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.
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)
