Grantham Gloomy, But Not Running From Equities

GMO’s Jeremy Grantham sounds quite gloomy in his latest quarterly letter, though he advises a “near normal” allocation to equities and says high-quality U.S. stocks are “relatively cheap”.

Grantham says that both debt overhangs and structural problems — such as income inequality, an aging population, deficiencies in infrastructure and education, and the government’s inability to deal with long-term issues — make him continue to believe that his forecast of “seven lean years” (which he made two-and-a-half years ago) will indeed play out for the U.S.

Grantham also says that the bursting of the two bubbles in the past decade didn’t hit the stock markets for as long a duration as they should have — which means pain may have been delayed rather than avoided. “Historians would notice that all major equity bubbles (like those in the U.S. in 1929 and 1965 and in Japan in 1989) broke way below trend line values and stayed there for years,” Grantham says. “The first of the two great bubbles that broke on [Alan Greenspan and Ben Bernanke’s] watch did not reach trend at all in 2002, and the second, in 2009 … took only three months to recover to trend. This pattern is unique. Now, with wounded balance sheets, perhaps the arsenal is empty and the next bust may well be like the old days.”

Grantham says GMO has looked at the 10 biggest bubbles prior to 2000 and found that it typically takes 14 years for the market to recover to trend. He thinks that when we have one of these longer declines, investors, “conditioned by our more recent ephemeral bear markets, will have a permanent built-in expectation of an imminent recovery that will not come.

But Grantham isn’t as bearish as one might expect given his dour long-term predictions on the economy and market. He says to “avoid lower quality U.S. stocks but otherwise have a near normal weight in global equities”; “tilt, where possible, to safety”; and “try to avoid duration risk in bonds”. He adds, “U.S. High Quality stocks are, according to us, still relatively cheap.”

Grantham also offers some interesting takes on valuation. He reiterates his contention that profit margins are abnormally high, and will at some point revert to their mean, which should hurt equities. He says he and colleague Ben Inker years ago designed a model to explain the ebbs and flows of the P/E ratio. “It had a surprisingly high explanatory power,” Grantham says. “We found that everything that made investors feel comfortable worked. That is to say, it was a behavioral model. Fundamentals like growth rates did not work. The two (out of three) most important drivers were profit margins and inflation.”

Given that profit margins are high and inflation is low, Grantham says market P/Es should be significantly higher — but they aren’t. The reason: “The cloud of negatives,” in the news, “which generally and surprisingly have historically had very little effect individually on the market, but apparently do depress ‘comfort’ when gathered into an army of negatives,” he says. One silver lining, he notes, is that by the time margins do decline, some of the negatives in that “army” may have been resolved.