This past weekend, Barron’s ran a must-read interview with Jeremy Grantham, one of my favorite financial market mavens.
Grantham, Co-Founder and Chief Investment Strategist of Grantham, Mayo, Van Otterloo & Co. (GMO), shared his view on the valuations of U.S. stocks…
“They’re 65% overpriced. If they go up another 30%, you would have a true bubble, at which point stocks would be close to twice their fair value,” says Grantham. “Similarly, in 2000, stocks were more than double their fair value.”
The market may be expensive… But 65% overvalued is hard to believe.
Where is Grantham getting this figure?
One valuation metric that he looks at is the market’s price-to-earnings (P/E) ratio. But the traditional P/E ratio can be misleading, so the Shiller P/E ratio, or CAPE (cyclically adjusted P/E), is often used for historical comparisons.
The CAPE uses a 10-year moving average of corporate earnings – adjusted for inflation – to smooth out the volatility in earnings. Sure enough, this metric shows that the market is pricey relative to its historical average:
Basically, the market is overvalued. Is it time to sell everything?
Actually, no, it’s not. Grantham sounds surprisingly bullish:
“My point is that with the professionals getting reinforced by the Fed going back to 1994, it will be very surprising if they don’t keep on playing this game until the market at least hits a classic bubble definition. Bubbles don’t usually stop until sensible investors, value investors, and prudent investors have been hung out to dry and kicked around the block. That hasn’t happened yet, so that tells you there is probably quite a bit left in this rally.”
It seems that Grantham is actually warning that valuations may once again reach stratospheric levels.
So, what’s an investor to do?
Keep Calm and Carry On
There’s always relative value somewhere in the market, and we should continue to seek it out.
After all, moving to cash means your dollars will suffer a loss of purchasing power due to inflation.
There was a time when savings would earn a rate of return higher than inflation, but those days are long gone thanks to the Federal Reserve’s zero-interest rate policy.
Grantham, whose criticism of the Fed is spot on, thinks foreign stocks offer some of the most compelling values. This is a view that I share, and I would add that dividend yields are higher abroad.
Here in the United States, there are also “high-quality” stocks that are cheaper than the market. GMO’s SEC filings reveal that the firm, which has $117-billion in assets under management, has a significant overweight in Oracle (ORCL), its third-largest equity holding. Perhaps they like fat profit margins and dividend growth.
GMO also initiated a position in Ensco (ESV) in 2013, and it’ll be interesting to see whether they build it up to a meaningful size. I certainly think they should increase their position in this high-yielding offshore driller.
Bottom line: The U.S. stock market may be overvalued as a whole. However, that doesn’t mean there aren’t attractive investments that can earn us a positive rate of return, regardless of whether a bubble develops.
Safe (and high-yield) investing,
Alan Gula, CFA