Jeremy Grantham of GMO on the Stock Market

This morning's Wall Street Journal carried a short article summarizing the most recent outlook letter from Jeremy Grantham. I have long been a fan of Mr. Grantham - his work is usually supported by fairly rigorous analysis of the data.

(By the way, as you can tell from my previous post today, I believe the term "bubble" has become one of the most overused terms in the markets. I would suggest that markets may be overpriced in the short run, but a market that is still 30% lower than it was in October 2007 is probably not in a "bubble")

A Bear Reawakens After a Bullish Run

GMO's Grantham Warns of a Stock Bubble

By JONATHAN BURTON

Jeremy Grantham, the investment guru who correctly predicted the 2009 market rally, now warns that a new bubble is forming.

Stocks are likely to move higher in coming months, but prices are expensive, and long-term investors should be mindful of a volatile mix that Federal Reserve policy and government actions are causing, according to Mr. Grantham, the frequently bearish chief investment strategist at Boston-based institutional money manager GMO.

Reuters

GMO's chief investment strategist, Jeremy Grantham, has returned to his bearish bent, saying easy money is inflating stocks.

"Once again, the Fed is playing with fire," Mr. Grantham wrote in his latest quarterly letter to institutional clients.

The Fed's policy of low interest rates and easy money has boosted the economy but has stimulated Wall Street and stocks even more, Mr. Grantham says.

That is why, much to his dismay, he sees another large speculative wave forming.

"I was counting on the Fed and the Administration to begin to get the point that low rates held too long promote asset bubbles, which are extremely dangerous to the economy and the financial system," he writes.

"Now, however, the penny is dropping," he says, "and I realize the Fed is unwittingly willing to risk a third speculative phase, which is supremely dangerous this time because its arsenal now is almost empty."

At the same time, Mr. Grantham says, higher prices suggest a stock market that is increasingly stable and confident, encouraging investors to buy first and ask questions later, if at all.

The upside, at least in the short term, is that speculation will drive the stock market for the next several months, he believes. Accordingly, he says GMO's strategy will be to "very slowly" trim equity positions and to "swallow our distaste for parking the rest in unattractive fixed-income."

This next leg up will be unlike 2009's rally, when low-quality and riskier stocks fared best, Mr. Grantham says.

He expects a broader advance, "in which high-quality stocks should hold their own or even outperform."

But it will be a false rally, he finds. The Standard & Poor's 500-stock index is worth "850 or so; thus any advance from here will make it once again seriously overpriced." The S&P 500 closed Tuesday at 1092.17.

Mr. Grantham is frequently bearish, so it was uncharacteristic in March 2009 when he urged investors to buy stocks. His timing, at the bottom of the market, was correct, just as it was in late 2007, when he warned that stocks were precariously perched.

Going forward, Mr. Grantham predicts a "multiyear headwind" on the markets, during which investors will see "below-average profit margins" and price/earnings ratios in a period more akin to the bumpy 1970s than the bumper 1990s.

Over what Mr. Grantham calls the next "seven lean years," GMO forecasts large-cap U.S. stocks to deliver a real return (after inflation) of 1.3% annualized, while small-caps provide a 0.5% return.

The outlook is better for high-quality U.S. stocks, which have an expected yearly return of 6.8%.

"For the longer term, the outperformance of high quality U.S. blue chips compared with the rest of U.S. stocks is … nearly certain," Mr. Grantham says.

International stocks also fare reasonably well in GMO's model, up about 4.7% annualized over the seven-year period, while emerging markets come in with a 3.9% annualized gain.

"Going into this next decade, we start with the U.S. overpriced," Mr. Grantham cautions, "so do not be conned into believing that every bad decade is followed by a good one."