Jeremy Grantham (Trades, Portfolio) is a very prominent figure in the financial world and is known as a great contrarian investor and value investor. He is best known for predicting asset bubbles in the past, such as in 2000 and 2008 and 1989 in Japan. In 2020, he also began to become increasingly certain that the current U.S. market had entered the phase of a "super bubble."
In January 2022, he published an article predicting the end of the super bubble. This discussion contains some of the main conclusions and provides some personal commentary from one of his recent interviews with The Compound and Friends, in which he describes what is next for the super bubble, which, according to him, has not burst yet.
The status of the bubble
Before we talk about how the super bubble is deflating, it is important to point out the nature of the bubble observed by Grantham. Unlike a normal bubble with a two-sigma deviation from trend, Grantham describes a super bubble as an event with a three-sigma deviation that has only occurred three times in U.S. history. Like the stock market bubbles of 1929, 2000 and the housing bubble of 2008, Grantham notes that unlike a normal bubble, they can actually wipe you out.
However, the current bubble, which became a super bubble in 2021, could be more like Japan in 1989. This time, it is not just stocks that were in a boom period, but to some extent housing, commodities and the bond market, the latter of which, looking at long-term Treasury bonds, has already plunged by about 50%. This kind of bubble across multiple asset classes is expected to bring more pain than the average equity bubble we had in the 2000s, according to Grantham.
In his recent interview, he described the 21st century as highly unusual, with the window from 2000 to the present having companies with abnormally high profit margins, abnormally high price-earnings ratios and the economy operating with abnormally low interest rates. From 2010 to the present, the U.S. market has outperformed the rest of the world by about 70%, with the "Magnificent 7" being a major driver of those returns if you look at their free cash flow and earnings. If you look at corporate profit margins, for example, the current period is indeed unprecedented.
Presumably, many asset classes in general have been pushed up by a vicious 40-year trend of lower interest rates, especially in the housing market, via the market mechanism. Grantham also recently pointed out "the 3% mortgage rates of 2021 explained everything" when we talk about house prices, and the more recent 7% still explains nothing. Things just take time to work themselves out in the housing market. As he put it: "People can afford to pay more when mortgage rates are 3%, but it's worth noting that the same thing happens in reverse."
Looking at the house price-to-median-income ratio in the United States, it is currently estimated at 7.4 times, the highest in recent history and higher than in 2008 when it peaked at 6.8 times. While it is a big departure from the trend, it is still different from some of the most exuberant places such as major cities in China and Canada, which are also expected to experience downturns. As Grantham said, "It's not a stable equilibrium now that the younger generation can no longer afford houses."
Looking back at equity markets, we can also extend these decades of very low, negative real interest rates and recognize that it has pushed investors up the risk curve to equities. For most of 2021, for example, the real yield on a 10-year Treasury hovered around -1%. The company that Grantham founded, GMO LLC, is currently forecasting a very bearish outlook for U.S. stocks, both large and small, predicting negative real returns for the next seven years. According to GMO, there is seemingly more value to be found when looking at the fixed-income market or the stock market outside the United States.
Source: GMO
Investors may like to point out the S&P 500 may not be as overvalued as Grantham makes it seem, referring to its 12-month price-earnings ratio, which is only relatively high at 23 times compared to its historical average of 16 times earnings. But if we look at the Shiller price-earnings ratio, or the smoothed and inflation-adjusted average earnings over the past 10 years, it currently stands at a staggering 30.81. In previous major stock bubbles, such as 1929 and 2000, this ratio also flared up and is a great measure to identify bubbles during periods of sudden high growth or high inflation, as we have recently experienced.
Redux of the 1970s?
Speaking of high inflation, Grantham was also asked if the current comparisons being drawn to the 1970s, one of the few times the U.S. experienced high inflation, might be justified. He believes there is something to it, in the sense that it may indeed be the only time we can compare it to at the moment.
But unlike the 1970s, we are still looking at pretty frothy valuations. For example, if you look at the Shiller price-earnings, the S&P 500 bottomed in 1974 at just over 8 times, versus the 30 times we see today. When U.S. inflation peaked in the 1980s, the S&P 500 bottomed even lower, with a Shiller price-earnings of about 6.6 times. According to Grantham, markets like low inflation, or steady 2% inflation. No spikes, no bounces, no sticky inflation. They also like high profit margins and stable growth. A market does not like bursts of high growth or erratic growth, even if the average is a decent growth rate.
Over the past 20 years, we have seen mostly an increase in profit margins, translating into high profits along with stable growth and low inflation combined with record-low interest rates, which would justify the high valuation of the S&P 500. Looking ahead, however, we are faced with interest rates around 5% across the yield curve, and we are already seeing margins narrowing from their historic highs, as well as uncertainty about economic growth and inflation.
You could say the United States is also very similar to the run-up in 1929, when profit margins also skyrocketed, and we had low inflation and high, stable economic growth. Looking back, it is no wonder the Shiller price-earnings was so high in 1929, as it can be seen as a Goldilocks zone. Considering today's valuations, Grantham's model suggests the Shiller price-earnings should be closer to 16.8 times. This is a very large gap from the current 30.8 at which it trades.
The Federal Reserve's track record
As with most other bear markets or recessions, the idea of a "soft landing" is making a resurgence. Grantham acknowledges this because, for most financial institutions, the imperative to remain bullish is usually overwhelming.
The Federal Reserve also seems to be pushing this narrative, even though Grantham says the only thing he really knows for certain is that "since Greenspan, the Federal Reserve hasn't gotten anything significant right." Every time they pivot, they get it wrong. Every opinion they give about a soft landing is wrong. And their battle plan has mostly been to push the market up. They have done that three times, and it has actually helped the economy. But the main problem is that asset prices have always gone down as a result, and that has a negative economic effect just when you do not need it.
According to him, "the Federal Reserve has absolutely no understanding of the pain involved in bursting an asset bubble," and rightly so, because today we are looking at bubbles with a three-sigma deviation from trend that are not difficult to verify. Like 1929 and 2000, these events stick out like a sore thumb. So Grantham believes there is not much the Fed can do at this point to stop the declines and that we are in the deflationary phase. In terms of the big picture, he believes we will have a recession that could last well into next year, with accompanying declines in stock prices.
More specifically, the guru mentioned in a recent interview that he is short the Russell 2000 in his endowment to hedge his venture capital portfolio. In his view, the Russell 2000 contains many "flaky" companies with the highest debt levels in history and little or no earnings.
Final thoughts
Although the S&P 500 has fallen significantly over the past two years, Grantham seems to believe the bubble has not yet deflated and that we are in the late phase of the super bubble. The S&P 500 may currently be only 13% away from its all-time high, but adjusted for inflation since the start of 2022, the market has fallen 20.70% in real terms.
Like Grantham states regarding inflation-adjusted returns, the fact is that "the passage of time is pretty painful, even if you stay flat." You lose money at a decent rate, and people have forgotten that. The point is that people do not report anything in real terms like in the 20th century because we have had little to no inflation in the last 25 years. But we ae talking about real dollars. And investors would have earned only 7.81% in real terms since Jan. 1, 2020. That would be an annualized real return of only about 2% over the past four years, far from the usual 6% to 7% real returns in modern history.
Speaking of price levels, Grantham also said he thinks it is unlikely the S&P 500 will not get anywhere near 3,000, and that if everything goes against it, which is sometimes the case, he would not be surprised if the index went to 2,000. But in that case, he argues that "a few wheels would have to fall off."
In summary, Grantham believes investors are still better off investing in markets other than the U.S., such as international markets like emerging markets, or perhaps in fixed income such as U.S. bonds or emerging market debt to get great real returns over the next decade.
