Powerful bull markets like this one, the second longest in American history, can test value investors’ resolve. When a man many consider to be the world’s most perceptive perma-bear appears to change color, other bears take notice.
In May, GMO co-founder and chief investment strategist Jeremy Grantham sent clients a quarterly letter that proved more controversial than most of his provocative missives. Titled “This Time Seems Very, Very Different,” Grantham’s letter immediately grabbed the value investing community’s attention. The piece pointed out that equity prices have spent the last two decades oscillating at multiples 65% to 70% above their 1935-1995 norms on a remarkably consistent basis.
The two decades since 1995 have seen two violent bear markets and two very different bull markets. But Grantham identified other, equally significant trends. Notably, the Shiller CAPE (cyclically adjusted price-earnings) ratio had only reverted to its pre-1996 mean for a brief six months during the 2008-2009 financial crisis.
On the surface, his arguments appear grounded in cold, statistical reality. Yet to some value apostles, Grantham’s letter sounded as though he were capitulating to a bubble-like roaring bull market that has bedeviled value investors.
Some people, like Jim Grant, publisher of Grant’s Interest Rate Observer, called the letter an apostasy. “The world is bullish and a bear’s got to eat,” Grant wrote.
Turning the tables on Grantham, Grant argued the 78-year-old was violating the cardinal sin of money management—career risk. Loosely defined, career risk occurs when a money manager decides to run with the crowd and willingly make the same mistake as other mainstream asset managers, secure in the knowledge that he can’t get fired, even if he is wrong, because there are simply too many other lemmings afflicted by the same pandemic of groupthink.
Grant’s accusation amused the British-born Grantham, who believes some members of the value cult need to look at the facts. Furthermore, Grantham doesn’t think the world is bullish at all. Quite the opposite.
Historically, he has reveled in challenging the conventional wisdom of Wall Street’s optimists, so his explanation about why equity prices remained persistently high blindsided the value crowd. After penning his May letter, Grantham discovered another factoid about trailing-12-month PE multiples, which peaked at 21 times earnings in 1929 and never reached that figure again until late 1997. “The entire block of 20 years I’m obsessed with”—1997 to 2017—“has an average PE higher than 1929. Don’t tell me that things aren’t different,” he retorts.
He’s a longtime believer that equity prices eventually will revert to the mean, but his recent comments suggest that the inevitable wait for that event might strain his value brethren’s patience. For many of them, it already has.
Back in the 1990s, Grantham, Jean-Marie Eveillard and others saw the technology stock boom for what it was—a bubble. They willingly watched the public withdraw their assets from their funds as investors found other managers happy to chase returns. In recent years, GMO and other active management shops, particularly those with a value tilt, have seen another exodus of assets. GMO’s assets are down about 34% to $77 billion since 2014, and last month it disbanded one of its investment teams that specialized in international active strategies.
A Cold-Blooded, Bureaucratic Anti-Bubble
So why is this time really so different, as Grantham argues? “This is not a bubble” as it is completely lacking in “all the psychological stuff you saw in 1999, 1929 and the 2007 housing market,” he says.
To Grantham, today’s equity market feels cold-blooded and bureaucratic. “Almost everything is going up in a boring way,” he explains. “It’s not the nature of a bubble; it’s almost an anti-bubble.”
The current bull market has been called the most hated in history. In September 2009, Schwab chief investment strategist Liz Ann Sonders told advisors at the firm’s annual IMPACT conference that she considered stocks cheap and attractive, but she quickly added that she had never encountered such an angry response from positive forecasts in her career.
Eight years later, the hate may have dissipated, but it’s hard to find any love. Grantham sees no euphoria or craziness. Walk into a restaurant in Boston for lunch and everyone is watching “Red Sox replays,” not CNBC.
“This market has been characterized by nervous investors” and virtually no public interest, he says. “In June, stocks hit two new highs in one week and it didn’t make the paper.”
Skeptics of the post-financial crisis equity market point to narrow market leadership and investor obsession with a handful of sexy stocks, FANG and Friends like Microsoft, Apple and Salesforce, as an indication we are witnessing a sequel to the tech stock bubble of the late 1990s. One might expect Grantham to be leading that chorus.
But that reasoning doesn’t cut the mustard for Grantham, who cites research conducted by AQR finding that every bull market has its winners and this one is no narrower than most. “In a [true] bubble, you buy tulips, not flowers; you buy tech stocks, not [most] stocks.”
That’s a marked contrast from the late 1990s. Back then, the advance-decline line was negative “for two years before everyone went to Cisco in 2000,” Grantham notes. These days, the advance-decline is still rising.
It’s not just equities. Many observers believe the real bubble waiting to wound investors is in bonds.
Moreover, yields are falling and prices are climbing across a spectrum of asset classes. Even among hard assets, which some think provide diversification from stocks and bonds, the prices of farms, forestry and real estate are rising. “It is a boring drop in the discount rate; for some reason, the discount rate has dropped.”
While value skeptics like Grant may question his recent thinking, Grantham is more critical of himself, albeit from a different angle. “I was very slow” in perceiving how dramatically conditions had changed over the last two decades.
Three years ago, he began to discern that there was a lot of positive machinery that supported the persistence of high stock prices. This, despite the fact that some of GMO’s traditional metrics pointed to the S&P 500 being overvalued by 30% or 40%.
Roughly half the level of excess valuation came from record corporate profit margins, which appeared unsustainable, with the other half coming from the PE multiples themselves. Profit margins were once about the most reliably “mean-reverting” data series in finance. But Grantham surmised that, with corporate America’s huge increase in power over the last 40 years, hefty margins might be sustainable, even if it continued to widen income inequality since more GDP is going to corporate profits than labor.
Other powerful factors were also at play. A student of the presidential election cycle’s impact on stock market swings, he suspected that U.S. equities would stay strong through the 2016 election.
In the slow GDP growth environment pervasive in the post-2000 world, a different variant of the career risk syndrome has appeared in the CEO suite. Caution among CEOs is particularly pronounced since the financial crisis.
One upshot is that risk-averse CEOs, when given the choice, are likely to take the easy route, increase dividends and repurchase shares to drive up their stocks so they can exercise their options and ride off into the sunset. Most CEOs face a tenure of less than eight years. In today’s unforgiving world, the odds of initiating a bold venture entailing up-front losses, then failing and yet still surviving are small indeed.
Another reason is a global savings imbalance. People in China and many emerging markets are over-saving, while those in the developed world are aging and playing catch-up because they haven’t saved enough. Opposite though these trends may be, both drive demand for financial assets.
Monetary policy and low inflation are other obvious factors. Former Fed chairmen Alan Greenspan and Ben Bernanke both possessed outsized faith in the magic of cheap money. “Bernanke had great faith that monetary policy could stimulate growth,” Grantham says. “It’s a delusion. Since Greenspan [became Fed chairman in 1987], we tripled our debt and growth has slowed noticeably.” From his recent remarks, Greenspan appears to believe low productivity and growth are the new normal.
It’s clear that abnormally low interest rates have forced many aging savers into equities, and Grantham believes these rates are likely to remain subdued for some time. Even without unpredictable leaders like Donald Trump on the global stage, strange things could happen. Moreover, no one knows what will trigger the next 15% or 20% correction.
None of the megatrends, such as demographics, income inequality, huge corporate profit margins or low interest rates, appear likely to disappear anytime soon. That’s why Grantham thinks equities could remain expensive long enough to drive more value investors to hit the hard stuff.
Understanding Valuation Metrics
Viewed by some as a diagnostician of bubbles and various valuation metrics, Grantham acknowledges that any measurement, even the Shiller CAPE ratio upon which he relies extensively, has its own limitations.
Some metrics have become almost worthless, he says. “Book value once approximated replacement cost,” he recalls.
Today, thanks to mergers, acquisitions, buybacks and other cases of financial engineering, book value has become “hopelessly polluted.” Furthermore, in an information economy dominated by service companies, many intangible or hard-to-value assets with earnings power bear little connection to numbers on balance sheets.
Defining value today is a lot more challenging than it was when Grantham was a young hotshot in the 1970s. In his view, it is easier to say what value isn’t.
Used the wrong way, many popular yardsticks can become value traps. Some cheap stocks have justifiably low P/E ratios because they have the least desirable future stream of earnings. Equities sporting high yields often signal that the market is scared of owning them. And low price-to-book ratios frequently indicate investors are voting on which company has the “dopiest” assets.
Just because a company looks cheap according to these metrics doesn’t mean it represents “serious value.” Grantham’s belief is that “if an investment is risky to your career, the more return you are going to need.”
When one looks at two companies within the same industry or even two countries in the same geographic region, pricing rarely gets far out of line. It’s when one compares two separate asset classes that the huge gaps in value may appear.
The idea that asset allocation trumped stock selection helped prompt Grantham to leave stock selection in 2000 and become the firm’s chief equity strategist.
Diversification Still Works
Financial advisors don’t need Grantham to remind them that global diversification has been a tough sell over the last eight years. Many advisors look to GMO’s seven-year forecasts for various asset classes, as this is where GMO has enjoyed an excellent track record.
It should be noted that GMO’s seven-year real return forecasts square more closely with the value investors whose wrath Grantham has incurred lately than with his recent commentaries. GMO expects U.S. large caps to return a negative 4.0% after inflation while U.S. small caps will give investors a negative 3.1%.
Emerging markets are the only equity asset class expected to offer a positive real return of 3.4%. In the bond market, emerging market debt is the only asset class with a positive projected return. Because GMO historically has been a value shop, Grantham concedes these forecasts have a conservative bias.
Since the bull market began in 2009, the MSCI EAFE Index ex-Japan has trailed the S&P 500 by 100%. For an extended period during the lost decade, the S&P underperformed that index by 80%. In early 2016, the Shiller PE for emerging markets stood at 10, cheaper than it was at the bottom of the financial crisis.
“The odds of that [emerging market versus the S&P 500] not winning is negligible,” Grantham says. “At the extreme, strange things can happen, but they don’t stay there very long. Whether the S&P is going to stay high is another question, but it cannot return as much as emerging can.”
It should be noted many other shrewd market observers like Mark Hulbert and managers within GMO itself have written that leadership may be about to transition from growth to value. Were that to materialize, financial markets might once again exhibit some of their pre-1995 characteristics. According to GMO’s Neil Constable and Rick Friedman, the stars are starting to align for value stocks, which could be “very well-positioned to benefit from a rising-rate environment.”
They may well be right. But as Grantham points out, nothing is cheap these days. That includes value stocks.
A View Forged In Chaos
Grantham acknowledges his own views on investing are colored by his experience. He began his career at mutual fund company Keystone in the 1960s as the great bull market of the postwar era was enjoying its final phase, a period The New Yorker’s John Brooks described memorably in a book titled The Go-Go Years. A group of equities emerged called “one-decision stocks,” meaning all an investor had to do was buy them and forget about them. From Grantham’s historical perspective, it was the only “genuine bubble in high-quality” companies.
Then came the 1973-74 bear market, a perfect storm that included the Arab-Israeli War, the oil embargo, Watergate and the advent of stagflation. The so-called one-decision Nifty Fifty stocks like Avon, Eastman Kodak and Polaroid cratered. Xerox, perhaps the hottest stock of that era, fell from $170 a share to $17 a share in little over a year.
By December 1974, much of the public had fled equities, and the Standard & Poor’s 500 index was yielding 5.5% and selling at seven times earnings. Working with Dean LeBaron and Dick Mayo at Batterymarch, an early pioneer in quantitative investing, Grantham recalls that it seemed like a stock needed to be yielding almost 10% to capture their attention. In the 1970s, if an investor bothered to show up and buy the cheap price-to-book or high-yielding stocks “you were going to win.”