Grantham: We're Closing In on Bubble Territory
Another 5%-10% appreciation would put the market in bubble territory, but that doesn't mean it will pop right away, says the GMO chief investment strategist.
Jason Stipp: I'm Jason Stipp for Morningstar. We're at the 2015 Morningstar Investment Conference and just attended a session by GMO's Jeremy Grantham talking about whether we're in a bubble and why it may or may not be breaking. He is here to offer some insights on that.
Jeremy, thanks so much for joining me.
Jeremy Grantham: It's a pleasure.
Stipp: After seeing your presentation, I might characterize the thesis, if I could, as, "We're close to a bubble, but a bubble without a trigger or a pinprick."
I'd like to break that down and ask you, what are the signs that we're perhaps approaching bubble territory? What do you look at and what would seem to indicate that asset levels, prices, are beginning to be high?
Grantham: I think the most important thing is value, and we measure it on replacement cost and so-called Shiller P/E, which is 10-year moving average of P/E. And we define a bubble as a two sigma event, the kind that would occur randomly every 44 years, which feels about right. And it's worked very well historically. In other words, all the great bubbles that everyone agrees felt like bubbles, passed the two sigma test, and none of the ones that didn't get to two sigma really felt like a serious bubble.
So it works pretty effectively, and it sounds about right, and we are not quite there yet, although we're getting close. Another 5% or 10%, and we will have hit the necessary, but not sufficient, condition on value. We'll be at the minimum level associated with a bubble. Now we could get 20%-30% higher than that, but at least, historically, we can start thinking about a bubble breaking.
Secondly, I think of psychological accompaniments. 1929, a frenzy of speculation; 2000, a frenzy of talking heads over the lunch place telling you what Internet stocks to buy. Japan, the same. And '07 a little bit less, but still a very optimistic period with everyone buying houses in Florida as an investment.
We're lacking that euphoria. It's beginning to tick up a bit in deals, it's beginning to tick up in finance, purchases, but there are too many areas where it's lacking. So I think it feels like a year or two to go, plenty of room for higher prices, plenty of room for more speculation, and I think that will happen, possibly by the election or possibly afterward. And then we'll be followed by the third Greenspan-era break of, I would guess, probably close to 50% once again, initiated by some unknowable, final pin being applied.
What you have to remember is, the higher the prices, the more jumpy people get. They don't feel jumpy yet to me, but by the end, say, 2000, they were clearly very jumpy, and so it's a bit of a touchy-feely enterprise, trying to time the last bid.
Stipp: You mentioned the Federal Reserve, and Federal Reserve regimes. Would you characterize the current Federal Reserve regime as one of the reasons that we haven't seen some other triggers that you might begin to see around this time as asset prices are getting higher and higher?
Grantham: Actually, I would credit the Federal Reserve for getting us this high and having generated the first two classic bubbles, and all the breaking and the pain that went with it. I give them full credit for all of the damage that was done. And I give them full credit for getting the market three times higher than it was six years ago.
So they have, in a sense, pulled their weight in terms of the upside. I don't think they've gotten in the way. I think it's just a question of time--everything is working nicely. They seem to like bubbles. They seem to be happy with them breaking. To me, it's a deal with the devil. You get a wealth effect from helping stock prices go up, and you get an anti-wealth effect when they decide to go down--usually at a time that is absolutely as inconvenient as it could possibly be--2002 or 2008-2009. When could you possibly less need an anti-wealth effect, and that's when you get it. So why they do this, Lord alone knows. But this is the third time at bat, and they don't seem to have learned any lesson.
Stipp: You mentioned that the rate increase, which everyone seems to be obsessing about, likely won't be the thing that causes the pinprick that breaks the bubble.
Grantham: Based on what happened in 2003 to 2006, eight increases totaling 4% with the market going up the whole time. It's hard to construe from history that a rate increase, particularly from these levels, of 25 bps is necessarily going to bring the world down.
Having said that, we seem to have worked ourselves into a bit of hysteria, so we might have a couple of nasty weeks. The Fed will, I guarantee it, then stroke us like you would not believe, verbally, and caress us and tell us that they are on our team and so on and so forth. And the market, I suspect, will then regroup and keep on regrouping until we hit a nice speculative level with the higher prices and we're ready to go.
Stipp: As an investor, given that there is this time period where we know that this is coming at some point, but we don't know when or exactly what event will happen, what do you do? What do you do as an investor with your money?
Grantham: This is key, by the way. It's clear if you want to be prudent what you have to do. You have to look at our seven-year forecast of negative real return from the U.S., barely positive from international, and act accordingly, which is, be prudent. If you hear me talking about history, you have to determine what weight to put on the historian talking about the history of bubbles forming and breaking, and the prudence of investing with the imputed returns.
Those returns are very likely to be pretty accurate. We do live in a mean-reverting world. High Ps will go lower, high profit margins will go lower, and you have to be braced for that.
So act prudently and just recognize that you may have to bite your lip quite a while as a value prudent manager watching the market go higher. And that's really a part of my job, trying to explain to people that even though the market is very overpriced, that will not necessarily stop it torturing you to death, or half to death.
Stipp: Jeremy Grantham of GMO, it was a great presentation. Great to hear your insights. Thanks so much for joining me today.
Grantham: Thank you. Pleasure to be here.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.