Grantham described the bubble buildup to 1,000 advisors and others on Wednesday.

Jeremy Grantham is not happy with the Federal Reserve or with the current frenzy of stock buybacks — and he says you shouldn’t be, either.

In the opening keynote address at the 2015 Morningstar Investment Conference on Wednesday in Chicago, the Grantham Mayo van Otterloo co-founder told a crowd of over 2,000 financial professionals about the problems with today’s high-flying markets.

The Fed, along with the corporations benefiting from low interest rates and executives growing wealthy from their stock options, “create a steady stream of bull markets that end badly,” the markets expert said. “They brag about their ability to push up stock prices and thus admit there is market manipulation.”

This situation is driven by the Fed’s “bad job description,” which fuels market inefficiencies and keeps markets from reverting to their historic means, leading to future bubbles or cycles of overvaluation.

Supporting such a process, Grantham, explains, is the current state of democracy in the U.S., which is ineffective due to the overpowering influence of corporate lobbying.

“We’re not seeing effective democracy in action” when “financial elites,” not the people, overly influence legislation, he said. “Glass-Steagall said you needed a cop on the corner of Wall and Broad. You do.”

“Investment bubbles are a great fascination for me,” Grantham admitted. “Are we in one today? Is it a significant concept? What is going to happen?”

As expected, the ever-analytical Grantham looked at the behavioral cycle that fuels stock prices: Everyone follows the herd, building up more and more market momentum. John Maynard Keynes, he reminded the audience, “said you could never be wrong on you own … succeed like [others] and then beat them to the draw.”

The behavior seen on Wall Street, he explains, “guarantees herding and momentum in all asset classes beyond fair value, and [that is a] major source of market inefficiencies.”

Still, Grantham cautioned, arbitrage is “slow and inevitable: Everything converges in capitalism on replacement costs … and it regresses in a slow burn on the capitalist process.”

What to Do

For investors and portfolio managers alike, this leads to a “big problem” – namely timing. “Is it one year or seven years?” he asked, reminding advisors and others at the conference: “Arbitrage or mean reversion pulls prices back to fair value.”

But regression has slowed down in recent years, “and everything has become sticky,” Grantham said. The main culprit behind this stickiness is the Federal Reserve under the leadership of Alan Greenspan, Ben Bernanke and Janet Yellen.

The P/E ratio of stock prices to corporate earnings in this new 25-year regime, according to him, is 60% higher than it was on average for the hundred years prior to Greenspan’s influence. “Bulls look good and clairvoyant, and the bears look slightly idiotic,” he stated.

Grantham, again, reminded conference attendees that profit margins were 8.4% for the last 10 years vs. 5.9% earlier.

What the past 25 years has done in the form of an overly inflated P/E ratio requires a 57% decline to revert or “normalize” the market’s key ratio and revert to the historic average that was present prior to Greenspan.

Economic Issues

Beyond this market imbalance, Grantham pointed the economy’s need to generate better growth and job expansion.

Holding such growth back is today’s stock-option culture, he says, pointing to the work of British economist Smithers. Some 80% of executive compensation is now paid in bonuses and options. “If you back up 30 years, it was only 20%,” Grantham explained.

The reason? It’s much “less dangerous” – and less risky – for management to use corporate cash for stock buybacks than for new manufacturing plants, for instance, he adds.

“In the ‘60s and ’70s, everyone wanted to build market share, and that was brilliant for capital spending, job and wage creation. But it was terrible for profit margins,” Grantham explained.

Low interest rates have made it “desperately appealing” for firms to borrow funds and buy stock “at an annualized rate of $600 billion,” he notes. The flipside is, capital expenditures are “dismal.”

In fact, capex as a percent of GDP “should be 6 percentage points higher” than its current level – “which is a real drag on economic growth,” the speaker explained. Bubbles & More Bubbles

Couldn’t a new market based on such extraordinary P/E ratios avoid the fate of other bubbles? “We found 28 bubbles in our research,” Grantham stated. “They broke completely … every [single] one … I will debate [Eugene] Fama and [Kenneth] French” about this historic consistency.

As with housing bubbles in the U.S. and overseas, which involved different scenarios of government incentives and disincentives, “If you do not interfere, you get this,” the expert explained, pointing at slides that showed the market decline resulting from the 2008 financial crisis.

“The level of stock [prices] at this time, I say, is interference with normal capitalist process,” he said, but not of the beneficial type. “We are not allowing profit margins to mean revert. It was the most dependable of all [dynamics] of finance and how capitalism truly functions.”

Overly high prices for stocks, bonds, art, etc., will not lead to a market crash. “You need a trigger. We will have to be seeing deals that become a frenzy,” Grantham explained. “Bubbles break when individuals pour into market.”

He says asset prices should continue to rise on a steady pace “at least until the [2016 presidential] election. “Bubbles break when the economy screams overrated capacity, when it screams.”

Yet, participation of workers in the labor force and capex are down, and public funding has been cut back.

“Is the trigger a rate increase?” Grantham asked, and then explained that history doesn’t indicate such a scenario. “We have to wait for more ‘oomph’ in speculation. Be brave!”

How should advisors and investors allocate assets in today’s market environment? “With great difficulty,” the financial expert quipped.

“The Fed wants everyone to reach. We [at GMO] do a little, but not too far,” he explained.

“We may see this [overvalued market] for seven years,” Grantham said. “It’s a wonderfully tricky game. It needs analysis, fairly good nerves and a willingness to lose some money. Be prudent, very prudent as Thomas Aquinas said, but not yet. I am waiting to very, very prudent – starting closer to the election – and I recommend the same for you.”

In terms of policy solutions, Grantham says the Securities and Exchange Commission could make options have terms of five years or more or tie corporate bonuses to an index, so executives are only paid for outperformance. Compensation increases of 30% or more over three years could be made non-tax deductible, he adds.

Grantham stressed that we “are paying for our sins from 2000,” with prices at 35 times earnings vs. the norm of 16. “It could take 20 years to suck up the pain. Ask the Japanese… it takes a crazy long time to correct crazy prices. Maybe it won’t take that long, but it takes a long time,” he explained.

“In a disturbed market,” he said, “we just need sensible determined management. Yes, I am bearish. [Yet] these are problems, and Homo sapiens can deal with this.”