Just a few months after he said that equities were undervalued for the first time in two decades, Jeremy Grantham now says the broader market is again overvalued — though he sees substantial opportunities in certain areas of the market.
In the GMO chief’s second-quarter letter, Grantham says that a year ago, stocks were overpriced, and a quarter ago, they were underpriced. “Now they have all — or almost all — converged for a few unusual moments at fair value,” he says. “A year ago, it was very easy to know what to be: a risk avoider. It was not so easy reinvesting when terrified, but most of us knew that we should have been doing more. But today? It’s difficult to be inspired at fair value.”
Grantham says there is still “presumably at least a decent shot (say, 50/50) at [the S&P 500] rising over 1000 in the next two to three quarters.” But, he adds, the recent rally has been driven by stimulus and speculation, with low-priced, volatile stocks leading the way, and GMO’s estimate of S&P fair value is now below 900. “Given our view that we are in for seven lean years in which the market will be looking for an excuse to be cheap, we recommend taking some risk units off the table, including becoming underweight in equities — between 1000 and 1100 on the S&P, if it gets there this year. Around 880 you should continue to move slowly to fair value, twiddle your thumbs, and wait to see what happens. Boring! Otherwise, it is time to focus on the lesser issues: which types of equities are cheaper or more expensive than the market.”
On the cheap side, Grantham remains high on U.S. high-quality blue chips. “They were really trashed on a relative basis by the second quarter rally in junk,” he says. “I understand a rally in junk after the record decline, but this was excessive and based apparently on unrealistic hopes for a strong, sustained economic recovery.” Grantham thinks a temporary, weaker recovery is more likely. “Our original estimate for the timing of some economic recovery to occur late this year or early next year still stands,” he says. “Without an unexpectedly strong improvement in the economy, it is hard to see high quality stocks losing much more ground, given their extreme value gap over junky stocks — more than an 11 percentage point spread per year on our seven-year forecast! If our numbers are correct, long quality (or long quality and short junk) is substantially the most outlying bet available today in all global equities.”
Grantham says he’s in the odd position of being wary of China but high on emerging markets, something he’s trying to reconcile. “We in asset allocation may, however, push our luck in emerging –- particularly ex-China emerging — using inertia to reduce our current modest overweight. If we do this, it will be out of respect for the high probability that emerging equities will sustain and increase their overpriced level relative to the rest of the world.”
But Grantham says that things are much harder for his firm now that prices are near fair value. Predicting movements away from rational prices in an irrational world should not be easy, and indeed it is not,” he says. “Only U.S. quality feels (and measures) to us like a real outlier. As for the rest, if you feel yourself becoming overconfident about anything, take a cold shower and start again. Just be patient. In our strange markets, you usually don’t have to wait too long for something really bizarre to show up.”
Grantham also has a lot to say about natural resources, and the problem their dwindling amounts may cause. “We must prepare ourselves for waves of higher resource prices and periods of shortages unlike anything we have faced outside of wartime conditions,” he warns. “In fact, I believe we are already several years into this painful transition but are still mostly invested in denying it. Everything within the investment business will be affected as well as everything outside of the business.”
