Jeremy Grantham of GMO has made some interesting comments recently on bubbles. In this FTfm interview, Grantham argues there is nothing more damaging to an economy than a breaking asset bubble. In his Q1 2010 quarterly letter, Grantham identifies bubbles in US equities, emerging nation equities, and commodities. Grantham also recommends continued allocation to these assets, a strange recommendation considering Grantham is a value investor, who traditionally shy away from overpriced assets.
Grantham believes them the US economy will follow the path depicted below. This tree gives equities a 79% chance of going higher and assumes equities will continue to increase if rates stay low.
Grantham's views on emerging economy equities are the same as the US--overpriced but going higher (unlike his colleague Edward Chancellor, see this white paper on China).
Grantham recognizes these bubbles must go down. GMO conducted a study of asset returns over the last 100 years and found 34 bubbles, almost all of which returned to their pre-bubble trends (the only bubbles that did not return are the UK and Australian housing bubbles, which he argues have not returned to their true prices because the use of variable mortgages has supported prices. He predicts prices to return to normal when interest rates rise.)
Considering that Grantham identifies these bubbles and clearly believes they are not sustainable, why is he suggesting putting capital in these markets?
Value investing should not require investors to automatically steer away from assets they perceive to be overvalued. The idea that value investing precludes participating in bubbles is not reflected in the original writings of Graham and Dodd. Graham and Dodd write in Security Analysis: "Undervaluations caused by neglect or prejudice may persist for an inconveniently long time ... and the same applies to inflated prices caused by over enthusiasm or artificial stimulus ... The market is not a weighing machine ... Rather we say that the market is a voting machine." Value investors often argue that in the long-run, the market is a weighing machine. While that is undoubtedly true, I fear that Grantham is right and "the long-run" it takes for the market to become a weighing machine again might exceed a typical investment horizon. This might be a case where in "the long-run", we're all dead.
