Famed strategist Jeremy Grantham views the market as 65% overvalued, but still sees some pockets of attractive investments.
For Jeremy Grantham, founder and strategist at GMO, a Boston-based money manager that oversees about $120 billion, it hasn't been easy watching equity markets rack up huge gains. As of Dec. 31, GMO was forecasting an annual real return of minus 1.7% for large-cap U.S. stocks over the next seven years. Grantham and his colleagues don't see much hope for bonds, either. Still, Grantham, 75, says the current stock boom has a much different feel than the tech bubble of 1999 and 2000. Back then, "there were clients who not only wanted to fire us, but who didn't want to ever see us again," he recalls. "It was personal." GMO runs various strategies, including its benchmark-free allocation funds, which aim for 5% annual real returns over a market cycle. The Wells Fargo Advantage Absolute Return fund (ticker: WARAX), which GMO subadvises, returned 9.65% last year. Grantham, whose market view is marked by an inherent bearishness and skepticism, is an engaging speaker. His passions include financial history, climate change, and other environmental issues.Barron's recently visited him at his office overlooking Boston Harbor.
Barron's: How frothy does the U.S. stock market look?
Grantham: There are two good standards for a bubble. One is boring statistics, and the other is an exciting behavioral frenzy, on which so many good books have been written. And based on the boring statistics, the data is really very clear: We are not even that close to a bubble. With the S&P 500 at around 1860 recently, we are at about a 1.4- to 1.5-sigma event. Another way to say that is that we are between one and two standard deviations outside the normal distribution of stock-valuation levels. A two-sigma event would put the S&P 500 at 2350. So using the standard definition, it has to go up another 30% from here to get to a bubble. But you don't know when an ordinary market move is a bubble; you only know that in hindsight. As for the second test, which is euphoria, I like to joke that in 2000 here in Boston, Celtics replays were displaced at lunchtime at the greasy spoons by talking heads on TV. You would go to one, and they would be touting the latest Internet stock. But I've noticed recently that they are still playing the sports highlights on the televisions in the pubs here.
There is a high level of enthusiasm from the financial professionals, hedge funds in particular. This time you have a very high level of confidence from the professionals—but not a very high level of confidence from the individual investors. The individuals are a bit more down to earth. They felt the pain of 2009 longer than the institutions did, and they have been slow to come back into stocks when you look at net buying of mutual funds. There has never been a bubble where individuals were not flooding into the market at the very end, though sometimes they are pretty late to the game. By the end of a real bubble, individuals are gung-ho, and they are not gung-ho yet. That says a lot.
What's brought about the discrepancy?
The belief in the Greenspan-Bernanke-Yellen put gets greater and greater each time there's a crisis. So we start in '94 with a bond crisis and a very successful bailout. Then we have the Long-Term Capital Management blowup in 1998. There's a bailout, which is very successful again. We have the Y2K bailout, which was a little unnecessary. And then we have the 2000 bubble and the ensuing collapse—the biggest bubble in American equity history. Uniquely, the stock market does not go below trend, even though the market is down 50%.
In 1929, it crashed through the trend line and stayed there for 20-odd years. The Nifty Fifty crashed through the trend line in 1973 and stayed down there until '86-'87. What is not typical is a bubble like the one in 2000. The market tumbled over three years, but it didn't even reach trend. And the cavalry comes over the hill with enormous stimulus and moral hazard, the kind of implicit promise that they would bail investors out in a crisis, which they did. And the market, never having hit even fair value for a minute, then doubles. I described it as the greatest sucker rally in history.
So that turned out to be a prescient call.
That was a lucky call, as much as anything else, because it took the breaking of the housing bubble in 2007 to end that rally. Obviously, the housing bubble was the absolute direct result of the Fed's bailout techniques, which included incredibly lower interest rates, and then there was eventually some help from the ridiculous financial instruments that were sold, along with very low standards for getting a mortgage. The U.S. housing market had been so stable and diversified historically. It had never bubbled, so to speak, in every district in America simultaneously until [Fed Chairman Alan] Greenspan got his hands on it. Then, starting in 2002, the U.S. housing market shoots up so much that, given its stable background, it statistically looked like the most magnificent outlier that we have had ever seen. And it wasn't just in housing, but in any American asset class. It was much worse than the 2000 equity bubble. It actually reached a 3½-sigma, or standard-deviation, event, which should occur randomly every 5,000 years. And at that point, Ben Bernanke was saying that the housing market largely reflected a strong U.S. economy.
How does this tie in with your point about institutional investors versus individuals?
The hedge funds said: "Boy, this is really great. The Fed did it once, they did it twice, they did it three times, including in the 2000 crash, and now they are probably going to come back and even bail out the housing bust." And, sure enough, the Fed busts its tail to do everything that mortals could possibly do, and everyone says how wonderful it was. To which I say it is like rewarding the captain of the Titanic for helping women and children into the lifeboats with admirable bravery, forgetting that it was only his recklessness in driving through the dark night in a famously glacier-intensive part of the ocean that caused the accident in the first place.
The key is that, for the hedge-fund guys and the smart institutional players, their faith in the Greenspan-Bernanke-Yellen put is getting massive. So they say that whenever things break, the Fed comes back in and puts the floor way higher than where it used to be. And the institutional players become more and more bullish. In each cycle, they use a bit more leverage and take a bit more risk. That's where we are surely now.
How overvalued are U.S. stocks?
They're 65% overpriced. If they go up another 30%, you would have a true bubble, at which point stocks would be close to twice their fair value. Similarly, in 2000, stocks were more than double their fair value. So they are quite capable of doing that. But my point is that with the professionals getting reinforced by the Fed going back to 1994, it will be very surprising if they don't keep on playing this game until the market at least hits a classic bubble definition. Bubbles don't usually stop until sensible investors, value investors, and prudent investors have been hung out to dry and kicked around the block. That hasn't happened yet, so that tells you there is probably quite a bit left in this rally.
If there is a bubble and it bursts, will the consequences resemble what we saw in 2008 and 2009?
No. That's the easy part. But the follow-up question—How will this play out?—is pretty well unanswerable. There have been plenty of times when individuals had too much debt, and there have been plenty of times when corporations were exposed. We've had times when chunks of the emerging-market countries have been exposed to foreign debt. What we haven't had is the major developed countries' governments strung out on debt. Debt levels have not dropped, but they have moved magnificently to federal governments, which now have the highest level of debt, on average, they have ever had. Those governments will be a stress point when the next bubble breaks. But how that plays out is difficult to say, because there is no historical precedent, with the possible exception of the 1930s.
So how is GMO positioning its portfolios?
There is an enormous creative tension for a sensible investor. On one hand, you know the market is worth a lot less than it is selling at, but you know about the Fed's policies. So it is very difficult for people like us at GMO because, for one thing, we have a seven-year forecast. It has had a terrific record—not because it is rocket science, but because the market, over a seven-year horizon, is mean-reverting, and it really does pay to avoid the particularly overpriced asset classes. But on a shorter time horizon, you can get whacked around the head, as we have been frequently.
What assets do look attractive?
Because of some secondary factors, there are pockets of global equities that haven't been swept along to anywhere near bubble territory. Emerging markets collectively are selling at very close to fair value. And the value stocks in most of Europe are pretty close to fair value. High-quality stocks in the U.S. are not nearly as bad as the rest of the market. So you can patch together global equities and get a semi-respectable-looking portfolio. Because of that, we have a substantial equity weighting in a typical account. The Wells Fargo Advantage Absolute Return fund has a 49% global equity weighting. That's a lot, when you look at our seven-year forecast and you see how many assets, including bonds and much of the U.S. stock market, are overpriced. But we have learned over the years not to invest everything on this month's data or this week's data or today's data—but to average in over a year. If nothing happens by October, our equity allocation will be down to about 38%, which would be completely compatible with our seven-year forecast.
What about bonds?
They look absolutely, nerve-rackingly overpriced, and in a crisis, who knows what will happen to those securities? They could make stocks look like a safe haven if the next bust occurs at the federal levels of the large countries. Bonds, including government bonds, are a lot more dangerous than people imagine.
What else is on your mind these days?
I worry about food, and I worry about Africa. The global economy has really two civilizations, or two systems. One is everything outside of Africa, where Taiwan, Thailand, Canada, Mexico, and other countries are all one big system moving together—trading oil and everything else. And then there is Africa, which, with the possible exception of South Africa, is its own little world. But it's the only part of the world where the population, on a broad basis, still is growing rapidly. It probably will decline, but these countries can't produce enough food, unless they get good advice and capital and fertilizer—or they become really clever farmers, and get a lot of help and sensible governments.
The countries I worry about most immediately are in North Africa, curling all the way into Syria, because they eat wheat. The price of wheat is two, three times what it used to be, and the price of energy is four times what it used to be. These are not rich people, so they have been desperately squeezed, and the weather is bearing down on agricultural production. The most dependable aspect of climate change is more droughts and more floods.
All of this has many implications, from countries like Egypt being able to feed its population to immigration policy in Europe to the impact on high-grade, low-cost phosphate, a big chunk of which comes from Morocco. Phosphorus is crucial for farming. The much higher prices of wheat, oil and, to some extent, fertilizers have helped destabilize various societies in this region. I worry about what happens if the deterioration spreads to Morocco.