Grantham: No Bubble, Yet
The GMO chief strategist advises prudence but says the market may well move even higher from here.
The market is creeping toward bubble-land but isn't there quite yet, said GMO chief investment strategist Jeremy Grantham during his keynote at the 2015 Morningstar Investment Conference. He warned investors to pay careful attention as valuation metrics begin to approach a "2 sigma event," or 2 standard deviations away from the norm.
"Every 2-sigma event is followed by an equal and offsetting 2-sigma reversion," he said, adding that the pattern occurred in 28 out of 28 of the major bubbles GMO has studied throughout history. "And they all went back half a year quicker than they went up," he added.
So, where's the mean and where are we today? Grantham cited a 21.1 price-to-earnings multiple on the S&P today versus a normal P/E of 16.0, while corporate profit margins are currently at 7.3% versus a norm of 5.7%. In a recent commentary, he further noted that the "Shiller P/E and Tobin's Q have moved up over the last six months to 1.5 and 1.8 standard deviations (sigma), respectively." (Tobin's Q is a ratio comparing the market value of a company to the replacement value of that company's assets). Reversion to the mean on those two scores implies a more 50% decline in the market from current levels, he said.
A Sluggish Reversion
But although profit margins have been abnormally high, they have been curiously slow to revert to historical norms, Grantham noted. "My belief is that it has a lot to do with a regime shift to the Greenspan era and his acolytes," he said. "The [market] P/E in the new regime has been 60% higher than it was for 100 years before."
In addition, he argued that the rise of stock options in executive compensation has played a role in making profit margins stickier--but not without a cost.
"We've entered a world where 80% of remuneration comes from stock options combined with ... a fixation on short-term profit maximization," which encourages CEOs to undertake stock buybacks versus capital expenditures. A buyback is "much less dangerous than buying a new plant," Grantham said, and also happens to increase the value of those stock options by directly boosting the stock price.
For its part, the current Fed regime's low-rate policies have "made it desperately appealing to borrow cheap debt to buy your own stock back." The result has been dismal corporate capital expenditures, which in turn depresses wage creation and does little to stimulate the economy.
"You get mean reversion if capitalism is allowed to work in the normal way," Grantham said. "What's happening in the stock market now amounts to interference with the normal process. We're not allowing profit margins to mean revert. We're not expanding our economy. We're running away from it and protecting our stock options. There is no arbitrage mechanism, and unless we break it, it will be an increasing drag on our economy."
What Will Finally Pop the Coming Bubble?
"You need a trigger to break it," Grantham said. "Broad overvaluation [alone] has never done it."
Instead, he argued, "The market will follow the line of least resistance from the Fed, plodding slowly and steadily higher, waiting for speculation from individuals and deals."
Neither is the dreaded impending Fed rate hike likely to cause the pop. "From 2004 to 2006, the Fed raised rates [multiple] times. Markets went up without missing a beat," he said. "Why would a single rate hike have everyone in a fit?"
In the meantime, Grantham characterized investing in the market as "a wonderfully tricky game."
"Be prudent, of course. Be very prudent ... but not yet," he said. "I'm waiting to be very, very prudent. I'm going to be incredibly prudent starting closer to the election. I recommend the same to you."