In his third-quarter letter to clients, GMO’s Jeremy Grantham offers a scathing critique of a myriad of groups whose actions (or inactions) led to the current economic climate — from regulators to homebuilders to CEOs to politicans — and says the stock market is now 25% overvalued and due for a tumble. He also reiterates his belief that U.S. “quality” stocks are the place to be, and that an emerging market bubble is looming.
“Fair value on the S&P  is now about 860 (fair value has declined steadily as the accounting smoke clears from the wreckage and there are still, perhaps, some smoldering embers),” Grantham writes. “This places today’s market (October 19) at almost 25% overpriced, and on a seven-year horizon would move our normal forecast of 5.7% real [annual gains] down by more than 3% a year.” Corporate profit margins and price/earnings ratios have also risen significantly above fair value, he adds.
Grantham sees a pullback in late 2009 as unlikely, with low interest rates, lots of money being pumped into the economy, the promise from the Federal Reserve of further help in case of future problems, momentum, and the herd mentality driving stocks higher. “Price, however, does matter eventually, and what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors.
“First,” he says, “the disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems, particularly pressure on profit margins as the quick fix of short-term labor cuts fades away. Second, the slow gravitational pull of value as U.S. stocks reach +30-35% overpricing in the face of an extended difficult environment.”
While he thinks the market will continue to hum along in the very short term, he says he “would still guess (a well informed guess, I hope) that before next year is out, the market will drop painfully from current levels. ‘Painfully’ is arbitrarily deemed by me to start at -15%. My guess, though, is that the U.S. market will drop below fair value, which is a 22% decline (from the S&P 500 level of 1098 on October 19).”
The good news, Grantham says, is that we haven’t fallen into a depression. He thinks industrial operating figures and inventories should recover, and he reiterates past statements that we’ll see a global recovery late this year or early next year. “But,” he says, “this does not mean that everything is fine longer term. It still seems a safe bet that seven lean years await us.”
Where, then, to invest? Grantham says he remains high on U.S. “quality stocks (high, stable return and low debt)”, which are particularly cheap after the recent junk rally. “In our seven-year forecast the quality segment has a full seven-percentage-point lead over the whole S&P 500, or 9% over the balance ex-quality,” he says. “This is now at genuine outlier levels.”