economy at the consequences of China stumbling," he said. Without China's robust demand, he added, "the whole level of global imports and exports would start to drop."

Don't hide under the mattress just yet. Grantham points out that many of the world's strongest companies are based in the U.S., which could help the U.S. market's relative performance. Moreover, he said, the weaker global picture will benefit the U.S. dollar, so the American market could turn out to be "a safe haven."

Bob Rodriguez: 'Buyer's strike'

Bob Rodriguez wants to be left alone. The manager of FPA Capital Fund and bond-focused sibling FPA New Income Fund has since June 2003 been on a self-proclaimed "buyer's strike" regarding high-quality bonds with maturities greater than two years.

Rodriguez believed then -- and is even more convinced now -- that longer-term Treasury yields aren't substantial enough to compensate investors for inflation's eroding impact on purchasing power. He wants to get 5% on 10-year Treasurys, which recently yielded 3.8%, before venturing back.

Consequently, Rodriguez continues to focus on "caution and capital preservation," as he explained to fund shareholders in a June letter. More than 40% of Capital Fund, for example, is given to short-term government agency and Treasury notes and cash.

"We will not provide long-term capital to borrowers with unsound and unwise business management practices at unattractive real yields," Rodriguez wrote. That includes the U.S. government, he noted. "We require a higher level of compensation -- i.e. more yield, for these potential risks."

The line in the sand hasn't hurt performance, however. Capital Fund, which is closed to new investors, has gained about 9% over the five years through Aug. 27, matching its midcap-value peers but with much less risk. New Income, meanwhile, is open to new money; it's 4% annualized five-year gain also was achieved with below-average risk.

"He's not naturally the most optimistic person you'll ever chat with," said Christopher Davis, a fund analyst at investment researcher Morningstar Inc. "Even in the best times he's looking for the gray lining in a silver cloud. That's one of the reasons you invest with him."

As for stocks, the value-oriented fund manager was early to embrace the energy sector several years ago and has hung on for the ride. And not surprisingly, Rodriguez steered clear of banks and other financial-services firms even as many of his value-driven counterparts saw bargains.

"By my calculation he adds about two percentage points a year through market timing or varying his exposure" to stocks, said Robin Carpenter, principal of CarpenterAnalytix.com, which develops investment tools for money managers. "That's a big number when it's added on top of the other returns you're getting. Some managers would kill for two extra percent."

Rodriguez declined requests to be interviewed.

John Hussman: 'Stay defensive'

It's tough to put John Hussman in a box. Not that you'd want to. Hussman runs two portfolios: stock-focused Hussman Strategic Growth Fund and bond-centric Hussman Strategic Total Return Fund. Both are run with a careful eye to valuations and broad economic conditions that dictate the degree of market risk that Hussman is willing to accept.

For Hussman nowadays, risk-taking doesn't offer much reward. "We're fully hedged," the fund manager said, meaning that a portfolio won't be affected, positively or negatively, by market gyrations.

The reason? Hussman said he's looking for another shoe to drop once investors recognize that the U.S. has not avoided recession.

"The stock, bond and foreign-exchange markets continue to trade essentially on the theme that the global economy is weakening, but that the U.S. has dodged a recession," Hussman wrote in his weekly market commentary in late August.

Investors' consensus is mistaken, Hussman contends. He said the U.S. is mired in recession, and once investors realize that earnings expectations are overblown, stocks will take another major hit.

"The potential downside could be abrupt, leaving little opportunity to make defensive changes after the fact," Hussman wrote.

While Strategic Growth's hedges insulate it from the market's volatility, Hussman is anything but neutral. The portfolio is fully invested in stocks, and how these selections fare determines the fund's return.

"What drives our fund is the difference in performance between the stocks we own and the indices we use to hedge," Hussman said.

That said, Hussman doesn't expect much from stocks. He predicted that U.S. market returns will average 4%-6% annualized over the next decade, primarily due to weaker corporate earnings. Given that slower-growth view, Hussman dumped most of his exposure to the commodity, industrials and precious-metals sectors, which thrive in expansionist periods, and he's spotted bargains in consumer-related industries such as health-care products and medical devices; one of Strategic Growth's top holdings is Johnson & Johnson.

"A lot of those [consumer] names in my view got too far depressed," Hussman said.

He also sees value in technology stocks, and at the end of June Strategic Growth had meaningful stakes in Amazon.com and Research in Motion Ltd.

Steve Leuthold: 'Pretty positive'

Steve Leuthold has been called a "superbear" for his extreme pessimism about stocks during the bull run of 1998, and more recently a year ago when stock exposure in flagship funds such as Leuthold Core Investment Fund and sibling Asset Allocation Fund barely scraped 30%.

Leuthold is a colorful figure, offering targeted portfolios with catchy names like the bear-market Grizzly Short Fund and the bottom-fishing Undervalued and Unloved Fund.

But Leuthold is straightforward about stock research, and he goes where it tells him. So he didn't balk a couple of weeks ago when the signs all said "buy."

Now Leuthold's allocation-driven portfolios are covering short positions and other hedges and moving from a neutral, 50-50 equity/bond allocation toward 60% stocks -- nearing their 70% maximum threshold.

"Our whole office is surprised," Leuthold said in an interview "This is quite a departure for us. I don't believe I've ever seen such a dynamic change, going from mildly negative through neutral to pretty positive."

Like Hussman, Leuthold is convinced that the U.S. economy is in recession. But he points out that the stock market typically bottoms around the midpoint of the downturn. By his reckoning, the economy entered recession toward the end of 2007, and the extensive valuation criteria he uses tell him there's now light at the end of the tunnel.

"The bottom has been made," Leuthold said. "The economy is going to start showing some positive signs sometime in the first half of 2009."

So he's getting in early, loading up on shares of biotechnology and alternative-energy companies in particular, and keeping a modest amount in oil drillers and natural gas producers.

Enthusiastic stock buying sets Leuthold apart, but it's in keeping with his iconoclastic ways.

"I guess I still am a contrarian," he said.

"He's definitely not your standard money-management personality," added Greg Carlson, a Morningstar fund analyst. "His approach is quite different from the norm. It's his willingness to be bearish that sets him apart."