Grantham: Stocks Overpriced, but (Unfortunately) Likely to Rise

In his latest quarterly letter, GMO’s Jeremy Grantham says stocks are overvalued, but likely to continue rising — and rising to dangerous “bubble” levels if the economic recovery is a slow one.

“Even though I guessed last April that we would have a quick rally to 1100, this looks quite likely to be far more,” Grantham writes, saying that the government’s bailouts of failing firms, huge deficit-spending, and low interest rate policy have encouraged large amounts of speculation and risk-taking that has driven stock prices higher. “If the economic recovery is slow and if unemployment drops slowly, then Bernanke will certainly keep rates very low, as he has promised in as clear a way as language permits,” Grantham predicts. “In that case, stocks and general speculation will very probably rise from levels that are already overpriced.”

A stronger recovery would mean rates would rise more quickly, causing some short-term hits to the markets, but “probably exercis[ing] no really damaging effect on the economy”, Grantham says.

He’s actually hoping that one of a myriad of dangers will flare up and put the clamps on speculation, even if it means short-term market hits. If that doesn’t happen, stocks could head into bubble territory, and the third bubble bursting since 2000 could cause major problems, he says. “The developed world’s financial and economic structure, already none too impressive, would simply buckle at the knees,” he says (his emphasis).

Grantham says it’s extremely hard to predict what will happen. But he offers his best guess, and says that his general conclusion “is that the line of least resistance is a market move in the next 18 months or so back to the old highs, say, 1500 to 1600 on the S&P, accompanied by an equivalent gain in most risk measures, followed once again by a very dangerous break. If that happens, rates will still be low and thus difficult to use as a jump starter, the financial system will still be fragile, and the piggybank will be more or less empty.” Grantham says it is “silly” for the Fed to allow or encourage such a scenario, and for investors to now be acting “so carefree”. He hopes other outcomes are collectively as likely to occur, but adds that “we are definitely playing with fire and need some luck.”

Grantham says global equity markets are moderately overpriced, and the U.S. is now “very overpriced but not nearly so bad as it could be”. But he says U.S. large high quality companies are still “a little cheap”. He expects a portfolio of “global stocks, tilted to U.S. high quality” to return about 5% per year, before inflation, over the next seven years, slightly below the 6% long-term average. His firm is thus slightly underweight equities, he says. He adds that in his personal portfolio, he’s more keen on emerging market stocks. While already overpriced, he says he expects them to run much higher as a bubble forms among them.

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