GMO's Jeremy Grantham Remains Bullish on Stocks

From Barron's Wall Street's Best Minds column:

The famed investor says the S&P 500 can gain another 20% in coming years despite stretched valuations.

By

Jeremy Grantham

May 1, 2014

Editor's Note: Grantham is founder of GMO, a Boston-based money manager. This is a lengthy excerpt of his latest quarterly market commentary. A full version of this piece, with charts, is available on the GMO Website. 

 

It is a sensible expectation that reasonable long-term value investors will endure pain in a bubble. It is almost a rule.

The pain will be psychological and will come from looking like an old fuddy-duddy…looking as if you have lost your way in the new golden era where some important things, which you have obviously missed, are different this time. 

For professionals this psychological pain will also come from loss of client respect, which always hurts, and loss of peer group respect, which can be irritating. 

In truth there is nothing much that we can do about this problem. Value investors must, as always, invest exclusively on long-term values and long-term risks. We must always build our portfolios from the best mix of these two characteristics. Therefore there is simply no alternative to standing our ground and taking it on the chin when crazy markets get even crazier. Our consolation will be in knowing that we will win in the end whereas if we start jumping around on other non-value considerations, who knows what might happen?

On the other hand, it is perhaps useful to be familiar with the various aspects of bubbles that may arrive to trouble us. It is in this spirit that this quarterly letter is written: to better prepare prudent investors for the probable future pain so that they can more easily process it and be less likely to do something foolish. 

What is a bubble? Seventeen years ago in 1997, when GMO was already fighting what was to become the biggest equity bubble in U.S. history, we realized that we needed to define bubbles. By mid-1997 the price earnings ratio on the S&P 500 was drawing level to the peaks of 1929 and 1965 – around 21 times earnings – and we had the difficult task of trying to persuade institutional investors that times were pretty dangerous. We wanted to prove that most bubbles had ended badly. In 1997, the data we had seemed to show that all bubbles, major bubbles anyway, had ended very badly: all 28 major bubbles we identified had eventually retreated all the way back to the original trend that had existed prior to each bubble, a very tough standard indeed. 

Having plenty of trained quants back then, it was no time before it was suggested that a two-standard-deviation (or 2-sigma) event might be a useful boundary definition for a bubble. In a normally distributed world, a 2-sigma event would occur every 44 years. 

GMO has spent a lot of time during the last 17 years making a considerable review of minor bubbles as well as the 28 major ones that we covered originally in 1997. One thing was clear from the 330 examples we had studied: 2-sigma events in our real world have tended to occur not every 44 years, but about every 31 years. This was quite a bit closer to the 44 years of a random world than we originally would have guessed given that the world is fat-tailed but, frankly, it is convenient: once every 31 years, which would be a longish career in investing, feels like it perfectly fits the title of "bubble." 

In my opinion, time has been kind to this definition in the intervening 17 years. A 2-sigma event now seems to me to be perfectly reasonable even if I have to admit it is completely arbitrary. Having a useful and practical definition of a bubble is important for I have come to believe that the forming and bursting of the great investment bubbles are by far the most important things that happen in investing. So, how do the great events of the past score on this 2-sigma definition? The six most important asset bubbles in modern times qualifies on the 2-sigma definition, although the 1965-72 peak, known in the trade then as the "Nifty-Fifty" event, did so by a modest margin....MUCH MORE

See also:
Barron's Interview: "Jeremy Grantham: Learning to Live With a Stock Bubble " (Quick, Hire a Kid!)
How Good Is Jeremy Grantham's Forecasting Record?
and many, many more (use the search blog box if interested)