GMO’s Jeremy Grantham is a legend in the investing world thanks to his extensive work on bubbles and his ability to see financial crises.
More recently, however, his bearish slant has made him the target of criticism as the stock market has surged to record highs.
But don’t expect Grantham to budge just yet. He’s a long-term thinker who’s undeterred by the short-term whims of the markets.
When he was asked what people would learn from the whole financial crisis, Jeremy [Grantham] said, “In the short term a lot, in the medium term a little, in the long term, nothing at all. That would be historical precedent.”
There are actually two ways to interpret this. First, people have short-term memories. They forget all of the important things they learn in the midst of crises.
A second way of interpreting the quote has to do with long-term trends. In the short-term, it may appear that the rules and trends (of the stock market for example) have changed. But in the long-term, we’ll eventually see things revert to the mean like they always do.
One of GMO’s big market calls is that we’ll see next to no returns in the stock market over the next seven years. This is based on the idea that long-term stock market valuations tend to revert to the mean. And currently, valuations are well above the mean.
So, if we do see the markets tumble and end up returning little or nothing, then we really will have effectively learned nothing.
Below is a chart from Montier. It’s of the cyclically-adjusted price-earnings (CAPE) ratio, which was popularised by Nobel Prize-winning economist Robert Shiller. CAPE is calculated by taking the S&P 500 and dividing it by the average of 10 years worth of earnings. If the ratio is above the long-term average of around 16x, the stock market is considered expensive. Currently CAPE is at around 24.
Riddled with annotations, Montier’s chart basically argues that no matter what upside and downside surprises we get in the world, market valuations always seem to revert to their long-term means.
This might mean earnings climb. But it also might mean we see a big sell-off in stocks. The latter is what happened when the dotcom bubble and then credit/housing bubble burst.