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GMO’s Grantham: Some Boom Left Before the Doom

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Hedge fund manager Jeremy Grantham expects investors can capture another 8%-plus return on stocks from present levels before the market reaches fully inflated bubble territory.

After that, a lengthy period of stock market losses can be expected to ensue.

The principal of Boston-based Grantham, Mayo, Van Otterloo & Co. combines both the good news and bad news in his first quarter letter to shareholders: the former being time still left to enjoy the thrill of a Fed-induced bubble; and the latter being years of stagnation and decline coming soon.

Grantham’s good news is delivered with sardonic revulsion at what he calls the Fed’s “Greenspan Era,” a period also encompassing the Fed chairmanships of Ben Bernanke and Janet Yellen.

During this period in Grantham’s view, monetary policy leaders have taken it upon themselves to push up asset values in order to create a wealth effect. Based on Shiller P/E, the GMO manager says market valuations have been 60% higher than in the previous 100 years.

This period has also seen the largest equity and housing bubbles (2000 and 2006, respectively) in U.S. history, prompting Grantham to opine:

“For me, recognizing the power of the Fed to move assets (although desperately limited power to boost the economy), it seems logical to assume that absent a major international economic accident, the current Fed is bound and determined to continue stimulating asset prices until we once again have a fully fledged bubble. And we are not there yet.”

The hedge fund manager stands by his previous forecasts that the S&P 500 needs to reach a level of around 2,250. When he first made that prediction two years ago, Grantham anticipated the fourth quarter of 2016 as the time of the market peak and subsequent doom.

Grantham’s currently quarterly letter omits a specific timeframe, saying more vaguely that “the current market still has a way to go before reaching bubble territory.”

The investment manager characterizes our present stage within the ongoing supercycle bull market as “middle-aged,” with room for further improvement in capital spending, home prices, housing starts and M&A activity, among other factors.

A “normal, modest” bear market is not incompatible with his forecast; Grantham implies a 10% to 20% drop in the market would satisfy politicians’ desire to keep the bubble blowing past the 2016 presidential election — in line with his initial forecast.

“So, ‘2,250, here we come,’ Grantham concludes (adding, without further comment, that “foreign markets are of course to be preferred”).

But before investors get too excited, the fund manager who is given to bleak views of the world — both ecological and economic — also offered a dismal long-term view of markets, reiterating his view that U.S. long-term growth rate has slowed to 1.5% (using traditional GDP accounting, though “perhaps closer to 1% in real life”).

The GMO manager notes that an attention-getting IMF paper published in April has vindicated his 1.5% view, though the Fed was just a couple of years ago citing estimates of around 3%, with more recent official estimates in the 2 to 2.5% range.

Grantham’s hope is that the IMF analysis will jolt the Fed into reframing its view of the U.S. economy:

“This would be timely because, as you may remember, I have been anxious about the Fed’s whipping our actual 1.5% donkey in the mistaken belief that it was a 3% racehorse,” he says.

But he acerbically asks, of an IMF report focused on reduced rate of U.S. economic growth and an aging workforce:

“How, by the way, does this point, straight from the U.S. Bureau of Census, take over five years to make it into semi-official GDP growth estimates?”

The resource-focused analyst also offers his own take that “the most underappreciated” drag on U.S. long-term growth has been “the loss of sustained cheap energy as oil has moved from a $16/barrel 100-year trend pre-1972 to today’s approximate $75/barrel trend price.”

What all these secular trends mean for markets are low — mainly negative, actually — returns across asset classes over the coming seven lean years.

Only emerging markets will be in the black in GMO’s seven-year real-return forecast, with emerging stocks averaging a measly 2.7% annual return, a hair above emerging debt’s 2.6 annual real return (after an inflation assumption of 2.2% over 15 years).

U.S. and international stocks and bonds are all expected to be losers, with U.S. small stocks and hedged international bonds the areas to expected to bleed the most (-3.2% and -3.6% per year respectively).

Interestingly, the resource-aware investor’s highest return expectations are for timber, with a real annual expected return of 4.8%—higher than emerging-market expected return but still shy of the long-term U.S. equity real return of 6.5% per year. 

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