Jeremy Grantham: The U.S. Market Is in a Super Bubble
The GMO strategist and perma-bear thinks the major asset classes are inflated, but calls value stocks 'pretty darn cheap.'
Our guest this week is Jeremy Grantham. Jeremy is the long-term investment strategist at his namesake firm, Grantham, Mayo, Van Otterloo & Co., or GMO, which he cofounded in 1977. He serves on GMO's Asset Allocation Committee and board of directors. Prior to GMO, Jeremy was cofounder of Batterymarch Financial Management and before that was an economist at Royal Dutch Shell. He earned his undergraduate degree from the University of Sheffield and his MBA from Harvard University. Jeremy is a member of the Academy of Arts and Sciences, holds a CBE from the U.K., and is a recipient of the Carnegie Medal of Philanthropy.
“10 Things You Didn’t Know About Jeremy Grantham,” by Allen Lee, moneyinc.com.
“Let the Wild Rumpus Begin,” by Jeremy Grantham, gmo.com, Jan. 20, 2022.
“‘Super Bubble’: Jeremy Grantham Says Historic Crash Has Begun,” by Clayton Jarvis, financialpost.com, Jan. 25, 2022.
“Market ‘Superbubble’ Could Lead to 50% Plunge, Says Grantham,” by Lawrence Carrel, forbes.com, Jan. 26, 2022.
“GMO’s Grantham: 7 Signs We’re in a Stock Collapse (And What to Do Now),” by Janet Levaux, thinkadvisor.com, Jan. 24, 2022.
“Is the Plunge in the Nasdaq and Bitcoin the end of the ‘Superbubble’”? by John Cassidy, newyorker.com, Jan. 24, 2022.
“The U.S. Is in One of the Greatest Bubbles in Financial History,” by Merryn Somerset Webb, moneyweek.com, Sept. 3, 2021.
“Grantham Calls Meme Stocks ‘Biggest U.S. Fantasy Trip,’” Kriti Gupta and John Authers, Bloomberg.com, June 22, 2021.
“Profiting From a Bubble in Growth Stocks,” by Jeremy Grantham, Simon Harris, Ben Inker, and Catherine LeGraw, gmo.com, March 25, 2021.
“Nikkei Back Above 30,000 After More Than Three Decades,” by Hideyuki Sano, reuters.com, Feb. 14, 2021.
“Waiting for the Last Dance,” by Jeremy Grantham, gmo.com, Jan. 5, 2021.
“COVID-19, Climate Change, and the Need for a New Marshall Plan,” by Jeremy Grantham, gmo.com, Oct. 30, 2020.
“Why Are Stock Market Prices So High?” by Jeremy Grantham, GMO Quarterly Letter, gmo.com, 2017.
“Loose Monetary Policy Is Today’s Biggest Market Risk,” by John Plender, ft.com, April 14, 2021.
“An Investment Only a Mother Could Love: The Tactical Case,” by Jeremy Grantham and Lucas White, gmo.com, April 30, 2020.
Innovation, Venture Capital, and Green Investing
“Grantham Stumbles on $200m Profit After Spac Swoop on Battery Maker,” by Robin Wigglesworth and Eric Platt, ft.com, Dec. 7, 2020.
“You Can’t Fool All the People All the Time,” by Jeremy Grantham, jpm.pm-research.com, Winter 1986.
“Green Investing May Be a Bubble, Jeremy Grantham Says, But He’s Doubling Down,” by Ben Steverman, fa-mag.com, Nov. 15, 2021.
“Where Jeremy Grantham Expects to Be ‘Kicking Ass,’” by Christine Idzelis, institutionalinvestor.com, Feb. 13, 2020.
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance and retirement planning for Morningstar.
Ptak: Our guest this week is Jeremy Grantham. Jeremy is the long-term investment strategist at his namesake firm, Grantham, Mayo, Van Otterloo & Co., or GMO, which he cofounded in 1977. He serves on GMO's Asset Allocation Committee and Board of Directors. Prior to GMO, Jeremy was cofounder of Batterymarch Financial Management and before that was an economist at Royal Dutch Shell. He earned his undergraduate degree from the University of Sheffield and his MBA from Harvard University. Jeremy is a member of the Academy of Arts and Sciences, holds a CBE from the U.K., and is a recipient of the Carnegie Medal of Philanthropy.
Jeremy, welcome to The Long View.
Jeremy Grantham: It's a real pleasure to be here.
Ptak: It's our pleasure to have you. Thanks again for being our guest. I wanted to start in what's the logical place, which is bubbles. You correctly called two recent bubbles that popped in the U.S.: the Internet bubble and the housing bubble. Yet, an investor who bought and held from the late 1990s to now has made out pretty well. So, the question is, why worry about bubbles as long as we have a long enough time horizon?
Grantham: If you can lock up your portfolio, throw the key away, you'll probably do OK. The problem is, if you hit these super bubbles that concern me, these three-sigma outliers in 1929, you didn't get back until 1956. And in 2000, you had lost a lot of money by 2009, and you got back in the game about 2012. And the same with the housing bubble. You can have a long wait. The mother and father of all equity bubbles is Japan in 1989, and they're still waiting. That's 22, 23 years, and they're still not back to the high. And what happens in real life is people don't hang in and wait for the 40-year return in the case of Japan. They change their strategy and abandon ship as the market goes down more often than not. So, these are very dangerous events, and you don't want to ride through them if you can avoid them. And they're not that common. So, when you are unfortunate enough to have one, my advice is to do some sidestepping of some of the pain.
Benz: So, you just used the term super bubble, and you're saying the U.S. market is in a super bubble, you believe. Can you explain what you mean starting with your definition of a regular bubble and then what makes this current one super?
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 two-sigma. A two-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 two-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 two-sigma events continue to go up. And the three of them in the U.S. have gone up to three-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 two-sigma. And two out of three, certainly more than half of two-sigma go on to three-sigma in recent times. And the three-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 pain to come down. And the quicker the bubbles end, the better off everybody is. And we mentioned this one as a two-sigma back in July of 2020 or August, about 3,500. The trendline is about 2,500; two-sigma is about 3,500; and three-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.
Ptak: You've said the bursting of the Japanese and U.S. housing market bubbles was devastating because in those cases you had manias in both the stock market and important economic sectors. What about now? Are you seeing the same dangerous combination?
Grantham: I have to admit the housing market doesn't seem to have the kind of psychological accompaniment of a crazy bubble like the stock market does. And it didn't worry me much back in July of 2020. But then, it decided to go into warp drive, and we've just had the biggest move in a 12-month period in the history of U.S. real estate, about 20% in the last 12 months, and quite a bit in the previous five or six months. So, since the U.S. equity market reached two-sigma, bubble territory, the housing market in the U.S. has shot upwards with great determination, and it actually sells at a higher multiple of family income than the housing bubble of 2006-07 because of that 20%. Twenty percent is a lot more in housing than 20% is in the stock market. That is just an amazing move. And it has certainly made the U.S. housing market extremely expensive--the highest price it has ever been as a multiple of your ability to buy at family income.
And history has been pretty straightforward. Whatever you do, don't have gloriously overpriced housing markets at the same time as you have a stock market bubble. Japan tried it, the biggest land and real estate bubble in history anywhere. Arguably the greatest bubble of anytime anywhere, and simultaneously, they had 65 times earnings it was said at the time in the Japanese stock market. That was the ultimate definition of potential pain as you had to mark them both down, and they did. And as I said, stock market isn't back to '89, but the land market isn't back to '89, either. So, you had double jeopardy, a lost decade, and you could say that those two bubbles from way back in '89 are still casting a shadow on the Japanese economy.
Benz: Thinking about the U.S. housing market, isn't it strong mainly because there's so little supply, and if that's the case, is there any reason to doubt that the fallout will be as severe as the last time that housing market was bubbly?
Grantham: That's actually exactly my view--that the housing market is not as reliably mean reverting as the stock markets have been. And the reason why not is because of zoning and all manner of inefficiencies that unfortunately surround the housing market. If you won’t let people build houses, then you get a chronic housing shortage. And most of the great markets in the world today have chronic housing shortages. They haven't been building enough in the U.K. for decades, or Australia, or New Zealand, and many European markets. So simply underbuilding, generating a shortage, and people simply have to pay more and more of their limited resources to buy a house. We didn't fall in that category until recently.
And you could divide the housing bubble into two groups: those where you had strict zoning and restraints on building. And when the housing bust occurred, they went down a bit, but they regrouped and went to new highs. And then, you had the three markets, where they were really cranking out new housing. In Ireland, they were covering the whole island with new houses; in Spain, everybody had to have two houses; and in the U.S., they were cranking out an extra 1.5 million houses a year over normal. And in those three markets, they caught up, they glutted the market, and the great housing bubbles collapsed and went all the way back to trend in the case of all three of those markets and below trend in all three of those markets. And this time, we have insufficient housing. So, you can't depend on the speed and extent of the decline.
The problem is, if the U.S. equity market goes down, if it casts a shadow on confidence, if it weakens the economy a bit, if there are other economic problems, then I expect the U.S. housing market to weaken. The way I described this is the potential for write-downs in asset prices and perceived value of your assets. If you are a record distance above trendline price in the U.S. housing market, even though there's no immediate reason why the house market should collapse, you will expect at some indefinite period and the time when people are pessimistic, the potential is there for substantially lower house prices. And one thing you should bear in mind is that housing is a complete creature of the interest rate through the mortgages. Mortgages--there's nothing like that in the stock market. Huge leverage. They're fixed term. They're completely institutionalized, they're completely socially acceptable, and they give you a level of leverage that you could only dream about in the stock market on very favorable terms in the case of the U.S. And if they lower your mortgage, why would you not pay more for your house?
Someone says to me today, “What should I do? I need to buy a house.” My attitude is, look, they're badly overpriced. Here's the data. They are higher priced compared to your income than they have ever been. But the mortgage is the lowest price it's ever been. The mortgage, if anything, is more underpriced than your house is overpriced. If you can guarantee to keep it for the life of the mortgage, 30 years, and you are prepared to rent it out if you have to, it's highly likely that you'll do OK. You may not do brilliantly, but you should do OK. And you may do very well. So, housing is a complete creature of interest rates. Makes it easier to understand also why interest rates drive asset prices than it is in the stock market where it's a little more complicated.
Ptak: Maybe you can touch on commodities, too. I think that's an area you've written about recently, and you've expressed concerns. I think you said that those are in a bubble, too. How did you arrive at that conclusion and how would the popping of a bubble in commodities be economically harmful?
Grantham: I've tended to say we have three and a half bubbles. Commodities are a little bit different. I don't fear them because we're going to lose income or assets when the price 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 left over to do everything else. And in that sense, you're poorer for dealing with the rest of the world. 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 have 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.
Benz: I wanted to follow up on the underpinnings of equity market overvaluation. Over the last 10 years or so U.S. stock funds and exchange-traded funds gathered only about $46 billion of net inflows total. So, that really isn't much considering that there are trillions of assets in U.S. stock funds. If U.S. retail fund investors aren't pushing valuations up, who's doing it? Is it corporate Treasurers buying back shares from retail investors? What's going on there?
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 Pet.com era, in my opinion. There was more money involved, bigger moves involved than we had ever seen.
But to get back to your point--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.
Ptak: I wanted to shift gears to forecast, to GMO's credit, very transparently lay out their forecasts for different asset classes. GMO's seven-year return forecast predicts U.S. large-cap stocks will lose a little over 7% per year after inflation. That's a forecast that implies that stocks are 40% to 50% overvalued, and I think you've alluded to that before. So, the first question is how you arrive at that estimate? And then, a follow-up to that--when I looked at your forecast, or I should say GMO's forecasts from seven years ago, it wasn't quite that pessimistic, but it was hardly optimistic. I think that it predicted that U.S. large-cap stocks would lose money--real. And so, maybe you can talk a little bit about why that forecast from seven years ago wasn't as accurate as perhaps you would have hoped at the time you made it.
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 averages 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/sales, every single decile of price/sales is above the 2000 previous world record. The least above is the highest-priced, the top 10% on price/sales, only just as of 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/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.
Benz: You've referenced three bubbles, three and a half bubbles. We haven't talked much about fixed income. But you do have a pretty grim view overall of future bond returns. If you're someone who is about to retire and live off of savings and investments, how would you approach that dilemma--the role of bonds in a portfolio?
Grantham: Yes, I think the 60-40 portfolio is disastrous looking today. And we have many asset-allocation funds at GMO called benchmark-free and so on, which attempt to make a decent return without regards to a benchmark. And it twists and it turns and it tries to be as ingenious as it can to own bits of paper, fixed-income feeling, where there's some extra way of making some return, some use of your brain power, some alpha that can be put into the pot. And the good news is we just had a nice stress test for the first time in a long time. The market got cracked. And even on the worst day, two days before the end of the month before the rally, our benchmark-free accounts were all up a few points. That isn't bad, plus 2% or 3%, with the equities down, bonds down, and we gave some of that back in the last few days. But we had a nice up month.
Ptak: So, to summarize, if I may, the sort of positioning that you might favor as an alternative to the 60-40, it sounds like it would be a portfolio that would lean more to non-U.S., EM in particular, EM value especially. And then in the fixed-income portion, it sounds like what you're saying is that perhaps you need to be considering things like cash and nontraditional strategies where they have less volatility to them, they're not as risky, and you have an opportunity to make a little bit more return than you otherwise would holding things like govies and corporates. Is that kind of the idea?
Grantham: Yes, that's not a bad summary. 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.
Ptak: I wanted to follow up real quick to ask about valuations, in particular, profit margins, which is a topic that you and others at GMO have written a lot about through the years. In 2017, I think you said you thought profit margins and valuations would stay elevated. I think there were a few factors you cited but boiled it down to real interest rates, which you've referenced a few times in this conversation. I think you had said then you thought it would take a while for real yields to rise, and until then valuations would remain higher than average. And since then, real yields, they've kind of drifted around, but they haven't really risen that much. So, wouldn't that argue for a higher-than-average multiple to go back to what you had previously written?
Grantham: Rates, inflation, profit margins, they don't justify high prices, they explain high price. And our explaining P/E model makes the point that if you tell me that profit margins are at the high end, and inflation is at the low end, I will more or less guarantee that P/Es are very high. That's really the point. And if you tell me that inflation is high and profit margins are low--1974 comes to mind--I will tell you that P/Es will be very low, in that case, 7 times earnings. And the model worked beautifully. Only one major deviation since 1925, and including in real life, and that was 2000. And in 2000, our model said, wow, that's terrific profits, and there's very low inflation, we should actually have the highest P/E we've ever had in history, which we did. Only, it was almost 40% higher than that. And that lasted only for a couple of years and then it came down to the model and trended very nicely around it until June of last year. And then, in June of last year, inflation started to rise rapidly, and the P/E, if anything, grifted higher. And there's nothing like that since 1925.
The only way we can explain the current P/E is if inflation is perfect. So, what the market is doing for the first time since we started the model in 1925 is completely believing that inflation is ephemeral and will have no lasting impact. And it never believed that before. It's always become very jumpy when it sees inflation. And this time, it's very relaxed and confident about inflation. And I suspect that's because we've had 20 years where inflation didn't matter, people have forgotten, and that's what the market does. And it's making a profound error. And what that means is that it will slowly come to grips with inflation, and it will work its way through a series of stock market struggles into the price.
And the same with interest rates. Interest rates have the devil of a hard time adjusting to unexpected inflation. It tends to push down the real rates. Eventually it does. And in the end, it pushes up the real rates because people need an inflation premium, they need some protection. If you're going to buy fixed income, and you don't know what the hell is going to happen to inflation, you are buying a much riskier instrument than you did for the 20 years where inflation was not much of an issue. And if it's riskier, you want a little extra insurance. And what happens in the long run when we come to terms with this is that the real rates will have a little inflation premium built into them. So, real rates will rise above where they would have been if inflation had stayed out of the picture. And then, inflation itself, of course, has to force its way almost dollar-for-dollar into the short-term interest rates, which it will do. And my guess, since it's the most reliable thing in the market, that inflation will impact price/earnings ratios as it always has done until the last chunk of time for last year.
But it could take a while. The companies are, in many cases, pretty well-healed, and profit margins are pretty fat. It does suggest that we could have a long drawn-out series of struggles with readjusting to a higher discount rate and higher inflation and the volatility that that brings to the situation. And it could well be that in that window, there will be other factors working to reduce the abnormally high profit margins, and I suspect there will be. That's another fairly long-term topic.
But in my opinion, we are clearly beginning to run out of resources, cheap, plentiful resources. And the old relationship that we had for 100 years until 2000 was one of declining real prices for resources, which makes getting rich a lot easier for our society, if the price of your oil and your coal and your iron ore and your copper and your corn is getting cheaper, and it was irregularly getting cheaper for your typical commodity. And that game seemed to change around 2000 and the prices shot up with China driving the system. They stumbled when China slammed on the brakes for a few years, and they were so frightened that they all stopped doing their CapEx. And now, when it's needed, there are no reserves of most of the important metals, particularly the ones needed for decarbonizing the economy--lithium, cobalt, copper, nickel--absolutely no great reserves, no cheap resources have developed waiting to come online.
And the same applies really to coal and oil and iron ore. There could be some real spikes caused by shortages. And they tend to be short-term shortages. People respond to them. And there will be terrific efforts made to replace commodities that are in super scarcity. But it's going to be a constant problem, I believe, for the future. And you can see that in the long-term price structure of almost every commodity I could think of. It trended upwards for a few years. And they have clearly wandered sideways to slightly up since 2000 after 100 years of declining. That era has gone. And now, we're going to be dealing with shortages much more often. And then, we have a shortage of labor. The fertility rate has dropped everywhere in the developed world and China. And we can guarantee that there will be fewer 20-year-olds coming into the labor markets of the developed world and China than there has ever been. We had a great surge of Chinese workers entering the labor market that drove the system, plus a couple of hundred million Eastern Europeans plugging into capitalism. And that's all done. It's now reversing. They have birth rates that would make your hair raise in Hungary and Poland--1.4; replacement is 2.1. Japan, South Korea is 0.9--0.9, a rate that would halve your population every generation. So, we're going to have a shortage of labor, and we're going to have periodic shortages of raw materials, and we're going to have great problems growing food because we're provably having many more floods, many more droughts and higher temperatures, none of which makes it easy to grow food.
And these are not wild opinions. These are pretty much facts. It is a fact that the UN Food Index is about as high as it has ever been. And it is a fact that the price of oil is about $90 a barrel. And the long-term trend used to be about 25. So, we have to get used to shortages. And if you have shortages of raw materials and shortages of labor, it doesn't feel good for growth and it doesn't feel good for inflation. And it's a different kind of inflation. It's an inflation that simply makes you poorer because you have to spend more of your resources to get your oil and your metals and your food than you used to. And so, there's less of it leftover. So, you feel poorer. It feels like inflation to you. It's not technical monetary inflation. But it's in a fact worse than that.
Benz: I wanted to shift away from macroeconomics and talk about markets a little bit. You're no fan of efficient markets theory. But it looks like the game has gotten tougher for active managers, because there are fewer novice investors to trade against. Do you agree with that thesis? And what implication does that have for mean reversion, which assumes that markets overshoot above and below trend?
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 an efficient market that occasionally by sheer randomness wanders off to three-sigma. And we had one in 2000, and we had a three-sigma housing bubble in 2007, and we have a three-sigma equity bubble again. Now, this is abnormally calm. And a three-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 four of 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 two-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.
Ptak: Sticking with the topic of the Fed, of which you've been very critical, including this conversation, what should they have done differently, especially considering in more recent years fiscal policy has been pretty tight? Granted, it's been quite loose in recent years, post-pandemic. But until then, I think that austerity was the watchword for many legislators. And so, fiscal policy was arguably tighter than it ought to have been. So, don't you think that monetary policy was maybe looser than it otherwise would have been to compensate for some of that tightness on the fiscal side?
Grantham: I am a much greater fan of fiscal stimulus than I am of monetary stimulus for some of the reasons we've talked about. And I don't think the Fed should have its mandate at all. I think its mandate should be to keep interest rates as stable as they could be. But since you bring it up, I don't really care what they do until we begin to see an asset bubble forming, and then they should let some steam off. They should start to take away the punchbowl. They can tighten up leverage standards or margin calls, increase the margin rate or limit the margin amount. Alan Greenspan once said there is no question if you wanted to control the price of stocks, that's what you could do. But they didn't do it. And they didn't do it because they didn't think it mattered. But they, of course, have the machinery in their fingers.
So, in '97, we passed through 21 times earnings. It's an important moment for me because that that was the 1929 peak, and it had never looked likely that we would ever get to that level in the first 20 years of my career, and we did. And then, the market continued up '98 and '99 until 35 times earnings. There's plenty of time there to worry. And Greenspan worried a little bit. If you remember, irrational exuberance, he said and went to a subcommittee and Congress, they slapped his head--interfering with my bull market, says one of them or whatever. And he never said anything against it again. Much, much higher prices than the point in '96 when he’d said irrational exuberance. The market may be showing signs of irrational exuberance. It went very much higher, and he didn't breathe a word against it. It's really a testimonial to his lack of spine or lack of wisdom or lack of many things.
But my complaint with them is the last couple of years as they allow these things to flower and to boom into the stratosphere, where we all pay the price because they always come back. And the coming back process is what you should worry about because it comes back when other things are going wrong. It comes back at exactly the wrong time, and it's a deal with the devil, the income effect. Income effect helps the economy when it's strong. The negative income effect hurts the economy when it's weak. How good a deal is that I ask you?
So, what could they have done? They could have been less generous and helpful to the stock market in '98-'99. They could have been distinctly less generous to the housing market. Greenspan lobbied. He lobbied to not control subprime crap--all those sliced and diced, unethical, immoral instruments that were put together to make Mr. Paulson rich, buy Goldman Sachs, and so on, and they would go out and find some sucker to buy them. And you could have tightened the system to make mortgages more difficult; you could have spoken to the bosses of the big banks; you could have caucused with the Treasury; you could have done a lot to prepare the world to be more careful about the housing bubble and simultaneously, fine-tune a little bit the stock markets. They have they have the tools. They know they have the tools. They just don't have the inclination. And the same thing has happened this time.
The stimulus program was so gigantic that it flooded into the AMCs and the meme stocks and helped push this market into the levels that we have seen. And the speculations this time are much the biggest in the history of the stock market adjusted for the size of the GDP. My favorite, of course, which I suffered from is QuantumScape. It was the biggest investment we ever made in the Grantham Foundation for the protection of the environment, and so on, and my account, we managed the whole thing as one piece. And the biggest investment was QuantumScape nine years ago in its third year of existence. And I started to rail against SPACs. They are infamous instruments, as I like to say, or people with a good name recognition and marginal ethics to make a lot of money. They make 20% of everything. They don't make 20% of the profits like a healthily greedy hedge fund. They make 20% of everything, win, lose, or draw. It is completely unjustifiably large and should be illegal. And the SEC will probably very shortly move against them, I should think, because he's not a complete idiot this guy. And so, my investment in this very, very smart research outfit trying to get a solid-state lithium-ion battery, which could change the world if it works well, comes out as a SPAC with four years still to run.
So, get this. It sells last December--the December before last of 2020--at $130 a share, $55 billion market cap, bigger than GM for a battery research enterprise four years away from any sales, forget profits. Now, there is nothing of that scale in 1929. There's Pet.com with scores of millions, tens of millions, in one or two cases, hundreds of millions. This is $55 billion for a company that has no earnings for four years, no sales. And AMC multiplied by 40, 50 times in a month and becomes, in the case of the other one, GameStop, becomes by far the largest company in the Russell 2000, over 10% of its total, I think, market cap. This is just exceptional craziness. I'm sorry, I'm getting carried away here.
Benz: No, that's great. I wanted to ask about indexing, switching gears a little bit. Your name turned up in Robin Wigglesworth's book about the rise of index investing. People might be surprised to learn that you played a role in the development of index funds. Can you talk about what led you to conclude that it would be a useful innovation? And is there anything today that you think could prove to be just as revolutionary as indexing has been?
Grantham: So, in 1971, Dean LeBaron and I were asked to go and sit on the back row at Harvard Business School for a summer course for pension fund offices. And the case is picking a manager, and it was Morgan Guaranty Trust, so called then, JPMorgan. It was the new guy on the block, T. Rowe Price, who were introducing growth, imagine that; how novel. And a crazy little startup locally, which was a made-up name standing in for our firm Batterymarch, which started--I was a cofounder of eight years before GMO. And at the end of the case, they said as they often do, we've got these two guys visiting, have you any questions for them, have they any points? And my point, which came up as we studied the case was, I was surprised that no one suggested giving their money to the gentleman from Standard & Poor's because of the four bits of data there, the three companies and the S&P, the best bet looked to be the Standard & Poor's. And our reason for doing it was it's a zero-sum game.
So, we were very happy that Batterymarch picked Mayo and me to run a portfolio and try and beat everybody. But we knew that in total, people who played the game would pay almost 2% in those days with high commissions to play the game. And the guys at the bar watching this, the indexes, if they owned everything, would make nothing. So, we'd make minus two, and they would make nothing, and they would beat us by definition. The zero-sum-game argument was completely sufficient reason to do indexing. It was not, however, the reason for our competitors at Wells Fargo. They were doing it first of all, because Samsonite, the luggage company, came in and said do it. But secondly, because the market was efficient, which it was not. Had the market been efficient back then, it too was a completely sufficient reason to do indexing. If the market is efficient, you should index. But the market was gloriously inefficient. And to prove it, Batterymarch, in the eight years we were there, won by 6 points a year without any extra risk. And then, for the first nine years at GMO we won by 8% a year with no damages. So, it was a gloriously inefficient market back in the day, but it was still a zero-sum game. So, the players still by definition underperformed by the cost of playing the game.
And so, that's why we did it. And I wrote my one article for the Journal of Portfolio Management saying but you can't fool all of the people all of the time, which was basically saying how long can you hide that simple truth? And the answer was pretty darn well, for a long time. Decades came and decades went, and it wasn't until about 2010 that indexing really got the bit between its teeth. It was 3% or 4% of the total and now it's 35, and you tell me, but it's finally begun to move. It's begun to move because of the simple truth: it is a zero-sum game, and the players will always lose to the indexes. And you get into some interesting end-games philosophy as you approach 100%, but that we can leave for another century.
Second part of the question was, is there anything to compare with that? And the answer is no. That's a simple truth, and it will somewhat inherit the earth, and it's exciting to try and beat the index, and smart people, very smart people, always will.
Ptak: We have one last question for you and it's about another form of investing that you engage in, which is, venture. You're a committed venture capitalist. I think you've spoken highly of that form of investing in the past. My question is, can you talk about whether the venture investments you've made have made you more optimistic in certain ways, whether it'd be about innovation or just what human beings can engineer when they put their minds to it, so to speak?
Grantham: It has indeed made me more optimistic. Venture capital is the last great exceptional virtue of the U.S. I think our capitalism is monopolistic, fat, and happy, and not as dynamic as it used to be in general. But venture capital, we are world beaters, the biggest, the best, and it intersects with the great research universities where the U.S. has pretty much a death grip on the great research universities, and the ones that we don't have, the U.K. has. And that combination plus a society that is pro-risk, willing to take risk and willing to forgive losers to have a second try, this makes for a formidable advantage. But now, we have a flowering in another sense that green VC has become a very big part, a big subcomponent, important subcomponent. And it is attracting an unusual type of person. And they are, trust me, altruistic. We meet dozens of them, and we hardly ever meet one who actually does not care about what he is doing, or she is doing. It is important that they have a worthwhile job. The thing about VC also is that in money management you're shuffling around in the zero-sum game. In venture capital, at its best, you are helping increase the flow of new ideas, you're helping to make it successful on occasion, and it's altogether incremental as opposed to shuffling. And I think if I were starting again, of course, I would go into venture capital. The ideas are exciting. The people are more interesting. The people, through my eyes, are better people who care about trying to improve the world. And where the brightest and the best used to go and write algorithms, Goldman Sachs or before that, go and work for McKinsey. A very substantial fraction of them now either want to start their own company or go into venture capital. And I completely get it, and I encourage it, I would recommend it. And yes, we've done extremely well in the Grantham Foundation with our VC. And it's a great irony because it's playing off the bubble, playing off the growth, and so on, and there's nothing much we could do about it because it's our mission to do that.
Ptak: Well, Jeremy, this has been such an interesting discussion. Thanks so much for your time and insights. We've very much enjoyed speaking with you.
Grantham: I've enjoyed talking to you and just getting going.
Benz: Thank you so much.
Grantham: You're welcome.
Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Benz: And @Christine_Benz.
Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)
(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)