It isn’t often that investment gurus tear their own arguments and predictions apart, but that’s just what Jeremy Grantham does in his latest quarterly letter to GMO investors.
Comparing himself to a parrot, “I have been repeating for 10 quarters now my belief that we would not have a traditional bubble burst in the US equity market until we had reached at least 2,300 on the S&P, the threshold level of major bubbles in the past, and at least until we had reached the election,” he explained.
He adds that he had hoped to “recommend a major sidestep of the coming [market] deluge …, allowing us then, after a 50% decline, to leap back into cheap equity markets enthusiastically, more enthusiastically, that is, than we did last time in 2009.”
Grantham readily admits that he sees himself as “a bubble historian and one who is eager to see one form and break.” But no more.
“I have come to believe, however, very reluctantly, that we bubble historians have, together with much of the market, been a bit brainwashed by our exposure in the last 30 years to 4 of the perhaps 6 or 8 great investment bubbles in history,” he wrote.
“For bubble historians eager to see pins used on bubbles and spoiled by the prevalence of bubbles in the last 30 years, it is tempting to see them too often,” the co-founder and chief investment strategist of asset manager Grantham, Mayo, & van Otterloo explained.
As for today’s market? It’s “not a classic bubble, not even close. The market is unlikely to go ‘bang’ in the way those bubbles did,” he writes.
Instead, the market is probably going to revert to the mean in a “slow and incomplete” process.
Sound good? Think again, says Grantham, who is known for his generally pessimistic outlook.
“The consequences are dismal for investors: we are likely to limp into the setting sun with very low returns. For bubble historians, though, it is heartbreaking for there will be no histrionics, no chance of being a real hero. Not this time.”
Grantham’s new look at bubbles, of course, is based on statistical analysis.
The 2,300 level on the S&P 500, he points out, marks the two-standard-deviation (or two-sigma) point that has “effectively separated real bubbles from mere bull markets.”
Today, though, it’s most likely “a red herring.” That’s because the data means we are comparing today’s “much higher” pricing environment with “far lower” levels in the past.
As other investment gurus are discussing today, things are different, and that’s because of – wait for it – “a 35-year downward move in [interest] rates …, which, with persistent help from the Fed over the last 20 years and a shift in the global economy, has led to a general drop in the discount rate applied to almost all assets.
As many advisors and investors are well aware, assets return 2-2.5% less than they did in the 1955-1995 era, Grantham notes.
This tough reality raises a number of questions, he says, but it also implies that for the next 20 years it doesn’t matter that much “whether the market crashes in two years, falls steadily over seven years or whimpers sideways for 20 years.”
The key difference, according the Grantham, is what happens in the short term: “Are we going to have our pain from regression to the mean in an intense two-year burst, a steady seven-year decline, or a drawn-out 20-year whimper?”
Again, we “are not in a traditional bubble today,” he states, which gives market watchers – and value managers, in particular – some room to think about the many possibilities to come.
Grantham argues that what stand out are the current level of euphoria, or “wishful thinking,” and a lack of excellent fundamentals, which “are way below optimal.”
This is due to the fact that “trend-line growth and productivity are at such low levels that the usually confident economic establishment is at an obvious loss to explain why.” Plus, capacity utilization is well below a peak level and is falling, we have lots of available labor, and home building is far below normal.
In addition, the geopolitical world is in a “nerve-wracking” state. “Far from euphoric extrapolations, the current market has been for a long while and remains extremely nervous,” Grantham explained.
Investors, he adds, are “willing to tie up money in ultra-safe long-term government bonds that guarantee zero real return rather than buy the marginal share of stock!”
The GMO investment strategist says classic bubbles coincide with credit bubbles, and today’s market lacks “a similarly consistent and broad-based credit boom.”
This means the current market “is closer to an anti-bubble than a bubble,” though this market is “extremely overpriced by historical standards.” (As of Monday, the S&P 500 is just 8% away from the two-sigma level GMO calculation of 2,300.)
It’s a paradox, he says: “None of the usual economic or psychological conditions for an investment bubble are being met, yet the current price is almost on the statistical boundary of a bubble.”
Returning to the topic of low interest rates, Grantham describes that the post-war era of 1945-2005 may “turn out to have been a golden era of global growth that will not be equaled again for at least a couple of decades.”
As other investment gurus have said: “We now appear to be in a slower-growing world, the result of a slower-growing and aging population and lower productivity,” he explained.
What could cause this situation to continue? Lower growth “and other reasons mentioned above will lower the demand for capital and thus result in a permanently lower return on all capital, at least to a moderate degree,” he says.
Though many might want the Fed and central banks to raise rates, that change in tactic is unlikely to dominate the next 20 years. “Economic dogmas die hard despite evidence of failure. Think of all the unnecessary pain and misdirection from the idea of Rational Expectations and the Efficient Market Hypothesis,” Grantham explained.
In a broader – and probably longer-term – sense, history means that asset return revert “to their old, normal levels.”
And that’s good news for Grantham and the rest of us.
“I propose that returning two-thirds of the way to the old normal has a higher probability than either returning all the way or staying indefinitely at current levels, although both are possible,” he noted.
For lot of reasons – demographics, Fed regimes, a lack of growth/innovation and income inequality – “a 20-year flight path to get back two-thirds of the way to normal so that T-bills will yield around 1.2-1.5% real again, and developed country equities will return 5.0% instead of our current 5.7% “normal” assumption” is most likely, Grantham believes.
(It took 35 years to go from high to low interest rates, the investment guru adds.)
“In summary, we expect returns of 2.8% a year from U.S. equities, 4% from EAFE, and 5.3% from emerging market equities,” he explained. “This last number does suggest the only, kamikaze, way to achieve a 5% target return.”
Normal bear markets with downward adjustments of 15-25% may always occur, Grantham says. For this and other reasons, GMO does not expect all of its strategists and analysts to “toe a party line,” he adds.
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