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.
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.