GMO co-founder Jeremy Grantham believes that the bubble in bonds has burst after a 40-year bull market. Equities and housing are likely right behind it, though he admits he isn’t sure which one will be next.

Housing was “late to the party,” in Grantham’s view, but prices have soared 15% in the last year. Bidding wars among Americans afflicted with cabin fever have erupted and home prices broke through their 2006 peaks.

If “we manage to pull a trifecta” and all three markets were to crash in the next year or two, the negative wealth effect, closely correlated to the severity of recessions, could be enormous, said Grantham. Were markets to re-price stocks, bonds and housing back to “near normal,” somewhere between $20 trillion and $30 trillion in wealth could disappear.

Back in 2017, Grantham told Financial Advisor that ever since 1995 stock prices had levitated to price levels only seen once in the early 20th Century–in 1929. Then a confluence of factors converged at the turn of the millennium to propel price-to-earnings multiples to new heights—60% higher than they stood at for most of 1900-1995 period.

Valuations remained near these levels for all but a few brief periods since the late 1990s, which Grantham views as a “long-term aberration.”

Globalization was probably the biggest single factor driving this anomaly. An expanding global labor market gave corporations a huge one-time advantage that weakened labor in the developed world. “Five hundred million Chinese were joined unexcitedly by 200 million Eastern Europeans [who had been] pretending to work for their Communist” masters, he explains. 

American workers saw sharp declines in their negotiating power. Wages in the U.S. rose only 10% after inflation in the last 50 years, Grantham notes. In contrast, real wages climbed more than 60% in both England and France, a little noticed fact.

This permitted American corporations to double their profit margins over a half century. Grantham expects the balance of power between capital and labor to drift partially back towards historical parity in the coming decade.

Sincere or not, both political parties in the U.S. suddenly have signaled increased sympathy for workers in lieu of corporations in recent years.  This is evidenced by the growing political clout of asymmetric politicians with similar appeal like Sen. Bernie Sanders and former President Donald Trump.

Thirty years of easy monetary policy dating back to former Fed Chairman Alan Greenspan also played a huge role in the bond bubble, Grantham says. Many global bond markets hit a 2,000-year high in 2020, he adds, crediting newsletter publisher Jim Grant for that observation.

Around the developed world, interest rates are even lower than in the U.S. Equities abroad, however, have not reached the heights that they have in America, home to the vibrant tech sector.

Grantham sees some clear parallels as well as differences between today and the tech bubble 20 years ago. Back in those days, a plethora of dot.com stocks like Pets.com were poster children for speculative excess.

Now it’s the SPACs (Special Purpose Acquisition Companies). The problem is that “SPACs are much bigger” and are “able to sidestep the SEC prohibition on selling daydreams,” Grantham argues. “We’re looking at something that’s going exponential.”

The market at least seems to be waking up to the problem. The average SPAC, Grantham says, is already down 25% and at least a few have swooned by 50% or more.

But in 2000, there was no bubble in the bond or housing markets. With that previous bubble largely confined to the tech sector, it was finite and there “were places to hide.” Eventually, the terrorist attacks of September 11 and the accounting scandals at Enron and Worldcom would spark a broader sell-off in 2002, but most non-tech stocks recovered fairly quickly in 2003.

This time the entire equity market is historically expensive by most metrics. “Don’t tell me it’s just the top decile,” Grantham says.

If one measures the equity universe by price-to-sales ratios and slices it into ten deciles, every single decile is selling at its all-time high. In recent weeks, even the top decile reached its 2000 peak and many high flyers at the turn of the millennium had little in the way of revenues.

That’s one of many reasons Grantham is confident that value will outperform growth in the next decade. In reality, however, value stocks have performed reasonably well for the last decade—until they are contrasted with their growth-stock counterparts that went vertical.

In one scenario that Grantham considers plausible, value stocks grind higher slowly but massively outperform their growth counterparts, which tumble by something like 50%. In an extended interview yesterday, Grantham also said there could be a wipeout across the board. In that rosy case, a 2,000 target on the S&P could also materialize, representing the third decline of 50% in this young century.

Another scenario that won’t happen is the one growth stock managers holding tech shares they know are overvalued pray for—namely, that the Amazons, Twilios and others, go sideways for the next decade. That “would be lovely for them,” Grantham says.

In every era of overpriced stocks going back to Nifty Fifty of the early 1970s, “There have been a lot of people who say we will resolve this by going sideways. That has never happened.”

The bottom line, Grantham says, is that economists know “next to nothing” that is useful about stocks. The school of rational expectations has “misled” investors for most of the last 70 years. Investing just isn’t a rational activity—it’s a behavioral one.