Grantham: Overvalued Markets Due for an Adjustment

By David Berman

There are bullish pundits and bearish pundits – and like broken clocks, some are always looking brilliant. And then there is Jeremy Grantham, chairman of investment management firm GMO LLC.

We’ve mentioned Mr. Grantham in this space before (as recently as last week), and we like him because he isn’t a broken clock. He has been skeptical of the U.S. stock market in the recent past, but then said in March of this year that, “if you invest too little after talking about handsome potential returns and the market rallies, you deserve to be shot.”

The S&P 500 was then poised at just 676, or 10 points above its 12-year low touched just days before. At the time, he believed the index’s fair value was 900. In the summer, he then forecast the index could rise to a high of 1100. Right again.

On Tuesday, Mr. Grantham released his latest quarterly commentary on the market. Far from converting into a perma-bull, he’s sounding cautious – even if the global economy does recover.

“The normal tendency of an economy to recover is nearly irresistible and needs coordinated incompetence to offset it...,” he said in his note. “But this does not mean that everything is fine longer term. It still seems a safe bet that seven lean years await us.”

He argued that price-to-earnings ratios, after adjusting for normal profit margins, are well above fair value now that the S&P 500 has rallied 60% from its low in March. He believes the index’s fair value is now just 860 – or more than 19% below its current level.

“Major imbalances are unlikely to be quick or easy to work through,” he said. “For example, we must eventually consume less, pay down debt, and realign our lives to being less capital-rich. Global trade imbalances must also readjust.”

But at the same time, he acknowledges that concepts of value don’t mean a whole lot next to the powerful forces of low interest rates and generous liquidity. At the same time, momentum is also helping to push stock prices higher, to a point where the market is looking silly again.

This will end – he guesses in the first few months of next year – due to two factors. First, economic and financial data will disappoint, revealing the longer-term troubles of the developed economies. This will put pressure on profit margins at a time when labour cuts are no longer a quick fix.

Second, with U.S. stocks looking overvalued, gravitational force will at last kick in.

“I have some modest hopes for a collective sensible resistance to the current Fed plot to have us all borrow and speculate again,” he said. “I would still guess (a well-informed guess, I hope) that before next year is out, the market will drop painfully from current levels.”

For him, “painfully” implies a dip of 15%. But a drop below fair value is more likely, and that could bring a 22% setback.

“Unlike the really tough bears, though, I see no need for a new low,” he said.

Meanwhile, the long-time fan of emerging markets warns that they are well on their way to bubble territory – but he doesn’t want to exit those investments too early.

“For once in my miserable life, I would like to participate in a bubble if only for a little piece of it instead of getting out two years too soon,” he said. “Riding a bubble up is a guilty pleasure totally denied to value managers who typically pay a high price to the God of Investment Discipline (Thor?) for being so painfully early.”

Comments

[Hedged In:]

Why didn't you link to the full article by Jeremy Grantham? It's here (in PDF):
www.gmo.com/websitecon...

Oct 27 04:37 PM

[p2i:]

The problem is that experts are wrong at least 50% of the time. Does that mean that Jeremy Grantham is due to be wrong this time? Could be.

Oct 27 06:37 PM

[a fat panda:]

It is a great article. What puzzles me is that he sites people and things that have no historical precedent. Yet he constantly puts the current market into historical context. He layers abuse on the incompetence of our leaders. Yet, these are the people who are going to lead us out of this.

Here is the main break with the past. Today government seems to think that the market is wrong and needs to be fixed. The government decides that we don't sell enough cars so we have a fix. We have too many houses, so there is a fix. Every ill has a cure that is worse than the disease.

There is another difference. While the government has always been populated with people who think that they are the smartest guy in the room, today is different because Americans have actually ceded power to these dipsticks.

Oct 27 07:57 PM

[untrusting ...:]

Yes, but where are we now? That is always the trick. Grantham clearly thinks we are at or very near the maximum optimism/euphoria stage, at least in terms of US equities anyway. We think he is probably a lot closer to being correct, than are the perma-bull camp.

The other possible arguement to consider is the momentum vs value theory. If one believes this has primarily been a momentum type run-up, then when the momentum fades .. they will have to see a substantial fall before most value investors would be interested in buying from momentum players. In our view, few if any value investors would be willing to invest unless price levels were to fall quite substantially from here. At least as much, if not more than Grantham's estimated levels.

If one considers, where are the buyers of US equities:
1) Not insiders - they are selling in near record levels.
2) Not corporate buybacks - majority have reduced buybacks.
3) Not retail investors - data shows bond funds are receiving 20:1 the cash inflows that equity funds are.
4) Not value investors - would require much lessor prices.
5) Not endowment funds - they have reduced exposure to US equities for years now and drawdowns will pressure them.
6) Hedge funds - who knows, but they will probably mainly trade the market and reduce exposure if the uptrend stalls.

So who is left? Traders mainly and traders will likely flee the markets if the trend breaks. That then leaves the prop. trading desks and HFT's to trade back and forth between themselves.
And the real wildcard, the Fed/Treasury. It certainly appears they have been extremely supportive of asset/stock inflation, but they are starting to get pressure on the big devaluation of the dollar and may have to back off at least temporarily if nothing else.

On Oct 27 09:36 PM Peter Mycroft Psaras wrote:

> “Bull markets are born on pessimism, grown on skepticism, mature
> on optimism and die on euphoria. The time of maximum pessimism is
> the best time to buy, and the time of maximum optimism is the best
> time to sell.” – Sir John Templeton

Oct 27 10:09 PM

[Ricard:]

Grantham has been right much more than 50% of the time.

On Oct 27 06:37 PM p2i wrote:

> The problem is that experts are wrong at least 50% of the time.
> Does that mean that Jeremy Grantham is due to be wrong this time?
> Could be.

Oct 28 03:08 AM

[rick12345:]

I like the way he immediately pairs the current situation to the great depression by suggesting another seven years of stagnant growth. I wonder if he also realizes that there were no developing economies growing at 9% during the 1930's. Every time we have a correction in the markets the bears come out of hiding to predict the forthcoming Armageddon. Let's look at some of the predictions:

We start with Dr Doom, Nouriel Roubini (Dec 2008) :

"We are in the middle of a very severe recession that's going to continue through all of 2009" -
Figures out next Tuesday could show that the US is technically out of recession.

"In my view, home prices are going to fall by another 15% before bottoming out in 2010." -
Home prices have risen for three straight months now.

Jim Rogers (Dec 2008)

"For stocks to go to a 6% yield without big dividend increases, the Dow will need to go below 4000. I'm not saying it will fall that far, but it could very well happen." -
Still waiting Jim...

Steve Hochberg, chief market analyst at research firm Elliott Wave
(March 2009)

"The 30-stock Dow Jones Industrial Average will lose half its value in the next six months to about 4,000 on the blue-chip index. When it's all over several years from now, the Dow will trade below 1,000" -
6 months on and the Dow has moved 2500 points higher instead of 3000

"What's going to happen when the stock market finally bottoms? You'll be able to go in there and buy stocks that used to trade at $85 a share for maybe half a dollar or a quarter of a dollar." -
- Damn I got ripped off in March.

Just goes to show that even the so called experts don't get it right all of the time.

Oct 28 04:07 AM

[bob Allard:]

Grantham is one of the kings of Value investors, and as such you will rarely lose money following his lead. His comment about riding a bubble is funny, and points to the key issue that we all think about: value is relatively easy to quantify, but market behavior is much more about emotion when it extends beyond value into euphoria or despair. Greed and fear are not easy to quantify, control, or predict, and Grantham's point speaks to this dilemma of the value investor- never getting too rich or too poor (although if you're managing $100B, you can do pretty well just on the fees...)

The difference that I see today versus the depression is the terrific interdependence and information velocity of the global economy. There is so much new wealth created each day that can travel so much more quickly (relative to the past) that global market discipline is stronger than ever - the pull to maintain stability and protect one's position whether one is a person, company, industry, region or country/currency. Interesting times!

Oct 28 08:57 AM

[Deepv:]

I don't understand how Jeremy puts a value of the S&P at 860-- basically the same value as he gave in previous quarters. Isn't there a time value of money adjustment? Or has he revised earnigns down? Or his interest rate up.

Jeremy's valuation is on cyclically adjusted "E" but we don't have a mormal denominator. I would think that the value of stocks is very sensitive to the fact that interest rates are ZERO and we are printing money like mad.

Oct 28 12:08 PM

[candleman:]

"Keep your eye on the doughnut and not on the hole."

"Our own" April 1930 rebound High occurred in October 2007. We are now on the way to "our own" July 1932 Low.

Once that is understood, everything falls into place.

Oct 28 01:52 PM

[Vjklander:]

The current economic morass is the natural and inevitable result of ignorant meddling by Congress and their co-conspirators in the White House and other bureaus, administrators, and petty officials within the government. These miscreants gave bad actors the ability to make huge bets on the viability of all publicly traded companies and also gave these same bad actors the ability to control the viability of all of those same publicly traded companies. And they still refuse to own up to it.

1. It started in 1996, December 5th to be specific, when Alan Greenspan took the Federal Reserve off the Gold Standard. The de facto gold standard that is. Prior to this, Mr. Greenspan set the Fed funds rate to the 2-year moving average of the price of gold. After that date, he used the Fund rate willy-nilly to attempt to control the market for political purposes rather than serve it. We now see the result.
2. In 1999, President Clinton’s appointee Franklin Raines reduced credit requirements to provide loans to people who couldn’t rationally afford them. These bad loans were securitized with other more stable loans and sold to investors backed by the full faith and credit of the US Government.
3. On Nov 2, 1999, President Clinton signed the Gramm-Leach-Bliley Act repealing the Glass-Steagall Act of 1933 which separated the investment banks from the commercial banks. This firewall had protected John Q. Public’s banking services from being unduly threatened by the risk inherent in the investment domain. On the single week of September 22, 2008, all the investment banks disappeared into the commercial banking realm, thus doubling the size, power, and control of the Federal Reserve.
4. On December 21, 2000, President Clinton signed into law the bill defining Credit Default Swaps and exempting them from regulation by the SEC and CFTC. There are 2 kinds of CDS; covered CDSs which are essentially insurance products exempted from oversight by insurance regulators, and naked CDSs, which are basically gambling, except the holders of the cards can pick their own hand.
5. On July 6, 2007, the SEC eliminated the uptick rule which heretofore had prevented gangs of short-sellers from driving a target company into insolvency. (As a side note, this was the result of lobbying by Bernie Madoff).
6. On November 15, 2007, the FASB imposed mark-to-market accounting. This essentially destroyed a firm’s ability to get financing using its securities as collateral.

So there you have it, the perfect storm created by Congress, the President, or their designees, which churned over time and eventually turned into the current disaster. It can also be noted, that all the measures taken by the Presidents and Congress over the last year have only had the effect of further exacerbating the problem until March 9, 2009.

1. On March 10, 2009, Representative Frank, Chairman of the Financial Services Committee, announced a plan to reinstate the uptick rule. In the week following that announcement, the markets rose 20%.
2. On March 16, 2009, the FASB announced plans to revise mark-to-market accounting to remove the feedback loop driving companies into insolvency. In the week following that announcement, the markets rose 10%.

But still Congress refuses to admit their own culpability and reverse the irrational interventions they have made in the market over the last decade. It is interesting to note the parallels between the actions of Congress and The 5 Stages of individuals faced with a long term mental illness like bipolar disorder .
1. Denial - The "No, not me" stage.
This stage is filled with disbelief and denial. You think the doctor has to be wrong, that there is no way you have a mental illness, especially not one you will have for the rest of your life.
2.Anger/Resentment - The "Why me?" stage.
Anger at the situation, perhaps anger at the person you perceive as triggering your episode. Anger at the doctor and the hospital for their audacity in labeling you with a mental illness. Perhaps anger with yourself for things you have done that you think may have "brought on" the episode of bipolar disorder. Anger that it is you who has been afflicted, when it could so easily have been someone else.
3. Bargaining - The "If I do this, you’ll do that" stage.
You try to negotiate to change the situation. If you think it was triggered by a relationship, for example, you swear that you will be better, and it won't ever happen again, if you just don't have to have this illness. You bargain that you will give up bad habits in exchange for wellness "I will quit drinking; smoking etc. if only the bipolar disorder goes away.
4. Depression- The "It's really happened" stage.
You realize the situation isn’t going to change. Perhaps you have had another episode. Perhaps you stopped taking your medication, only to discover that you became ill again. It finally begins to set in, and you ponder what this disorder is going to do to your life as you had known and accepted it. This is a stage of preparedness for acceptance, and finally one day it is reached.
5. Acceptance - The "I do have Bipolar Disorder" stage.

The actions necessary to placate Mr. Market are this simple:
1. Direct the Chairman of the Federal Reserve to set the fund rate according to the price of gold.
2. Define the only acceptable home loans to receive federal guarantees to be fixed- year, fixed-rate mortgages on owner-occupied primary residences with no prepayment penalties and required proof of ability to pay.
3. Reinstate the firewalls between commercial and investment banking.
4. Place covered CDSs under the purview of insurance regulators and ban naked CDSs.
5. Reinstate the uptick rule on all stock transactions.
6. Eliminate mark-to-market accounting.

Oct 28 03:25 PM

[rennert:]

But here is the latest: People in the Malls are carrying shopping bags again. Not 3and 4 bags but 1-3bags.Everyone on my street here in Florida is working. No houses for sale on my street either. Milk going for $8.50 a gallon. Fed needs to raise at least 1%. That will not derail the economy. I can not find a handyman or tree trimmer they are all too busy, they have work stacked up for weeks. Fed needs to raise Now. Silent Inflation is upon us.

Oct 28 04:29 PM

[KDG:]

Our current global population is 6.793 billion.

The growth trajectory of the global human population and the rate at which emerging markets are integrating into the global economy is unprecedented.


On Oct 28 04:29 PM rennert wrote:

> But here is the latest: People in the Malls are carrying shopping
> bags again. Not 3and 4 bags but 1-3bags.Everyone on my street here
> in Florida is working. No houses for sale on my street either. Milk
> going for $8.50 a gallon. Fed needs to raise at least 1%. That will
> not derail the economy. I can not find a handyman or tree trimmer
> they are all too busy, they have work stacked up for weeks. Fed needs
> to raise Now. Silent Inflation is upon us.

Oct 28 07:47 PM

[Ouch$:]

VJKLANDER, GREAT WORK!!!!!!!!!!

I HAD TO PRINT YOUR RESPONSE TO THE ARTICLE, MAY I USE IT TO EXPLAIN THE PROBLEMS TO PEOPLE WHO DON'T BOTHER TO READ.

Oct 28 11:10 PM

[rick12345:]

I'm reading this kind of thing more and more. Hopefully you're right and the stimulus is finally kicking in.


On Oct 28 04:29 PM rennert wrote:

> But here is the latest: People in the Malls are carrying shopping
> bags again. Not 3and 4 bags but 1-3bags.Everyone on my street here
> in Florida is working. No houses for sale on my street either. Milk
> going for $8.50 a gallon. Fed needs to raise at least 1%. That will
> not derail the economy. I can not find a handyman or tree trimmer
> they are all too busy, they have work stacked up for weeks. Fed needs
> to raise Now. Silent Inflation is upon us.

Oct 28 11:15 PM

[alajac:]

You're getting ripped off: milk in Detroit is $1.75 a gallon. And the only ones carrying bags around here are living on the street.


On Oct 28 04:29 PM rennert wrote:

> But here is the latest: People in the Malls are carrying shopping
> bags again. Not 3and 4 bags but 1-3bags.Everyone on my street here
> in Florida is working. No houses for sale on my street either. Milk
> going for $8.50 a gallon. Fed needs to raise at least 1%. That will
> not derail the economy. I can not find a handyman or tree trimmer
> they are all too busy, they have work stacked up for weeks. Fed needs
> to raise Now. Silent Inflation is upon us.

Oct 29 10:51 AM

[aminorex:]

Don't forget the other major Congressional mis-step: Bankruptcy "Reform". They rigged the law so that debtors were better off walking away from their mortgages instead of filing bankruptcy. Result: Toxic assets.

Dec 04 05:08 PM