Grantham: Stocks Will Continue Upward until the Election

Grantham said that in order for equity yields and returns to increase, “we have to take a hit because the market is overpriced; remember it tripled in the last six years”. Grantham said P/E ratios need a 37% decline and margins need a 30% decline. He recommended that “if you’re young, take the whack [and] if you’re old, pray for the Fed to keep going.” A younger investor with less accumulated assets would benefit more from a correction than an older investor with more accumulated investments. He noted that the GMO forecasts have been called “wrong” before, particularly in the case of the run-up preceding the dot-com crash. But he proudly reminded the audience that GMO was eventually vindicated, and they got it completely right prior to the US housing crash of 2008.

Grantham said that GMO’s forecasts have not been as accurate as they have been in the past. He attributed this to government policies, which have prevented capitalism from working in normal ways. Mean reversion has been impaired because of Fed policy, particularly since the transition to the “new regime” of Greenspan, Bernanke and Yellen, who have followed the identical “battle plan.”

Fed policy has fueled high margins, a stock-option culture and a fixation on short-term results. Since the regime shift, the P/E level has risen 60% higher than it was the 100 years before. He said this is a significant shift that has had enormous consequences and “has made bulls look good and clairvoyant and bears look slightly idiotic.” Profit margins have been 40% higher since the Greenspan era, averaging 8.4% when they used to average 5.9%.

On the stock-option culture and capital-expenditure spending

Grantham said that 30 years ago 20% of senior management remuneration was attributed to stock options; today it has exploded to 80%. In order to dominate an industry from the 1960s through the 1980s, corporations sought market share. This was good for capital spending, job creation and wage growth, but was terrible for profits. The downside of this strategy was the risk associated with the capital expenditure while building a new manufacturing plant, bringing a plant on line and fending off corporate raiders.

Since the 1980s, corporate management teams have chosen the much less risky path of stock buybacks to drive valuations and profitability. It is easier for corporations to meet their quarterly numbers through stock buy-backs than it is through capital investment. The pace of stock buy-backs has accelerated dramatically and is at a record annualized rate of $700 billion per year-to-date while capital spending is 4% below average even after a six-year recovery with record profit margins.

He lamented that this is a high price to pay to make senior management rich, and the lack of capital spending is a drag on economic growth. Grantham conceded that management teams are much more comfortable buying back stock, mopping up sellers, pushing stock price up and making their stock options more valuable.

On investment bubbles, government interference and where we are now

Grantham challenged the Fama-French market efficiency theory. Grantham and his GMO team have identified and studied 28 important investment bubbles that all “broke completely.” He defined a bubble as a two-sigma (or two standard deviations above its historical mean) event. Each historical bubble that was two standard deviations above its mean reverted to the mean six months faster on average than they rose. In 28 of 28 cases, two-sigma events were highly predictable and lead to collapses, he said.

As if directing his voice toward Fama and French, Grantham said, “It is a death knell to the concept of market efficiency and a huge underpinning to my belief in the crazy behavior of Homo sapiens.”

Grantham reiterated his attack on government interference and the negative effects it has on mean reversion. He offered the examples of the U.K. and Sydney housing crises where government policies that facilitated immigration while preventing housing investment due to zoning restrictions at the local levels were the root of both bubbles. In contrast, he said that overbuilt housing markets in the U.S., Ireland and Spain were also due to government interference. But in those cases, the interference was from Fed-induced low interest rates that facilitated excessive housing construction; in all three cases bubbles resulted.

Grantham said that the looming stock market bubble is another example of a bubble driven by government interference. Grantham said that the stock-buyback culture is facilitated by the Fed, which has artificially depressed interest rates, made debt incrementally cheap and allowed corporations to be more profitable. It has made it “desperately appealing” to borrow cheap debt for a corporation to buy back its own stock.

With regard to the Fed, Grantham said, “They have a bad job description badly executed” and have been “a cause of constant trouble in the financial market.” He said they have created a steady stream of bull markets that have ended badly, and they brag about the wealth effect they get from that. Grantham said that, in effect, the Fed has admitted that the markets have been manipulated. He said that we are not expanding our economy with huge profit margins and “unless we correct this with regulation, it will be a drag on our economy.”

Grantham’s research showed that we are getting close to a two-sigma event, as the markets are hovering around 1.5 sigma, and there is “no chance it will break until we get over two sigma.” Grantham said the markets will “plod higher” and follow the path of least resistance of the Fed at least until the election. With the election as a potential bubble breaking trigger, Grantham said “I’m prudent, but I’m going to be incredibly prudent closer to the election.”

On the trigger that breaks the bubble

Although we currently have many of the necessary bubble conditions -- including overpriced equity, bond and fine arts markets -- Grantham said there needs to be a trigger to break the bubble. There are no “institutional pessimists,” he said, and there will be no trigger until individuals pour into the market. He said, “We need to wait until deals become more frenzied and individuals become crazy buyers.”

He does not see a Fed rate hike as the trigger. He forewarned the audience, “You have to wait for the trigger so be brave.” Grantham said the moral hazard of the Fed-driven economy is that in a bull market you are on your own, but in a bear market the Fed will immediately come to help. This makes for long seven-year bull markets followed by 18-month declines. Grantham thinks this provides further support for the stock-option culture where “options rise, you make a fortune, they crash and you rewrite the options.”

On the other nine issues that keep Grantham worries about

In addition to bubbles, Grantham is also focused on:

1. The limitations of Homo sapiens. It is not that Grantham is pessimistic but that our predisposition toward optimism and avoidance of negative information results in “bubble after bubble” without the memory of the pain that preceded it.

2. The implications of longer term resource limitations. Economists do not factor in resource limitations in their models.

3. Especially the limitations of oil, which has driven our economy to where it is today. Cheap oil is running out, and this is a stress to the economy.

4. Climate problems and the effects of climate extremes brought on by carbon emissions.

5. Food problems due to water shortages, soil erosion, population growth, climate extremes, flooding and droughts. These will destabilize economies of poorer countries in particular.

6. Income inequality. With regard to the U.S., Grantham said, “It is hard to imagine an army of average workers making no progress is good for economic growth”.

7. Pressure on GDP growth in the developed world in the context of aging and slowing populations, resource constraints and low capital expenditure investment.

8. Deficiencies of modern capitalism, democracy and corporate values.

9. Deficiencies in the U.S. Federal Reserve.

Despite echoing dour end-of-the-known-world themes, Grantham concluded with an optimistic call to action, “If we rise to the occasion, we will overcome resource issues, climate change and everything else. The question is, will we?”

Justin Kermond is the vice president of business development for Advisor Perspectives.

Read more articles by Justin Kermond