- The highly regarded veteran fund manager Jeremy Grantham contends that American stocks are in a rare speculative “superbubble” that could cause severe losses for investors who fail to safeguard their portfolios.
- Whatever the merits of Grantham’s forecast, investors do seem to be lowering their expectations for stocks and taking the Federal Reserve’s efforts to fight inflation more seriously.
- Grantham and his colleagues find much better value and stronger long-term prospects in emerging markets.
Prophecies of doom are seldom in short supply, but they seem more prevalent, and easier to believe, when evidence of doom starts to accumulate and becomes hard to ignore. It’s no wonder, then, with the stock market experiencing one of its worst declines in more than a decade—and apparently embarking on a fresh leg down after a recovery earlier in the summer— that one widely respected, veteran investment manager’s warning about a “superbubble” is generating particular alarm now.
Jeremy Grantham, co-founder of the fund management firm GMO (he’s the G), has warned that speculation and a thirst for risk-taking have sent stock valuations to levels seen on only a handful of other occasions in the last century. The two clear examples he cited in his latest paper, “Entering the Superbubble’s Final Act,” published on Aug, 31, occurred in 1929, just before the Great Depression, and 2000, when the dot-com boom came to an abrupt end. He assigns honorable mention to others, such as the nifty-fifty rally that ended in the early 1970s and the frenzy that gripped Japan in the late 1980s.
The excesses that built up in the stock market, fueled by extraordinarily loose monetary policy by the Federal Reserve and other central banks, sent interest rates plunging for more than a decade and flooded the global economy with easy money available for speculation. What makes superbubbles ripe for popping, Grantham said in his paper, is when the overvaluation created by such excesses runs headlong into a deterioration of economic and financial conditions. That is just about to occur, in his opinion, if it has not begun already.
“The U.S. stock market remains very expensive and an increase in inflation like the one this year has always hurt [price-earnings] multiples, although more slowly than normal this time,” he wrote. “But now the fundamentals have also started to deteriorate enormously and surprisingly: between COVID in China, war in Europe, food and energy crises, record fiscal tightening and more, the outlook is far grimmer than could have been foreseen in January. . . . Each cycle is different and unique—but every historical parallel suggests that the worst is yet to come.”
He did not offer a precise forecast, but he noted that all superbubbles feature stock market declines of at least 50%.
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Grantham’s comments were covered far and wide, by Bloomberg News, the Financial Times, New York Post, Fortune, MarketWatch, CNBC and other media outlets as far off as Africa, India, Australia and the Middle East. The coverage was by no means alarmist—there was a lot of “on one hand, on the other”—but there wasn’t the sort of outright dismissal that might be expected to accompany such a bold warning during more fruitful periods of market action.
The respectful consideration given to his forecast that the market’s poor performance this year is just the beginning of a deep and protracted downturn is due in part to the fact that Grantham has had a long, distinguished career that has been profitable for him and for investors whose money his firm has looked after. This is not the first time that he has expressed a strong belief that we are in a superbubble and that its popping was imminent, but he is no permabear or crackpot gold bug; in other warnings about the dangerous speculation he saw on Wall Street, he acknowledged that the bubble that was forming likely had further to inflate.
Some doomsayers use gathering signs of woe to take advantage of people’s gullibility and fear, striking while the iron is hot to reap attention and perhaps financial reward. Others have benign intentions. Grantham is certainly in the second category, and there are sound reasons to think he may be right.
One is that even after a nearly 20% decline, the benchmark S&P 500 index remains extremely overvalued based on the Shiller price-earnings ratio, which measures share prices against average inflation-adjusted earnings over the last 10 years. The ratio in early September was 29.9, almost exactly where it was as the market began its crash in 1929 and higher than at any time since the 1870s, apart from the dotcom boom and the bull run that is being unwound.
Meanwhile, as the Fed raises interest rates to combat inflation, forecasts for economic growth and earnings continue to slide. Mike Wilson, the Morgan Stanley strategist who has been uncannily accurate in calling the market this year, recently reduced his forecast for 2023 S&P 500 earnings per share by 10%.
Another reason for concern is revealed in the increasingly articulated observation on Wall Street that market sentiment has hit a sour spot, the opposite of a sweet spot. Investors are acknowledging the deterioration in financial and economic conditions by renewing their selling; they seem to be coming around at last to believe that the Fed isn’t kidding about raising rates, even if economic growth and investment returns suffer for it.
Yet they have not begun to display the sort of panic and indiscriminate, desperate selling that signals capitulation, essentially a widespread belief that the prophets of doom are right. Such capitulation often heralds a lasting market bottom. In a note to clients, J.P. Morgan highlighted the orderly nature of the recent selloff and the conspicuous absence of nervous, volatile trading when “you begin getting calls from relatives about which assets to sell.”
Unlike many of his peers, Grantham is concerned about how investments will perform in the next several years, not this quarter or tomorrow’s trading session.
Starting with present valuations, reasonable assumptions about economic and financial conditions, and the knowledge that markets revert to long-term growth trends eventually, he and his colleagues at GMO create seven-year, inflation-adjusted forecasts. With that time horizon, it matters little whether an overvalued asset returns to Earth now, soon or not for a while, or whether it falls to a reasonable level or becomes unreasonably cheap.
Their latest forecast, at the end of July, called for shares of large American companies to underperform inflation by 2.2% a year. They expect some assets, notably bonds of various types, to do even worse, and others, such as foreign stocks, to show very modest inflation-adjusted gains. On the bright side, they foresee strong returns for emerging markets, with emerging market value stocks beating inflation by 8.5% annually.
GMO’s farsighted perspective is rare on Wall Street, but it’s the right approach for ordinary investors to take as they plan for their retirement or other long-term goals.
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American stocks may or may not be in a superbubble, or even a regular bubble, but they don’t seem to be much of a bargain. Other markets offer better long-term value with less risk. Lightening up on U.S. holdings on rallies and diversifying into emerging markets and other cheaper alternatives seem like a prudent course during this difficult period.
Even if you don’t consider Grantham a prophet, you can still profit by following his advice.