Follow the Money
Jeremy Grantham: All the World's a Bubble
By Brett Arends
Mutual Funds Columnist
4/27/2007 10:07 AM EDT
How high will the Dow go? 15,000? 20,000?
How about 36,000?
While euphoria sweeps stock markets here and worldwide, there are at least a few voices of dissent.
One, unsurprisingly, is legendary value investor Jeremy Grantham -- the man Dick Cheney, plus a lot of other rich people, trusts with his money. Grantham, chairman of Boston firm Grantham Mayo Van Otterloo, has been a voice of caution for years. But he has upped his concerns in his latest letter to shareholders. Grantham says we are now seeing the first worldwide bubble in history covering all asset classes.
Everything is in bubble territory, he says.
"From Indian antiquities to modern Chinese art," he wrote in a letter to clients this week following a six-week world tour, "from land in Panama to Mayfair; from forestry, infrastructure and the junkiest bonds to mundane blue chips; it's bubble time!"
"Everyone, everywhere is reinforcing one another," he wrote. "Wherever you travel you will hear it confirmed that 'they don't make any more land,' and that 'with these growth rates and low interest rates, equity markets must keep rising,' and 'private equity will continue to drive the markets.' "
As Grantham points out, a bubble needs two things: excellent fundamentals and easy money.
"The mechanism is surprisingly simple," he wrote. "Perfect conditions create very strong 'animal spirits,' reflected statistically in a low risk premium. Widely available cheap credit offers investors the opportunity to act on their optimism."
And it becomes self-sustaining. "The more leverage you take, the better you do; the better you do, the more leverage you take. A critical part of a bubble is the reinforcement you get for your very optimistic view from those around you."
It's something to think about the next time you hear someone tell you that the stock market will keep rising simply because the world economy is doing so well. That would make sense only if we were paying a constant price for each unit of world GDP, instead of higher and higher prices for one slice of that GDP -- equity.
Grantham concludes that every asset class is expensive today compared with historic averages and compared with the cost of replacing it. By his calculations, the only assets likely to beat inflation by any significant margin if you hold them for the next seven years are managed timber, "high-quality" U.S. stocks, and bonds.
As noted in this column several weeks ago, Grantham's U.S. "high-quality" stocks include Home Depot (HD) , Merck (MRK) , Wal-Mart (WMT) , AT&T (T) , Pfizer (PFE) , Johnson & Johnson (JNJ) , Exxon Mobil (XOM) , UnitedHealth (UNH) , Verizon (VZ) and Lowe's (LOW) .
"The bursting of [this] bubble will be across all countries and all assets, with the probable exception of high-grade bonds," Grantham warned. "Since no similar global event has occurred before, the stresses to the system are likely to be unexpected. All of this is likely to depress confidence and lower economic activity."
Grantham sees two big potential catalysts that might turn this bull market into a bear: a surge in inflation, leading to higher interest rates, and a squeeze on profit margins, which are currently running way above long-term averages.
As for timing, he concedes that's impossible to predict. But here's the kicker: Even Grantham thinks you probably need to be bullish right now. The reason? Most bubbles, he notes, go through a short but dramatic "exponential phase" just before they burst. Like Japan in 1989 or the Internet in early 2000.
"My colleagues," wrote Grantham, "suggest that this global bubble has not yet had this phase and perhaps they are right. ... In which case, pessimists or conservatives will take considerably more pain."