Market near bubble becareful says Jeremy Grantham

The market is creeping toward bubble-land but isn't there quite yet, said GMO chief investment strategist Jeremy Grantham during his keynote at the 2015 Morningstar Investment Conference. 

He warned investors to pay careful attention as valuation metrics begin to approach a "2 sigma event," or 2 standard deviations away from the norm. 

"Every 2-sigma event is followed by an equal and offsetting 2-sigma reversion," he said, adding that the pattern occurred in 28 out of 28 of the major bubbles GMO has studied throughout history. "And they all went back half a year quicker than they went up," he added.

So, where's the mean and where are we today? Grantham cited a 21.1 price-to-earnings multiple on the S&P today versus a normal P/E of 16.0, while corporate profit margins are currently at 7.3% versus a norm of 5.7%. In a recent commentary, he further noted that the "Shiller P/E and Tobin's Q have moved up over the last six months to 1.5 and 1.8 standard deviations (sigma), respectively." (Tobin's Q is a ratio comparing the market value of a company to the replacement value of that company's assets). Reversion to the mean on those two scores implies a more 50% decline in the market from current levels, he said.

But although profit margins have been abnormally high, they have been curiously slow to revert to historical norms, Grantham noted. "My belief is that it has a lot to do with a regime shift to the Greenspan era and his acolytes," he said. "The [market] P/E in the new regime has been 60% higher than it was for 100 years before."

In addition, he argued that the rise of stock options in executive compensation has played a role in making profit margins stickier--but not without a cost.

"We've entered a world where 80% of remuneration comes from stock options combined with ... a fixation on short-term profit maximization," which encourages CEOs to undertake stock buybacks versus capital expenditures. A buyback is "much less dangerous than buying a new plant," Grantham said, and also happens to increase the value of those stock options by directly boosting the stock price.

For its part, the current Fed regime's low-rate policies have "made it desperately appealing to borrow cheap debt to buy your own stock back." The result has been dismal corporate capital expenditures, which in turn depresses wage creation and does little to stimulate the economy.

"You get mean reversion if capitalism is allowed to work in the normal way," Grantham said. "What's happening in the stock market now amounts to interference with the normal process. We're not allowing profit margins to mean revert. We're not expanding our economy. We're running away from it and protecting our stock options. There is no arbitrage mechanism, and unless we break it, it will be an increasing drag on our economy."

What Will Finally Pop the Coming Bubble?
"You need a trigger to break it," Grantham said. "Broad overvaluation [alone] has never done it."

Instead, he argued, "The market will follow the line of least resistance from the Fed, plodding slowly and steadily higher, waiting for speculation from individuals and deals."

Neither is the dreaded impending Fed rate hike likely to cause the pop. "From 2004 to 2006, the Fed raised rates [multiple] times. Markets went up without missing a beat," he said. "Why would a single rate hike have everyone in a fit?"

In the meantime, Grantham characterized investing in the market as "a wonderfully tricky game."

"Be prudent, of course. Be very prudent ... but not yet," he said. "I'm waiting to be very, very prudent. I'm going to be incredibly prudent starting closer to the election. I recommend the same to you."

From MorningStar

Energy Revolution is coming with new forms of energy

I have become increasingly impressed with the potential for a revolution in energy, which will make it extremely unlikely that a lack of energy will be the issue that brings us to our knees. Even in the expected event that there are no important breakthroughs in the cost of nuclear power, the potential for alternative energy sources, mainly solar and wind power, to completely replace coal and gas for utility generation globally is, I think, certain.

The question is only whether it takes 30 years or 70 years. That we will replace oil for land transportation with electricity or fuel cells derived indirectly from electricity is also certain, and there, perhaps, the timing question is whether this will take 20 or 40 years.

I have felt for some time that new investments today in coal and tar sands are highly likely to become stranded assets, and everything I have seen, in the last year particularly, increases my confidence.

China especially is escalating rapidly in its drive to limit future pollution from coal and gasoline and diesel powered vehicles. Increased smog last year in major cities led to an unprecedented level of general complaint.

China simply can’t afford to have Chinese and foreign business leaders leaving important industrial areas in order to protect the health of themselves and their families. Nor are they likely to be comfortable with a high level of sustained complaint from the general public. They have responded in what I consider to be Chinese style, with a growing list of new targets for reducing pollution. A typical example recently was an increase of 60% in their target for total installed solar by the end of 2015! Hardly a month goes by without a new step being announced.


One can easily see that in 10 years there could be a new world order in cars. Some emerging countries, notably China, are likely to take more dramatic and faster steps to reduce demand than we have ever thought about. Already they have 200 million electric vehicles – mostly motorbikes – almost as many as the rest of the world squared.

In short, with slower global economic growth, more fuel-efficient gasoline and diesel vehicles, more hybrids, cheaper electric cars, more natural gas vehicles, and possibly new technologies using fuel cells and, conceivably, methanol, it is certain that oil demand from developed countries will decline, probably faster than expected.

Total global oil demand at current prices or higher is likely to peak in 10 years or so. At much lower prices we would fairly quickly lose most of our high-cost production: deep offshore, fracking, and tar sands.

Times may be changing faster than we think. My guess is that oil prices will be higher than now in 10 years, but after that, who knows?

The idea of “peak oil demand” as opposed to peak oil supply has gone, in my opinion, from being a joke to an idea worth beginning to think about in a single year. Some changes seem to be always around the corner and then at long last they move faster than you expected and you are caught flat-footed.

Jeremy Grantham on profit margins reverting to mean

Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.

Markets will soar higher to bubble territory

Jeremy Grantham, founder of GMO, the asset manager in Boston, has predicted that rising dealmaking would “push the market up to true bubble levels, where it will once again become very dangerous indeed”.

Capitalism cannot solve every problem

People simply do not get the point that you can’t have sustainable growth forever. You can have sustainability forever, or growth for a few years. Capitalism does millions of things better than the alternatives. However, it is totally ill-equipped to deal with a small handful of issues. Unfortunately, they are the issues that are absolutely central to our long-term well-being and even survival.