Investment Letters blog has uploaded Jeremy Grantham’s latest letter. The title is “Meltdown! The Global Competence Crisis.” Jeremy says “I for one am officially scared.” It deserves to be read in its entirety, as usual.

Jimmy Cramer, on the other hand, is calling a bottom. Let me see, who do I think is more than likely correct?

It is rare when I read something with which I agree 100%. Here is such a case, this succint interview with Jeremy Grantham (in the Globe & Mail).

You draw comparisons between what’s happening today and the start of the Great Depression.

We’re in that 1929-30 window, where we’ve had a shock to the system. But the secondary effects - less consumption, lower profit margins, lower GDP, lower employment, lower global trade - are beginning to work through the system. They’re steadfastly ignored because they’re still quite slight. It takes a year, 18 months [or] even longer for some of these effects to show up.

As the article notes, Jeremy, like me, got out of the NASDAQ bubble way too early. However, it is encouraging to note that his analysis and mine come up with the same answers.

While the stock market has been showing signs of stabilization, fresh problems in the credit markets are showing up. High yield (the bonds formerly known as junk) spreads are at 52-week highs. Check out the AAA commercial mortgage credit swap spreads (turn the children’s eyes away, this is ugly). Don’t even look at the lower grades.

I don’t know where we’re going, but I’m pretty sure we’re not there yet.

How about corporate debt, you say? Well, you’ll be sorry you asked.

Edit: The Financial Times picks up this story. Page one in the print edition.

Edit: Jeremy Grantham in this weekend’s Barrons:

I have yet to meet a private-equity firm that put into its spreadsheet the assumption that system-wide profit margins could decline by 20% to 30%. They have taken the current, abnormally high profit margins as a given and then determined to improve them by, let’s say, 15% and assume everything works out pretty well. But if the base declines by 20%, even if they end up improving margins by 15%, they are going backwards. And if they pay the 25% premium up front, which was normal, and if they leverage 4-to-1, which was normal, then they almost precisely wipe out all of the clients’ money, all of the 20% in equity and if, perish the thought, they don’t add 15%, but add perhaps zero to 5%, then they do more than wipe out the equity, they leave the underlying debt in ragged disarray. That is the next shoe to drop on the credit side.

… you’ve got to ask yourself a question: Do I feel lucky? Well, do ya, punk?

Edit: Bloomberg: CDO Losses Driving Credit-Default Swaps to Record, Analysts Say

Edit: Financial Times: Subprime losses could rise to $400 bn

Speaking after the meeting of Group of Seven finance leaders, Peer Steinbrück, German finance minister, said the G7 now feared that write-offs of losses on securities linked to US subprime mortgages could reach $400bn. This is sharply higher than the $120bn credit losses that Wall Street banks and other institutions have revealed in recent weeks – and also far bigger than the US Federal Reserve’s estimates for subprime losses last year of $100bn-$150bn.

Edit: WSJ: New Hitches In Markets May Widen Credit Woes

A widening array of financial-market problems threatens to trigger a new phase in the global credit crunch, extending it beyond the risky mortgages that have cost banks and investors more than $100 billion in losses and helped push the U.S. economy toward recession.

In the past few days, low-rated corporate loans — the kind that fueled the buyout boom of recent years — have plummeted in value. As a result, banks are expected to try to unload some of those loans this week at fire-sale prices.

Nervous buyers also have retreated in recent days from the market for securities backed by student loans and municipal bonds, roiling some corners of the short-term money markets. Similarly, investors have recoiled from debt backed by commercial real estate, such as office buildings.

Steve Roach pipes up from his new job in Siberia Asia. His point is one that I have made in the past - central banks cannot ignore asset prices.

“It is high time for monetary authorities to adopt new procedures–namely, taking the state of asset markets into explicit consideration when framing policy options. As the increasing prevalence of bubbles indicates, a failure to recognize the interplay between the state of asset markets and the real economy is an egregious policy error.”

(Note: readability grades: Kincaid: 16.3, ARI: 16.9, Coleman-Liau: 16.5, Flesch Index: 22.4/100, Fog Index: 18.0, Lix: 57.0 = higher than school year 11, SMOG-Grading: 15.2 - must be a real economist)

And from the same Fortune section, we have Jeremy Grantham:

“There is a lot of pain still to be had in the equity markets, particularly aimed at the risky end of the spectrum. We think the fair value on the market is about a third lower in the U.S and EAFE from today and about a quarter less in emerging markets.”

And Jim Rogers:

“I have been and continue to be short the investment banks and the commercial banks. If they bounce up, I’ll probably short more. I’m certainly not buying anything. The market’s only down 8%. I don’t consider that a buying opportunity. The things that I’m short, some people probably think are buying opportunities, but I don’t. I’ve been short the banks for close to a year, and for a while it was not fun. But I added to my positions, and now it’s a lot of fun.”

And to round out the crew with a wistful note, we have Warren Buffett:

“In one way, I’m sympathetic to the institutional reluctance to face the music. I’d give a lot to mark my weight to “model” rather than to “market.”"

It is usual in the investment world to break down the returns on a portfolio into two components, “alpha” and “beta.” Alpha is the part of the portfolio return which can be attributed to the active management of the portfolio - the manager’s skill, if you like, while beta is that which is due to the general change in market prices, usually determined as those of an index appropriate to the portfolio’s investment focus. So an index fund, which carefully tracks the returns of an index such as the S&P 500, is pure beta. There is no management decision-making, it just owns a portfolio of shares in the proportion in which they are represented in the index. The index fund therefore charges low fees, typically less than 1% of assets, because all it offers is basically an administrative service.

The original idea behind hedge funds, as the name implies, is that such a fund would “hedge” away the beta, the market risk and, of course, the market return, leaving only the return due to the talent of the manager - the alpha. So the “pure” hedge fund in the traditional sense is the exact converse of the index fund because it is pure alpha.

Markets, as we have recently seen, can be subject to wild swings and serious drawdowns. Between 2000 and 2002, for example, the Nasdaq Composite Index fell by 70%. Quite apart from not wanting 70% losses, this volatility of returns means that it is very dangerous to leverage portfolios whose returns have a significant beta component. Whereas the idea behind alpha is that it should be reliable and consistent, even though it may be modest in absolute quantity. Because if alpha-based returns are stable and consistent, they can be increased by adding leverage. Since the risk of drawdown is small, little capital is needed to absorb the swings and most of the portfolio can be financed with debt. This attribute makes alpha very valuable and justifies the high fees that hedge fund managers charge. For example, a portfolio that returns 2-3% over the cost of borrowed money, with never more than a 2-3% drawdown, could safely be leveraged 10:1 to return, say, 15-20% after interest costs and management fees. Hedge funds often charge a 2% fee plus 20% of profits. Real alpha is worth it.

The problem comes when hedge funds aren’t really hedge funds. In a bubble enviroment when steadily increasing leverage keeps jacking up asset prices, the temptation is to simply leverage up the returns offered by the market - the beta - and charge clients big fees as if the returns came from alpha. It looks good for a while, so long as the beta return stays positive and drawdowns are small. But inevitably the market reverses, and then the beta-based return and the alpha-based returns diverge, often with exciting consequences. Because leverage has been used, drawdowns quickly eliminate the investor’s capital and the funds blow up in an ugly mess of margin calls, seized collateral and apologetic managers. Just as we have been seeing.

Alpha requires management talent. The huge growth of hedge funds has probably not been accompanied by a miraculous growth in the number of talented managers out there, able to deliver alpha. So it is not unreasonable to believe that there are a lot of hedge funds out there, which are really selling beta with leverage at alpha prices. Jeremy Grantham recently predicted that half the hedge funds currently in business would disappear within the next five years. I don’t expect it to take that long.