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.