In a wide-ranging and timely conversation, Jeremy Grantham joined Morningstar’s Christine Benz and Jeff Ptak on The Long View podcast, discussing everything from meme stocks to the housing market to the potential bursting of the stock market “super bubble.”
Grantham, the long-term investment strategist at his namesake firm that he co-founded, Grantham, Mayo, Van Otterloo & Co., spoke at length about what we’ve learned, and what has changed, since 2008, taking into account new strains for investors that rose alongside the pandemic.
Grantham offers a strong warning: The bursting of the U.S. stock market “super bubble” could be more devastating than investors are prepared for. Here are our six takeaways on how not to repeat history and potentially sidestep the market crash.
What is a bubble? And what makes the U.S. stock market a ‘super bubble’?
Grantham: About 25 years ago, we felt in order to talk about bubbles, we should probably define them statistically. And so, we did just that. And we picked a standard statistical term of a 2-sigma. A 2-sigma event is the kind that should occur every 44 years in a perfectly random world. And with human beings who are capable of being a little inefficient, they occur every 35 years in the equity markets, close enough, I would say, for government work. And we noticed that all of them in the developed world in modern times in equity markets went back to the trend. And the trend is easy to measure. The 2-sigma is pretty straightforward statistics. And the fact that all of them went back without exception, we find a very compelling idea.
The complexity comes from the fact that some of these 2-sigma events continue to go up. And the three of them in the U.S. have gone up to 3-sigma, which is the kind that you would expect every 100 years, but as I like to say, humans do seriously crazy pretty well. So, they are much further away from random than 2-sigma. And two out of three, certainly more than half of 2-sigma go on to 3-sigma in recent times. And the 3-sigma events, we have 1929, 2000 and today, in the equity market, and Japan as a major market overseas in 1989. And it doesn’t change the outcome. You go back to trend. But since by definition, you’ve gone further up, it takes longer and more painful and more pain to come down. And the quicker the bubbles end, the better off everybody is. And we mentioned this one as a 2-sigma back in July of 2020 or August about 3,500. The trendline is about 2,500. 2-sigma is about 3,500 and 3-sigma is 4,500, 4,600. We got to 4,800 in December. And if you’re going to have a bubble, it’s better to break from 3,500 to 2,500 than it is to break from 4,800 to 2,500. And therefore, the real McCoy super bubbles are extremely painful in terms of a reduction of perceived wealth. And there is a wealth effect. When they mark down your portfolio or your house, you spend a little less the following year or two.
How overvalued is the market?
Grantham: Well, seven years ago, the market was above its long-term trend in terms of value, and they went a whole lot higher. So, any value-based forecast won’t even get the sign right. If you want to be friendly to our public forecast, you could take the 10-year forecast, which is what we used to use in 2000, where we suggested that emerging would make money and the S&P would lose a lot of money in the following 10 years. And 10 years later, the S&P had lost a lot of money and emerging had made a lot of money. Even though they were technically highly correlated, the sheer difference in value had generated enormous difference in outcomes. And the reason we looked good was because 10 years later, the market was at fair value, or for a second or two in 2009, it was actually decently cheap for six months, even on long-term value.
The point is, if we measure at fair value or below, our forecast for the prior 10 years or seven years look brilliant. If you measure at a market peak, our forecast for the prior seven years or 10 years look terrible. It’s pretty straightforward. And we’re selling at twice fair value. As you know, we’re selling on Warren Buffett’s measure GDP to the stock market at the highest ratios ever, much higher than 2000, the previous record holder. On smoothed average of earnings, we’re very similar to 2000, and that’s because the last 20 years have been abnormally profitable. That in turn may be mean reverting. I believe it will be. We’ll see. But for 20 years, the profit margins as a percentage of GDP, total profits have been higher and profit margins have been higher. And so, the Shiller P/E is perhaps a little overfriendly to the market. So, we look a little less overpriced than 2000. If you look at price to sales, every single decile of price to sales is above the 2000 previous world record. The least above is the highest-priced, the top 10% on price to sales, only just late last year went ahead of the top 10% in 2000. The bottom 10%, however, is way over where the bottom 10% was in 2000. And every single decile in between is – so, every decile by price to sales is more overpriced than it was the top of the market in 2000. So, this is very broad overpricing. So, there’s no real measure of value, long-term value, that you could find where this isn’t one of the most overpriced markets we have ever seen.
‘There are 3.5 bubbles,’ says Grantham, but should we worry about commodities?
Grantham: I’ve tended to say we have 3.5 bubbles. Commodities are a little bit different. I don’t fear them because we’re going to lose income or assets when the prices of commodities go down. Ordinary people don’t earn big positions in copper and oil in the futures market. What I worry about is the income effect. If the price of oil goes to $120, which it may well, and the price of metals keep on going up, and the price of food keeps on going up, it simply squeezes your income. There is less leftover to do everything else. And in that sense, you’re poorer for dealing with the rest of the world. And that’s (indiscernible) effect. If that coincides with the wealth effect from the stock market imploding, you have a double whammy, which you had in the housing bust. Housing came down, and in a sense, it took the stock market along for the ride. The S&P went down 50%. And there was a very handsome negative income effect. At the same time, your house was going down, and your confidence level was falling. That double whammy, which they had in Japan for 20 years really, we also had in the U.S., and it was much more painful and guaranteed a much tougher economic environment than we had had for quite a few decades. So, you don’t want to do that.
And you’re playing with fire if you combine the lowest interest rates and the highest bond prices in history with the highest stock market in history and the highest multiple of family income in housing. I’m not saying that they will all go together. There are reasons as you suggest that the housing market may unravel more slowly. It will be more a slow steady function of interest rates. And nevertheless, we’re playing with fire by having all of those things overpriced at the same time. We’re running the risk that we will be squeezed by high energy and commodity prices, because we’re squeezed from the loss of perceived value in our housing and the stock market.
Meme Stocks: Who is driving equity market overvaluation?
Grantham: Corporate buybacks have been the shining number one driver of this 11-year bull market and has changed everything. And then, with the stimulus program, of course, the individuals came back quite suddenly, and in many cases, unexpectedly, not just unexpectedly in the numbers and the amount, but in their style. The meme stock style of investing is something no one has ever seen before happily. Hopefully, we’ll never see it again. But it did take basically worthless stocks like GameStop up 110 times in a month and 40, 50 times for AMC, the movie chain. These are levels of craziness that we had not seen in 1929 and even in the Pets.com era. In my opinion, they there was more money involved, bigger moves involved than we had ever seen.
But to get back to your point – so, individuals came storming in at the end, buying their own stocks by hand, not moving into institutional-type mutual funds. And the whole time, corporations were buying their stock back. Why wouldn’t they? It’s a safer way to invest their cash flow than developing new ideas of their own. And they would rather go out and buy a company from the venture capital industry as a capital transaction. Why would they risk income transactions by developing their own new ideas? So, they’re basically outsourcing to the venture capital industry. And that’s the same kind of attitude that is represented by buying your stock back. You know exactly what you’re getting, you know what it costs, you know what the effect is. You get rid of the weak holders of the stock, and it helps push the price of the stock up. The fact that it should not in an efficient world is irrelevant. In the real world, you get rid of weak holders, and steady buying pressure on stocks pushes the price earnings ratio up, and their stock options benefit. 85% of the remuneration comes from direct stock grants and from stock options. Why would they not put management of the share price as a top priority? I avoided the word manipulation, but I was very tempted to use it.
How can you protect yourself from the bubble bursting?
Grantham: Value is pretty darn cheap compared to growth. And the U.S. is about as expensive as it gets compared to other developed countries. So, non-U.S. equities are oddly semi reasonable. They’re overpriced, but they’re not too bad. And one or two of them, like Japan, the U.K., are really not materially overpriced even, which is unusual. With the U.S. not unique incidentally – 2000 was rather like that – but it’s unusual to have such a big disparity between one euphoric market and the rest of the world being relatively serious and more ordinary looking. Emerging, obviously, has some problems or question marks with China, but emerging in total looks very much cheaper than the U.S., about half price. And the value component is cheap within emerging. So, value stocks outside the U.S. are not too bad. And you can expect, if you put them away for 10 years, to make a respectable – even if it’s sub-average, you should make a respectable return. The U.S., I suspect you’ll make no money at all for 10 years. And you have to find the kind of moral equivalent in fixed income, other ways of investing your money. And I am not the person to talk to about the broad asset allocation portfolios. I have not been doing that for well over a decade.
Who is to blame?
Grantham: Well, I would say, if anything looks alive and well about market inefficiency, it’s the macro level of the market. Because we are meant to have a 3-sigma bubble every 100 years in an efficient market that occasionally by sheer randomness wanders off to 3-sigma. And we had one in 2000, and we had a 3-sigma housing bubble in 2007, and we have a 3-sigma equity bubble again. Now, this is abnormally calm. And a 3-sigma event is a major, major event, but the stock markets are at least (indiscernible). And then, you go under trend in the right conditions. All the great bubbles used to go under trend until the Greenspan era. Greenspan made moral hazards such a pronounced feature of Fed management that he has somewhat changed the dynamics and his successors completely followed that policy. So, they believe that you should bail out any stock market decline, but a bubble should be ignored. And in fact, they, from time to time, all for them, have expressed doubt as to whether bubbles actually exist as a phenomenon.
So, markets break, they come and help you; markets bubble, they ignore it, and you’re on your own. It’s a wonderful asymmetrical moral hazard, and it results in the formation, not an accident at all, of these three great 2-sigma events in 25 years. And the first one, the 2000 tech bubble burst with wretched effect. And then, we had a nasty recession, the housing and the stock market go in 2008, which was twice as bad and would have been a depression for not just the Fed, but for massive then unprecedented government stimulus. And here we are in the third one. These are dangerous things. I don’t know what the Fed thinks it’s doing. Well, I actually know what the Fed thinks it’s doing. The Fed does not worry its pretty little head about the downside of asset bubbles breaking or the risk involved in asset bubbles forming. It spends its time worrying about other things. And we pay a very high price for an unstable asset system and an occasionally destabilized economy.
This article was adapted from an interview that aired on Morningstar’s The Long View podcast. Listen to the full episode.
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