Grantham: The essence of every bubble is wonderful fundamentals, euphorically extrapolated

Jeremy Grantham sat down with Consuelo Mack at WealthTrack to expand upon his recent bullish comments about the US markets.  However, far from being bullish, the essence of Grantham’s comments were bearish. He suggested investors should expect a couple of percent real return in US equities over the next couple of decades. The veteran investor also made bearish comments about the US bond market. His advice is to rotate out of US equities and pile into emerging markets, as much as you dare.

It must be noted first that Jeremy Grantham has called a few stock market bubbles. He called the tech stock bubble of the 1990s and the global credit bubble of the 2000s, to be sure. And he was spot on in timing the 2009 market bottom. See my February and March 2009 posts Jeremy Grantham: “Pull the trigger” and More bullishness from Jeremy Grantham. So when Grantham talks of how to deal with a market melt-up, we should listen.

Grantham is the Co-Founder and Chief Investment Strategist at Boston-based fund manager GMO. And his written piece at GMO a couple of weeks ago focused on the melt-up. In contrast, the views he expressed in his WealthTrack interview show concern about overvaluation in US markets, in absolute and relative terms. I want to pick apart what he said and follow it with the video of his conversation.

Grantham’s macro view

Here’s the macro picture he presents: there are a very few number of bubbles in US equity market history. There’s the one that ended in 1929 and the one in the 1950s and the one that ended in 1999. But that’s it. So, it makes statistical analysis very hard. Moreover, it’s even more difficult to predict a bubble because they start out of nothing. Grantham believes it’s only moderately possible to predict that last phase of a bubble, the melt-up, because there the telltale signs of overvaluation and euphoria are all around. And that’s why he’s made his call now.

Grantham says that, “by traditional standards, the market is very expensive, extremely expensive.” Yet, at the same time, here we are, going into the 10th year of an economic expansion and cyclical bull market. And we are seeing a synchronized global expansion. In Grantham’s view, this is fertile ground for a bubble. In fact, the essence of every bubble is “wonderful fundamentals, euphorically extrapolated”. Good fundamentals are “a base for real optimism”. But combine them with a late cycle environment, high valuations, and unrealistic extrapolation and you have the makings of a bubble. And Grantham says, “there’s never been a bubble when the fundamentals did not shine.”

What’s Grantham looking for?

To validate a melt-up, he wants to see market acceleration. For example, Grantham says during the blow-off top phase, the smallest bubble rose 60% in 21 months. That’s the minimum definition for Grantham for a melt-up. If this market goes up another nine months the way it has for the last three months — with a 2 1/2% gain each month, it will reach this critical level by October.

Now, Consuelo Mack rightly noted that we don’t see anything like the kind of excessive speculation we saw in other melt-ups. And she asked Grantham how he could be prepared for one now. His answer: we only saw that extreme euphoria at the end of those melt-ups. We’re not there yet.

The interesting bit of Grantham’s analysis is that the US is an outlier here. If you look globally at markets that are trading one sigma above historic return levels, in January 2018, the figure is only 17%. That’s in sharp contrast to 2007, which was nothing compared to 2000 in terms of US stock market overvaluation. 2007 was not a classic stock market bubble. Instead it was a global credit bubble in which two-thirds of all markets had returns at least one sigma above historic return levels. That’s substantially higher than every other time in history except 1929, by the way.

None of this bodes well for investors who want to ride US based assets for the long term. The traditional US investor who had 60% equities and 40% bonds invested in only US assets has had a great ride since the tech bubble. Over the longer term, from the early 1980s, bonds are down from 16% under Volcker down to 3% now. You’re not going to have that tailwind again, not for bond values and not for equity values via the discount rate. In Grantham’s view, bonds are in for some hurt, while US equities are expensive.

The prediction

A couple of percent real return over an entire 20-year time horizon. That’s the projection for Gen X — the baby bust generation —as it retires, a demographic train wreck if it does happen. Moreover, Grantham says he reaches this figure with valuations converging only two-thirds to the mean instead of 100% as other value investors would have. He says,“the world has changed in many important ways I think,” suggesting he now believes corporate profit margins will not mean revert — that labor will not receive the same share of profits that it historically has done.

The advice

For individual value investors must rotate out of the US and go into emerging markets. They should keep cash more on hand as well. Since the US is so over-valued, Grantham also recommends putting a minority position in developed economy stocks ex-US – i.e Europe, Japan, Australia, etc.

Put as much as you dare into emerging markets, Grantham says – 50%! And he says you can get exposure via index mutual funds as well as ETFs. His view: Emerging markets represent off the scale relative value.

Oh, and put a small hedge into momentum stocks to minimize regret for missing out on the boom — a couple of percent allocation.

Best piece of advice: Have a strategy and stick to it no matter what.  You should already be saying to yourself, “If X happens, I do Y. And stick to it regardless. If Apple and Tencent go up X percent, I sell and do X with my money.”

My view

I like Grantham. His arguments are well-reasoned and his advice on having a strategy using exact price targets to buy and to sell is the discipline investors need to avoid psychological traps.

The one place where I find his analysis most suspect is where he talks about cost-push inflation, saying we’ve “never had a labor market this tight”. I disagree with this emphatically. I believe the headline level of unemployment is misleadingly low. And, moreover, the loss of bargaining power by labour due to globalization and global wage arbitrage is a cap on inflation. This is why corporate profit margins have yet to mean revert.

If the market melts up, then it will melt down. Grantham said as much in his written piece. And then the question is whether that meltdown occurs as a result of a real economy failure — a recession, or as a result of a market blip like the Crash of 1987. Likely, a true bear market, where investors lose 50% will happen only if the real economy turns down. And, in a world of increased inequality and global wage arbitrage, that’s negative for the developed economy middle classes, the global economy’s biggest spenders. There’s no wonder that 70% of people in all southeast Asian countries believed globalization has been a force for good, while people in places like France, the US and the UK are much more sceptical.This is not an inflationary scenario.

The bottom line: Grantham’s equity market views are very plausible. But, on bonds, I am not a believer yet. Great interview, anyway — here’s the clip. Enjoy.

P.S. – If you want to see what Grantham was saying a decade ago as the credit bubble was imploding in 2008, see my post, “Jeremy Grantham: In-depth television interview with Consuelo Mack” from that time.

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