Beware a Bernanke-Fueled Market Bubble
The only things that really matter in investing are the bubbles and the busts. Bubbles are obedient in one sense—they break. It's like throwing feathers into a hurricane: Some feathers will stay up for two weeks and some for two months, but we know with certainty they will all eventually hit the ground. And the feathers have been flying recently.
Ben Bernanke is a true academic. He doesn't believe in bubbles, and so he can't see them. He will be perfectly relaxed as he approaches the next cliff, which will be a broad-based speculative bubble created by the same forces that brought us the last two: Artificially low interest rates. The stock market is up 80 percent and speculative stocks are up 140 percent. I estimate there is a 75 percent chance we will see a bubble and bust for the third time since 2000. It's a hell of a way to run a ship.
There is a 25 percent chance that the economic recovery in the U.S. could be strong, broad, and sustained, which would surprise 90 percent of investors. No one can stop interest rates from rising in that kind of a recovery. We could get lucky and have some air let out of the market in the six months before October, which is just more than two years before the next election. Presidents often push the tough measures in the first two years, then look ahead to reelection and manage the economy more with an eye to keeping unemployment low and paychecks fatter.
Plenty could go wrong, and market psychology is quite fragile. That said, there has not been a serious decline in year three of a Presidential cycle since 1932. So I say to value-oriented money managers: Do not expect the market to come down just because it is overpriced going into year three of a Presidency.
While the U.S. market is very overpriced, large high-quality companies are still a little cheap. The market would be at fair value with a price-earnings multiple of 16, so the p-e of high-quality franchise stocks should be higher, say, 17. High-quality stocks are those of companies with high and stable profit margins. If margins are high enough, increased competition usually brings them down. But if margins stay high and stable, then they have what Warren Buffett calls a moat—a protected franchise. These companies are price-setters: Coca-Cola (KO), Johnson & Johnson (JNJ), Microsoft (MSFT). J&J has a p-e of 13. Even though quality stocks are cheap, they've still outperformed the overall market by 40 percent over almost 50 years.
Global equity markets, taken together, are moderately overpriced. And emerging markets don't have a huge percentage of high-quality franchise companies. Nor do other developed nations. It's mainly an American factor. We have close to 80 percent of the world's franchise companies. It's another way of saying that Coca-Cola and J&J don't grow on trees. Nevertheless, emerging markets are a reasonable value for long-term investors. They have growth. We don't.
The Stats: Jeremy Grantham, 71, is chief investment strategist at GMO, which manages $107 billion in assets for institutional and high-net- worth investors. A mutual fund that approximates GMO's asset allocation strategy is the Evergreen Asset Allocation Fund (EACFX).