Jeremy Grantham Predicted Two Previous Bubbles. And Now?
The investor thinks stock valuations are high. But so are profit margins, he says.
With the S&P 500 up more than 15% this year, it may be time for a reality check. To that end, we spoke with Jeremy Grantham, co-founder and chief investment strategist at Boston-based money manager Grantham, Mayo, Van Otterloo & Co. and a noted spotter of market bubbles.
He thinks U.S. stocks and bonds will fail to generate inflation-beating returns over the next seven years, but he doesn’t see an imminent crash in share prices.
Mr. Grantham and his firm recently have had their own reality check. Many investors cashed out of the company’s mutual funds and institutional investment accounts early this year, impatient with a bearish approach as U.S. stocks rallied.
But Mr. Grantham has already cemented his legend by arguing that U.S. stocks were overvalued in 2000 and again in 2007, anticipating the market’s two most-recent crashes. He also noted before the 2008-09 financial crisis that the relationship between home prices and income had become unglued, and said at least one large financial institution would fail.
By Mr. Grantham’s lights, U.S. stock prices are again high, with an overall Shiller price/earnings ratio (share price relative to the past decade of real average earnings) over 30, compared with its average of 16.8 since 1880. But profit margins also are unusually high, lending support to the high valuations, he says. And the Federal Reserve’s policy of keeping interest rates low supports share prices by making fixed-income investments less attractive as an alternative to stocks.
So this time, instead of a crash, stock valuations may take decades to revert to anywhere near the long-term average, Mr. Grantham says.
Edited excerpts of the interview:
WHAT’S DIFFERENT
WSJ: You made some news over the past year, saying “this time is different” regarding high profit margins and stock prices. But you’ve said that not everyone understood you correctly.
MR. GRANTHAM: Valuations will revert over a 20-year period. And even then it probably won’t be a complete reversal to the levels that we saw pre-’98. We’ll get two-thirds of the way back. Somewhere along the line journalists made it a permanent high plateau. That’s precisely what it isn’t. Reversion will occur, but it will take time.
If you look at the 20-year horizon, which is the one that matters to pension funds, we’re forecasting 2.8% real [average annual returns] for U.S. stocks.
The two great stress tests of the new era were the tech bubble and housing bubble. In neither case did prices go down below [the long-term trend line] and stay there. The Fed has learned to come to the rescue.
Those things and stubbornly high profit margins were grinding away in the back of my brain. Finally, after a painful two or three years, I realized this time it’s different.
WSJ: You’ve famously called profit margins the most mean-reverting data set in finance. What’s keeping them high now?
MR. GRANTHAM:Some outsized margins are structural—the brand power of large corporations. I think what is [also] going on is new-fashioned bullying, not the old-fashioned monopoly. Bully politicians into getting favorable legislation. Bully the Justice Department into going to sleep. Bully regulatory agencies. It’s the power of corporations—better regulations and favoritism for giant companies.
WSJ: Speaking of the advantages of large companies, are the biggest, most profitable U.S. companies—the so-called high-quality businesses—still cheap?
MR. GRANTHAM: Even those are not cheap anymore. They had the wind in their sails, and a few years ago we thought they were cheaper than the rest of the market. They are still less expensive than the overall market, but much less so than previously. We define high-quality businesses as those having consistent and stable high returns on invested capital, and low debt.
Both emerging and developed markets [outside the U.S.] will probably deliver better returns. If you need a bigger return to survive, you should take a bigger bet on emerging markets.
PURGATORY, HELL AND CAPITALISM
WSJ: Your colleague and GMO portfolio manager, Ben Inker, has wondered whether we are in purgatory, with low-return investment choices until a reversion of valuations creates better ones, or hell, with low-return investment choices without a reversion and the future high returns the resulting low prices would afford. Where are you?
MR. GRANTHAM: I’m neither in hell nor purgatory. This is a structural problem. There is lower population growth. China is saving so much, putting downward pressure on the cost of capital. Fed policy is that you remorselessly keep the pressure on rates so that each leg down [in interest rates] is lower than the last.
How quickly do we expect the Fed’s policy to change? Cycles come and cycles go, and probably sometime there will be inflation and [the Fed] will have to raise rates.
Four and a half years ago, in the final paragraph of my quarterly letter, I’d been talking about the Fed bullying rates down. When you consider the bully, the career risk of the bullied [the need to buy stocks regardless of valuation because others are buying them], and the willingness of [individual investors] to believe the unbelievable, you’ve got to think that the Fed can win another round or two [keeping interest rates low and asset prices high].
WSJ: Is this high-profit-margin situation an unusual one for capitalism?
MR. GRANTHAM: The U.S. form of capitalism has lost its way. The social contract was previously in good shape. Corporations looked after their employees. They were more paternalistic. Great pension funds were starting up. The CEOs were increasing income alongside their workers. CEOs earned more than 40 times workers. Today, that number is 350 times, and the system has gone to hell. Keynes, Schumpeter—and Marx, not to mention—thought, by their nature, corporations and capitalism would overreach simply because they could. Corporations would use their advantages to get more power and more money. Their share of the pie would increase, and cause society to push back. Sooner or later there will be a pushback.
Mr. Coumarianos, a former Morningstar analyst, is a writer in Laguna Niguel, Calif. He can be reached at reports@wsj.com.
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