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BL Portfolio interview: Jeremy Grantham on market bubbles, value investing

Hari Viswanath |BL Research Bureau | | Updated on: May 31, 2022
 Jeremy Grantham

 Jeremy Grantham

The investing legend also shares his insights on lessons history has taught when it comes to equities

When Jeremy Grantham talks, market participants across the world listen. Over the last five decades, he comes with an exceptional track record of spotting every bubble across major global markets, staying clear of it and giving sufficient warning to all. Whether it was the Japanese stock market and real estate bubble of late 1980s, the dotcom bubble of 2000 or housing bubble of 2007, he was prescient in his predictions. Investors who heeded his calls were spared the crushing portfolio declines as the bubbles unravelled. Jeremy Grantham is famous not just for his bearish predictions and sticking to his guns and avoiding the dotcom bubble stocks throughout the years the bubble played out. He is also equally famous for perfectly identifying the market bottom during the darkest days of the 2007-09 bear market in March 2009.

In a freewheeling chat with BusinessLine, he shares his take on where the US markets are since his recent bubble warnings, his view on global markets, and time-tested investing strategies that value investors can apply. Excerpts:

Profile
Jeremy Grantham co-founded asset management company GMO in 1977. GMO is one of the world’s most well-known companies in the hedge fund industry. Prior to GMO’s founding, Grantham was co-founder of Batterymarch Financial Management in 1969 where he recommended commercial indexing in 1971.

Way back in January 2021, you said the next market crash in the US will rival the ones in 1929 and 2000. It seems to be headed in that direction…..

What I meant was that in terms of overpricing in the market, it was even worse than 1929. In terms of crazy investor behaviour, I thought it was quite likely to be worse than 1929.

Thus, I was suggesting that, in a sense, this possibly was the most spectacular bubble in American history; of course, not as big as the one in Japan in 1989. However, in 1929, the government got everything wrong in its response. I am not suggesting that now.

I don’t mean that it will get so ugly as 1929 and we will have a depression.

Since your prediction in January 2021, the frenzied stocks are down 80-90 per cent.The S&P 500 moved up last year,  but into 2022, it too has started correcting…..

The great bubbles, the psychological extravaganzas, they are the things I study. And there are only a handful of them. When they start to lose air, the most aggressive speculative ones start to go down first.

My most unfortunate example would be Quantumscape, because I owned a lot of the stocks myself (the biggest position of my life). It goes back nine years into my venture capital investment in green investing. It’s a solid-state battery enterprise, a research lab. It got listed as a SPAC (most unfortunate) in 2020, years before it had a product to sell. That is right at the tippy top of vulnerable growth stocks list. A company not only with no earnings, but no sales. And not only with no sales, but certain to not have any for several years. This stock peaked out (at a marketcap of around $50 billion) in December 2020. It is down around 90 per cent since. Two or three months later some of the meme stocks, the ARK Innovation ETF peaked out, and then all the growth stocks without any earnings started coming down.

That’s a classic pattern not unusual for a great bubble unravelling well.

So if someone asks when did the bubble start to break in the US, arguably December 2020. But in any case, by the spring of 2021, it was clearly in a very typical way beginning to go down, led by the super speculative stocks And they had declined all through the year and this year they have got murdered.

How similar is today’s scenario with what happened in the year 2000?

What happened in 2000 was that the balance of the market actually went up. So instead of saying ‘Look at the Dow Jones Index, it is only down 8 per cent’, you would have been saying by September 2000, ‘Hey if you look at the S&P 500, if you take away the speculative growth, it is up 17 per cent.’

So if you see, the pack of all growth stocks were down 50 per cent, the internet stocks in specific had disappeared between March and September of 2000, but the balance of S&P 500 went up. So, S&P 500 in total was flat. What you had was 30 per cent of the index murdered and 70 per cent doing quite nicely.

This time it isn’t quite as impressive as 2000. The S&P 500 or Dow Jones haven’t quite been able to go up, and now they are going down.

So the markets have finished phase 1 — where the speculative stocks go down and the blue chips go up. We are now entering phase 2, where the weakness begins to extend across the board. Even value stocks are down.

Can phase 2 be different this time, as some of the relatively better stocks (as compared to deeply unprofitable stocks), those like Snapchat and Zoom are already down more than 80 per cent from peak, while the Dow Jones is down only a little over 10 per cent from peak?

Exactly as it happened in 2000. And by the way, stocks can be down 80 per cent and fall another 50 per cent. As one of my colleagues says, ‘What does it feel like to be down 90 per cent? It feels like you went down 80 per cent and you halved!’ In 2000, Amazon went down 92 per cent, and it was succeeding brilliantly and, on its way to inheriting the earth. But it went down 92 per cent. Do not think because you are down 80 per cent, you can’t go down anymore.

What are your identifiers for assessing late-stage bubbles ?

When it comes to bubbles, valuation or expensiveness is no guide for when the bubble can break. Some break much cheaper than others. A much better guide to when it will break is the behaviour. You wait until this crazy behaviour takes hold, you wait until the market has accelerated — not just the going up, but the rate of ascent. The Nasdaq doubled from the Covid lows in 9 months, and it was up 50 per cent from the beginning of 2020 by then.  The divergence between speculative stocks and bluechips is another factor.

What drives this divergence between speculative stocks and bluechips ?

There is a commercial imperative for institutional participants to play bull markets till the end.   Chuck Prince, the former boss of Citibank, famously said in 2007 — he had to keep dancing, the music was still playing; to which George Soros later said, actually, the music had stopped but he just hadn’t heard it.

But, they are not completely stupid. They don’t have to dance with the most speculative stocks. So they dance with the Coca-Colas and other Dow Jones bluechips. And it worked in the sense, these companies survived. It allows you to dance off the cliff and allows you a reasonable chance to survive the fall.

That’s why, in the crazy long bull markets, they shift towards the bluechips. They don’t do anything like that at any other time. You can never find a decent bull market where the volatile, highly risky speculative stocks underperform. But then in late stage they underperform. And they don’t just underperform, they go down. This happened in 1929, 2000, 2021 and 2022, while the bluechips fare better. So this time too it is exactly the same as in earlier bubbles. This is classic.

What is your view on markets outside the US ?

The rest of the world is much less overpriced. Certain countries, such as the UK, Japan, that I follow are pretty much normally priced, which is unusual as, often in a bull market like 1929, everyone goes together. Whereas 2000 was a US tech event. This fall has been more like that. Therefore I assume that the rest of the world will do substantially less badly.

One of the problems, though, unlike 2000, this bubble has spread into other asset classes — particularly real estate. Due to the low interest rates in the developed world, real estate in the developed world and in China has become ludicrously expensive.

I look at home prices as a multiple of family income. That is the best long-term measure. The US used to be at 3 times and is now at 7 times. But Australia, Canada, England, France — these places are at 9-10 times. They are substantially worse.

In many parts of the world, real estate market has had a big run, and so this is a cause for vulnerability.

So where do you think US markets are headed in the long term?

I think this time it is more than just a stock market event. I think this is the end of an era. We have had a long Goldilocks era where everything worked for corporations and stocks to do well. Corporate profits were much higher than normal and PE ratios too were much higher than normal. Inflation and real interest rates were non-existent.

Nothing is certain in life, but probably we are going back to a more normal pre-2000 world. A scenario where inflation comes and goes and is always part of the conversation, interest rates ebb and flow and they don’t just go down. The PE ratios will tend to decline over the next 10 or 20 years. They may not go back to the average of the 20th century, but they will very likely decline in that direction.

The bubble breaking this time superficially is like 2000, but then may morph into the 1970s — inflation, higher rates, lower profits and shortages.

In addition to these we are experiencing certain secular changes — we are running out of labour in the West; population is slowing down, baby cohorts have dropped like a stone. And so for the next 20 years, it is guaranteed that we will have smaller cohorts of 20-year-olds coming to the workforce. So, we will be squeezed for labour. Climate change, and the fact that we are running out of cheap resources (metals and energy) are other factors to consider.

We may look back at this first 20 years of the 21 st century as the golden era.

How should one approach investing in this scenario?

You should do the best you can by trying to identify cheap stocks in attractive industries. That’s all you can do, and you shouldn’t expect to make the kind of money you made in the last 10 years.

Opportunities like what one got in Amazon or Google in the early years of this century are going to shrink. And I also think society is going to get more sensitive about the power that those kind of companies have. Now people in Europe and America are asking tougher questions on what is their role in society and what kind of monopolies they should have.

One way or the other I would expect them to have lower profit margins 10 years down the line than what they have today. But at the same time let me clarify, they are amazing companies.

You have great track record in identifying value in markets. You published your report ‘Re-investing when terrified’ right at the bottom of the bear market in March 2009, giving a strong case to go out and buy stocks. The returns from the date of that report have been massive. How did  you spot value in markets?

The point about a serious bear market like 2009, when everything starts to go wrong, is that investors do get to be a little catatonic. And it’s the very opposite, mirror image of a bubble. In that note I published, I noted the market was actually cheap for the first time in 20 years. Why would you miss that opportunity? And before that, in late 2008, I wrote the market could go down another 15 or 20 per cent (which it did), but from that level it might ‘double, triple or quadruple’ (which also it did).

I was optimistic because the prices were so much cheaper. So the skills of a value investor come to fore in a bear market.

How can investors identify value ?

To measure the markets and see if it is very expensive, you have to remember that it is not just about the PE ratio, but also the profit margins. Profit margins are mean reverting in the long run. They do tend to go to certain percentage of GDP. You have to work out what is normal PE times normal profit margin, which equals a fair price. Anything below that, you should be interested; anything above, you should be ready to get kicked.

What we have done recently is, we have been at the very peak of profit margins and we have multiplied that with the very peak of PE ratios. This is terrible double counting! What happens as a consequence of this is you might end up with what we encountered in 1974 — where the markets were trading at 7 times earnings on depressed profit margins. So double counting plays both ways, leading to overvaluation and undervaluation at different times.

So this metric can be used across geographies/any country, as a starting point for investing?

Yes. Just check out for yourself what is the normal earnings power of the system as a percentage of GDP or corporate GDP, and then what is the normal PE ratio over the long term. And you can work out what is the fair price. And maybe if you are plus or minus 20 per cent, that’s ok. Go as long back as you can go in terms of getting reliable data.

Published on May 28, 2022
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