Markets blog

Bernanke risking another catastrophic bubble, Jeremy Grantham warns

Jeremy Grantham is worth listening to.  Ten years ago, he predicted that US stocks would fall in value over the following decade as well as warning that the NASDAQ would lose roughly 70% of its value.  More recently, he predicted the bursting of the US housing bubble as well as warning that a global financial crisis was inevitable.  No perma-bear though, Grantham urged investors to stock up on equities in March 2009, saying that it was imperative to take advantage when investors were “terrified”.  

Grantham’s latest quarterly letter to clients is out and it’s a concerned one.  Federal Reserve chief Ben Bernanke is “begging us to speculate” and his rock-bottom interest rate policy risks creating the third serious bubble in just ten years.  Right now, the US market is “very overpriced” but “not nearly so bad as it could be”.  Grantham, whose firm manages over $100bn in assets, is praying for a strong and sustained economic recovery, one that will result in rate rises before “real bubble territory” is reached.  Rate increases would see the market “settle down” and any decline would likely “exercise no really damaging effect on the economy.”  

It’s more likely that the economy will limp along, however, ensuring that rates will be kept low for too long and creating a “very real danger of a third dangerous bubble in stocks and in risk-taking in general”.  It’s like lining up behind a hot stove and begging that one’s hand be burned a third time, Grantham snorts.  

A keen follower of the so-called presidential cycle, he notes that there has been no serious market decline in the third year of a presidential term since 1932.  In other words, overpriced stocks are likely to become dangerously overpriced next year unless some serious market break occurs in the coming months.  Possible causes of such a break include an unexpected second leg down in house prices, a rapid rise in commodity prices or a crisis in the euro (think Greece, Portugal, etc).  Such a market decline would nevertheless allow the economy to limp along and would be far preferable to another 30-40% rise “along with risk trades similarly flourishing and then all breaking”.  The odds of such an occurrence are “nerve-wrackingly high” and the developed world’s already fragile financial structure would “simply buckle at the knees”.

Scary stuff.  However, while US indices are seriously overpriced, global equities are merely “moderately” so while large, high-quality US companies are “still a little cheap” having been left behind in the overall market rally.  A mix of global stocks, tilted to US high-quality, should achieve annual returns of 5% plus inflation over the following seven years, only slightly below the long-term norm of 6% (Grantham’s long-term forecasts, based on solid fundamental and quantitative analysis, are famously accurate – so accurate was his 10-year forecast in 2000, he has estimated that the odds of it being right by chance were 1 in 550,000).  

I hope to revisit Grantham’s letter, which includes a thoughtful analysis of the advantages and disadvantages of Graham and Dodd-type value investing, later in the week.  In the meantime, all investors should head along to gmo.com and check it out for themselves.  Like all his quarterly letters, it’s a must-read.

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