In late 2017, the investing legend Jeremy Grantham was officially on bubble watch.
He said as much in a quarterly letter he coauthored for his firm, Grantham, Mayo, & van Otterloo (GMO), back in December. It wasn’t an extremely pressing concern quite yet but something in the back of his mind.
That all changed in January when, as he describes it, stories of investor overconfidence became too numerous to ignore.
Grantham’s favorite anecdote came courtesy of the bus one of his Boston-based colleagues would take to work from New Hampshire. Every morning, an elderly woman would see the GMO employee reading financial literature and ask questions.
One inquiry in particular stuck out to him: Should she sell her house worth about $300,000 and put it in the stock market?
“What do you expect to get?” the GMO employee recalled asking.
Her response stunned him. And when he relayed it to Grantham, the market guru was sure an unsustainable situation was afoot.
“Well, the market has been rising at 17% per year,” she’d replied. “And I’d be hoping for 20%.”
That, to Grantham, was stock market overexuberance personified – and a glaring warning sign of an impending financial bubble. He began to brace in earnest for an imminent bust.
This was significant, since predicting major asset bubbles is what has made Grantham such a world-renowned investor. His track record speaks for itself. He predicted the dot-com and housing bubbles that wound up crushing markets. In fact, his otherworldly prescience actually extends back to the late 1980s, when he called a bubble in Japanese equities and real estate.
But mere months after his January revelation, something happened that made him reconsider once again. And President Donald Trump was at the center of it.
“We were only a few months from being in ecstasy land,” Grantham, the cofounder and chief investment strategist at GMO, which oversees $71 billion, told Business Insider by phone. “Then the trouble with trade, and the US proposals for tariffs that have now become more than proposals, came into play.”
An outlook derailed by Trump’s trade war
Grantham estimates that if the trade sanctions and tariffs announced and gradually implemented by Trump hadn’t materialized, the market could be 10% higher than it is today.
Such a continuation of overstretched valuations would’ve perfectly met his definition of a “melt-up” in stocks – otherwise known as the period of steep increases that normally occurs at the end of a market cycle, before the bubble bursts.
“The effect on currencies and emerging markets has really made it difficult to maintain a super-high level of euphoria,” Grantham said. “I consider this a melt-up nipped in the bud by you-know-who.”
While many pundits have decried Trump’s trade escalation as heavy-handed and potentially damaging to the global economy, in an ironic twist of fate it may have saved the US market from a painful explosion.
But to hear Grantham tell it, that may not have been such a good thing.
“It’s a pity, because we know how great bull markets and great economies end,” he said. “They traditionally end with a melt-up and a blowup. What about when that doesn’t happen? Who knows? We have no experience of a decadelong bull market fizzling out. Here we are, in no-man’s land.”
That’s not to say the market landscape is devoid of bubble-like behavior. A few years ago, Grantham said the latest cycle wouldn’t reach peak bubble conditions until at least one of two things happened: a new high in deals or a new high in initial public offerings.
Well, as it now stands, merger-and-acquisition activity is, in fact, occurring at a record pace. And if you consider IPO equivalents – such as when a private company is acquired by what Grantham calls “the Googles of the world” – another record situation may be forming.
Grantham sees this, but he can’t fully talk himself into a dangerous bubble – not since Trump’s trade tensions injected a big dose of skepticism into the market. That’s a far cry from his dot-com and housing bubble calls, in which his level of conviction was through the roof.
“There are decent indicators of the market being in a late stage,” Grantham said. “But that still doesn’t free us from the conundrum of – how can we end if we don’t get a spectacular blowup and a collapse? Collapses in the past have needed that last adrenaline shock – that last 30% or so of complete speculation.”
Grantham’s new bull-market endgame
Just because Grantham’s expectation for a sudden market crash has been muted doesn’t mean stocks will continue climbing indefinitely. He says it simply means the inevitable downturn will be a protracted version of prior meltdowns.
The problem is, there’s no real precedent for a bull market ending in such fashion. But Grantham still ventures to offer a grand prediction – one characterized by regular bouts of moderate turbulence that he says will wear on the psyches of investors.
“My guess is – you have an extended, very psychologically painful, long, drawn-out series of stumbles and starts, where you go up 10% and down 15%, up 12% and down 14%,” he said.
“You have this series of nonspectacular, ordinary mini-bear markets that wear away at the P/E, and eventually the economy weakens, and eventually the profit margins go down,” Grantham continued. “It helps drip, drip, drip the market back down. Not with a bang – more with a whimper.”
Grantham does note that blockbuster earnings growth has already eroded traditional measures of P/E in recent quarters, as profits have outpaced share gains; however, that would be more encouraging if US profit margins weren’t already at an all-time peak and thereby primed to drop.
Ultimately, when it comes to Grantham’s forecast “drip” down in stocks, Trump’s trade war still takes center stage. He says now that the market was deprived of one last bout of speculative fervor, the eventual market meltdown will be less immediately severe. Rather than being spring-loaded to quickly drop, say, 50%, he says it will instead fall 20% to 25% over multiple years.
Still, Grantham isn’t ruling out a continuation of January’s dangerous “melt-up.” He says that if the trade war gets resolved or turns out to be less punishing for investors than initially advertised, speculative behavior could come roaring back.
But judging by how things have gone in recent months, that seems like a stretch.
“Back last December, I said there was a 50% chance that we’d have a traditional melt-up and blowup,” Grantham said. “That’s gradually come down every week these trade and currency war things go on, and as we come closer to the end of this economic cycle.”