What Jeremy Grantham is not telling you about a US stock market bubble

Recently, veteran fund manager Jeremy Grantham made headlines for suggesting US markets could be in a bubble. He wrote that we should brace ourselves for a possible near-term melt-up. And then Grantham detailed how much of a melt-up would be enough to confirm a bubble.

The interesting bit was his recommendation that investors rotate out of the US stocks. The market veteran says US stocks offer a poor relative value. Instead of US stocks, Grantham recommends investors increase their allocation in emerging markets and even developed economy stocks.

There are a few problems with this recommendation. First, there is home country bias. That’s the natural tendency for investors to put their money in domestic markets. People feel comfortable with domestic equities because they recognize the companies and know the names. And US equities have done well for investors, not just in this bull market, but since the early 1980s.

It’s a big leap for the average investor to move away from a portfolio of 60% domestic equities and 40% domestic bonds. Moving to a portfolio laden with exposure to countries and markets of which one has no knowledge may be a leap too far. I don’t see the average US investor going there when US equities have done so well.

Even so, there’s the fact that some big emerging markets have also seen a huge rally in shares. India, for example, has seen a return of 145% in the last four years. Ambit Capital CEO Saurabh Mukherjea says the Indian bull market is set for a ‘frenzy’ much like Grantham’s talk of a US melt-up. He says the Indian market’s average price has risen from 17 to 24 times trailing earnings, which is expensive.

And, of course we also know that the other big emerging market in China has seen a boom in equities. Recent valuation levels are more reasonable than they were three years ago. But, that’s because of a nasty crash in 2015. Would Joe investor in America ride out a new crash in Ping An Insurance, China Minsheng Bank and Kweichow Moutai? I doubt it. Those are some of the biggest names in the CSI 300, the China Securities Index, by the way.

My point is that home country bias underpins the move to passive investing in the US. Defined benefit pensions are mostly gone. And ordinary Americans are taking on more of the financial risk of retirement via 401(k)s. Passive investing makes sense in that world because you recognize the names, shop at the stores and buy the products. That’s not true with the emerging markets. Most of the names are not just foreign, but unknown.

If we do see a melt-up into a US stock market bubble, home country bias will be a big factor getting us there.

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