Jeremy Grantham, who is the co-founder and chief investment strategist of (GMO), a Boston-based asset management firm, released his quarterly letter. Jeremy built his reputation on predicting major market bubbles. He called the housing bubble and warned about technology valuations in 1999.
I thought this recent quarterly letter was well written. He uses historical facts to make a case that while markets are overvalued, they are not in a bubble. According to GMO, the average P/E ratio over the last 20 years is 23.36. Over a 20 year period prior to 1997, the P/E ratio averaged around 14. He provides a few very good explanations as to why markets are trading at such high valuations.
U.S. profits are much higher than they were 20 years ago. The average U.S. profit margin is now 7% and 20 years ago it was 5%. He presents four arguments why profit margins should remain elevated.
Globalization – “Increased globalization has no doubt increased the value of brands, and the U.S. has much more than its fair share of both the old established brands such as Coca-Cola and the J&J variety as well as the new ones like Apple, Amazon, and Facebook.”
Increasing corporate power – “Steadily increasing corporate power over the last 40 years has been, I think it’s fair to say, the defining feature of the US government and politics in general.”
Monopoly power – “The general pattern described so far is entirely compatible with increased monopoly power for US corporations. Put it this way, if they had materially more monopoly power, we would expect to see exactly what we do see: higher profit margins; increased reluctance to expand capacity; slight reductions in GDP growth and productivity; pressure on wages, unions, and labor negotiations.”
Low interest rates – “The single largest input to higher margins, though, is likely to be the existence of much lower real interest rates since 1997 combined with higher leverage. Pre-1997 real rates averaged 200 bps higher than now, and leverage was 25% lower.”
Going forward, he believes that the biggest risk to markets is rising interest rates. However, interest rates are unlikely to move that much higher given that much of the world is grounded below 0%.
This investment environment has resulted in many low risk investors buying more stocks. Back on August 5th, I wrote how the game rules were changing. The old rule of thumb of investing for retirement savers was to invest less in equities as they aged. This rule was very successful before we entered this period of globalization, increased corporate power, monopoly power, and low interest rates. As Jeremy wrote in his quarterly letter, “a regular bear market of 15% to 20% can always occur for any one of many reasons”, but this current trend could go on longer than people expect.
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