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Why Is No One Listening to Jeremy Grantham?

The notorious bear and GMO co-founder has “touchy-feely” evidence of a market bubble in the making — and a battle plan.

  • By Christine Idzelis

When legendary investor Jeremy Grantham heard a colleague recount sharing a bus ride from New Hampshire to Boston with a young woman who wanted to sell her house to invest in stocks, alarm bells went off. This, he thought, signaled the euphoria seen before a market crash.

It was late January, and the U.S. stock market had roared into 2018 posting new highs for six straight trading days. The woman wasn’t satisfied with her $300,000 house crawling up a few percentage points in value when stocks had risen by double digits annually since 2009. “She wants to be in the market,” says Grantham, who co-founded GMO in 1977, from his office on the Boston Harbor. And she was reaching for a 20 percent return.

To the mind of Grantham, who called the major bubbles of 2000 and 2007, this story was more evidence of a “melt-up” in the stock market, which he had warned about just weeks before. This is when the market shoots up after several years of rising prices, signaling the final stages of a great bubble near to bursting, according to the 79-year-old.

U.S. stocks soared in 2017, with the S&P 500 index returning 22 percent, and continued to push higher this year before volatility shook the market in February. After the index tumbled by 10 percent, from an all-time peak on January 26 to this year’s trough on February 8, analysts expect new highs in 2018.

As a value investor, Grantham has done plenty of homework on the stock market over the past half-century. He was not alive to witness the 1929 bubble, but has studied it closely. It’s true that data can flash warning signals that a bull market is heading for a steep fall, but it’s the “touchy-feely” — the traces of euphoria in ordinary situations — that is particularly telling, Grantham says. 

“The stories are more important than the price,” he says. “Be prepared for the fact that the market can break your heart on the upside.”

The psychology of a bubble can be incredibly painful for asset managers with careers at stake, according to Grantham. In normal times it’s reasonable to believe clients are concerned about how well a manager can handle a downturn. “But in a bubble, forget it,” he says. “Clients care much, much more about underperforming all their friends on the golf course.”

Grantham — GMO’s chief investment strategist — has a decadeslong grasp of markets to inform his bets. His office on Rowes Wharf, with its art, its sofa, and a balcony looking out to the harbor, has a lived-in feel redolent of history and study. Newspapers are spread about the room, and beyond his desk are several sculptures, including a Buddha. A photograph of the destruction left by Boston’s great 1872 fire leans against one wall. 

In a melt-up, it’s easy to stand out for lagging performance. While everyone is bragging about their gains, sitting on a pile of cash can cost asset managers their clients, so many managers stay invested. “They’re leaping around with great energy, comparing notes,” says Grantham. “They simply can’t stand that one or two of their rivals are playing the game and making a lot of money and making them look bad.” 

When stocks plummet, the situation is markedly different. Everyone becomes “catatonic,” trying to avoid discussing how much they lost, he explains. No one gets fired in that moment — clients wait until the event concludes before sorting through what happened. 

Grantham warned in a January 3 letter that, in his “very personal view,” investors should brace for a melt-up in the near term. Prudent preparation for a downturn will take a psychological toll, he notes. Know how much pain you can stand because the average client is going to lose patience. “The market, instead of going down, not only goes up, but goes up at a faster rate than normal,” he says. “You’re going to feel dreadful.”

Seventy percent of fund managers view the global economy as “late-cycle,” the highest level since January 2008, according to a Bank of America Merrill Lynch survey conducted in early February. These managers expect, on average, an S&P 500 peak of 3,100. 

The index, which measures the performance of large U.S. companies, has largely recovered from its early-February drop.

“We thought a pullback would be normal,” says Jill Carey Hall, an equities strategist with Bank of America Merrill Lynch. Since 1930 the U.S. stock market has fallen by at least 5 percent three times a year on average, she says, noting that such a drawdown hadn’t previously happened since June 2016.

U.S. stocks haven’t looked cheap. Before their plunge the S&P 500’s 12-month forward price-earnings ratio traded around a 15-year high of more than 18 times, according to Hall. In November the P/E ratio was 18.3 times, the highest since May 2002, she notes.

“We had so much excitement in January, there’s at least some chance that this thing will blow up now — game over,” says Grantham. “But I think it will recover and go to new highs.” Grantham expects the melt-up to eventually lead to a 50 percent drop in the stock market, if not more. If the market came crashing down this fall, he says, “it would look like a perfect bubble.”

Hall isn’t worried. Bank of America strategists expect the S&P 500 to finish 2018 at 3,000, she points out. 

Ken Fisher, the billionaire founder and co–chief investment officer of Fisher Investments, likewise expects U.S. stocks to rise this year. “Bear markets always begin gently and quietly,” Fisher says in a phone interview. “A short, sharp break off of all-time highs is never how bear markets begin.”

Instead, they tend to fall by 2 to 3 percent a month over their entire duration, with most of the decline coming in the last 40 percent. Bear markets begin by “lulling in greater fools with peaceful, minor” declines, says Fisher. “Nobody gets lulled by what just happened.”

Founded in 1979, Fisher Investments manages about $100 billion for high-net-worth clients and institutional investors globally. Just under half of the Camas, Washington–based firm’s assets are tied to institutional clients. Fisher hasn’t seen broad euphoria suggesting “that big, bad terrible thing, so it’s higher prices ahead.” He would also expect a major pickup in initial public offerings before a potential collapse.

The market reflects how comfortable and confident investors feel, Grantham says. Their confidence is tied to inflation (they hate it), profit margins (they love them large), and the pace of growth in gross domestic product. The U.S. has been working well on all three fronts, he says, with very low inflation, record corporate profits, and steady, not-too-rapid GDP growth.

Though inflation has remained stubbornly low in the wake of the 2008 financial crisis, recent signs point to a rise. The U.S. saw its fastest wage growth since 2009 in January, up 2.9 percent from a year earlier, according to a February 2 Labor Department report. The drop in U.S. stocks steepened after the announcement. 

Still, Grantham believes the market may ultimately forgive a modest rise in inflation as the Federal Reserve has aimed for — and missed — its 2 percent target for years. “People will say, ‘Heck, we wanted to get to 2 percent. We wanted labor to get paid a little more — we’ve been starving these guys since 1970, for God’s sake! Let’s pay them something because they’re all tapping out their credit cards.’”

Defaults on credit card debt have picked up, Grantham notes, a situation that eventually “saps the economy.” In his view, it’s rational and ethical to hope wages rise. “But what do we do as a capitalist society? We freak out that it may impact profit margins.”

The $1.5 trillion tax cut package passed in December slashed the corporate rate to 21 percent from 35 percent, and should for a few quarters offset concerns over margins as companies’ earnings will benefit in the short term. Bank of America’s equity strategists expect earnings per share to rise in 2018 as a result of the tax overhaul, but, like Grantham, they don’t foresee lasting impacts. “The benefit is going to get competed away,” Hall says. “We wouldn’t really expect it to have a longer-term impact.” 

Companies may reinvest the tax cut windfall or increase employee compensation. Or they might pass the benefit on to consumers, reducing prices to compete with rivals. In another scenario, growth accelerated by the lower tax rate may inspire a more aggressive Federal Reserve, Hall surmises. She says the central bank could hike rates, tamping down economic growth.

The bull market began on the back of unprecedented central bank intervention during the crisis. It will soon press past its ninth year. If — or when — it all comes crashing down, some investors will have license to say “I told you so.” Jeremy Grantham is one of them.

He has a battle plan for an overvalued U.S. stock market: Allocate heavily to emerging-markets equities, the cheapest asset he’s identified. “Compared to buying American stocks, I think it’s defensive,” Grantham says.

GMO manages money for institutional investors, overseeing $74 billion as of the end of September. Grantham also personally invests for his sister and children, and has put their money where his mouth is. About 55 percent of their retirement funds are in emerging markets, he disclosed in the firm’s third-quarter letter. 

He has a strong track record within the family. Grantham’s sister’s portfolio was defensively positioned in 2008 as the subprime mortgage crisis wreaked global havoc, creating huge losses for investors and spurring the worst U.S. recession since the Great Depression. “And I want her to be net short for the next burst,” Grantham notes.

Individual investors have an advantage over institutions in making bold allocation decisions because they don’t face career risk. Behaving like the rest of the crowd was a big element in the run-up to the 2008 crisis, according to Grantham. “If you do what everyone else is doing, even if you all run off the cliff at the same time, you typically don’t get fired,” he says of professional asset managers. “As long as the boss and everybody else was talking a good game, you could play along, and if it all got crushed, no one would pick on you.”

It’s hard to convince large investors such as pension funds to quickly get onboard with unconventional investment strategies. They tend to move slowly, with monthly or quarterly investment committee meetings, according to Fisher. And there’s not as much latitude for defensive portfolio adjustments or variance in cash levels compared with individual investors.

“I got 2000 right,” Fisher says of the tech bubble. “When we turned bearish, we lost clients because of it.” Fisher believed the technology sector would implode because so many unprofitable companies were burning through cash and depending on markets to raise money. “The reality is, when you really get to a stock market peak, people don’t want to believe any of that,” he says.

GMO beat a fairly rapid retreat before the bubble burst in 2000, noting in late 1997 that it was the highest-priced market in U.S. history, according to Grantham. When the firm got out of tech stocks in 1998, it wasn’t on the strength of touchy-feely evidence. “The market was stone-cold sober,” he remembers. “Even by the end of ’98, we were bleeding like pigs. The market was still pretty sober.”

Then, during the second half of 1999, signs of euphoria appeared at local lunch spots. Pundits shilling for the likes of dominated television. The online pet retailer’s sock puppet dog mascot appeared as a balloon in the Macy’s Thanksgiving Day Parade, and in a Super Bowl ad early the next year. was shuttered in November 2000.

No one knows exactly when a bubble will pop or what precisely will trigger the stock market’s fall. The economy was fine when internet companies and the Nasdaq began to disintegrate one day in 2000, and no particular announcement spurred the sell-off, Grantham points out.

“The breaking of the bubble is a wonderfully unknowable thing,” he says. “We’ve had 90 years to study 1929 — we still don’t know why it broke when it did.” There were, though, crazy stories prognosticating the crash, like the shoeshine boy giving out stock tips. 

This is the type of touchy-feely signal that Grantham has an eye and ear for. 

He says Bitcoin’s rise has no connection to the stock market, other than that it shows the “animal spirits” of investors willing to gamble on the latest craze. “Why the hell are you buying it? You can’t even really use it,” he notes. The volatile cryptocurrency’s explosive climb in value is purely speculative, with people buying it on the belief that someone will pay more for it later, Grantham explains.

Bubbles can mesmerize investors. History shows that even geniuses may fall victim to market euphoria. Sir Isaac Newton was wiped out by the South Sea bubble in the early 1700s, for instance. Newton, who transformed science with his laws of motion and gravity, had bought shares in Britain’s South Sea Company and made a nice return when he unloaded them. Then he watched his friends, who were shareholders, become “inordinately rich at a much faster rate,” Grantham says, prompting Newton to borrow money for a much bigger bet on the company. Then shares plummeted.

“You can be the smartest guy that lived for a couple thousand years and still get hammered by a bubble,” the GMO co-founder notes. 

But Grantham hasn’t always gotten everything right, either. In 2016, for example, he wrote a letter admitting that his bullish 2011 outlook on resources had turned out wrong. 

“What I apologized for was misleading people who read my report,” he says. “The resource cycle moved against them. No doubt they would have been disappointed and eventually pulled their money out.” He wrote the report to point out that world commodities prices had been declining for a century. “They were interrupted by wars and oil crises, but they wended their way down,” he explains. “My paper was meant to be saying, That’s happened for 100 years. My guess is it’s finished.”

Now Grantham has a direr view of the U.S. stock market than many analysts. 

Erin Browne, head of asset allocation for UBS Asset Management, isn’t too concerned about the S&P 500 being historically expensive. The index’s composite has shifted over the decades toward tech companies, among others, that tend to trade at higher P/E ratios, she says. Recent market volatility produced buying opportunities, she adds, while fundamentals have remained healthy.

Or they’re leading investors toward a full melt-up. The S&P 500 soared about 7 percent over a few weeks in January. If — instead of turning down in February — shares had continued to climb at a slightly slower pace through March, Grantham thinks the index might have crossed 3,150 points as a full-fledged bubble.

“Then the question is, how are the touchy-feelies doing?” Grantham says. “If they kept advancing like January, they’d be magnificent in two months.”

Photo credit: Jeremy Grantham, GMO (Daniel Acker/Bloomberg)