Grantham, who is co-founder and chief investment strategist at GMO, the Boston-based asset management firm which runs more than £100bn, is well-known for successfully predicting previous asset bubbles such as the dot-com bubble of the late-1990s and the 2008 global financial crisis.
Though global equities have been through a weaker period over recent months, he says the current market is heading in the same direction as previous speculative bubbles.
Performance of indices over three months
Source: FE Analytics
On a number of occasions, he has voiced concerns about the huge amount of central bank intervention since the previous crash and while he thinks the US Federal Reserves’ quantitative easing programme and desire to keep interest rates at ultra-low levels has hugely benefitted equity investors, he warns they have been set up for a significant fall.
As a result, he says the S&P 500 – which he believes is the bellwether of global equity markets – can make further gains from its current 2,051 but adds that investors should remain very aware of the risks that lie ahead.
“My personal fond hope and expectation is still for a market that runs deep into bubble territory – which starts at 2,250 on the S&P 500 on our data – before crashing as it always does,” Grantham said.
Grantham isn’t alone in his concerns about the state of the market, with many leading industry experts expressing anxiety over the huge gains from risk asserts since the market bottomed after the Lehman Brothers-induced crash.
Performance of indices since March 2009
Source: FE Analytics
The likes of FE Alpha Manager Iain Stewart, who heads of the £9bn Newton Real Return fund, has warned FE Trustnet in the past that the Fed and the Bank of England’s unconventional monetary policy has created some of the biggest bubbles of all time.
“Basically, they are tackling huge amounts of debt with more money. This will inevitably create a bubble,” Stewart (pictured) told FE Trustnet last year.
“The problem is there isn’t a ‘plan B’. If all this QE doesn’t work, they will just have another bout of it. These guys actually believe that these policies can work and unless they junk these, basically, religious beliefs about QE, it is going to continue.” Grantham says there are a number of obvious headwinds on the horizon.
“The negatives this time include the ending of the Fed’s bond purchase programme,” he said.
“There is also talk of a rate increase early next year, given the recent recovery of the US economy reflected in the improved employment report of early October and positive adjustments to the previous month’s employment numbers. Other negatives include the potential for escalation of several minor but intractable wars and the recent Ebola outbreak.”
He also says that the US equity market being substantially overvalued creates issues for investors. Stewart agrees with this view who told FE Trustnet that “the key to return is the price you pay and, however you cut it”.
Given his bearish outlook, it is unsurprising that Grantham urges investors to think very carefully about how they build their portfolios in the current environment.
“As always, the prudent investor should definitely recognise overvaluation, factor in regression to the mean and calculate the longer-term returns that result from this process,” he explained.
“The other necessary ingredients to the investment mix are suitable measures of risk and when these are added to estimated returns we believe efficient portfolios can be produced.”
However, he admits it is very hard to create “efficient portfolios” at the moment as no areas of the market have been left undistorted from the Fed’s added liquidity – plus he warns that asset classes have become more correlated as a result.
“On our data, with US large cap equities offering negative returns except for high quality stocks with foreign developed and emerging equities overpriced, and with bonds and cash also very unattractive, investors have to twist and turn to find even a semi-respectable portfolio,” Grantham said.
He added: “It is a particularly tough process today with nowhere to hide and no very good investments compared to, say, the time around the 2000 bubble when there were several.”
The strategist says there are no guarantees of success but he and his team recommend a model portfolio for investors “who can do without a benchmark and can settle for owning a sensible long-term efficient portfolio” – which is highlighted below.
He doesn’t think investors can afford to rely too heavily on that model, however, and says they must constantly review their holdings over the coming year or so.
Grantham expects the market to continue to run ahead over this period but stands by the view it will eventually crash “as it always does”.
“Hopefully by then, but depending on what the rest of the world’s equities do, our holdings of global equities will be down to 20 per cent or less,” he said.
“Usually the bubble excitement – which seems inevitably to be led by US markets – starts about now, entering the sweet spot of the presidential cycle’s year three, but occasionally, as you have probably discovered the hard way already, history can be a snare and not a help,” he added.
