Jeremy Grantham’s GMO called the dot-com bubble. His firm now sees ‘very odd and speculative things’ going on again — and warns large US stocks could see negative returns over the next 7 years.

  • Growth stocks are in a bubble that is due to burst, GMO's Ben Inker and John Pease said in their Q3 letter.
  • They laid out how investors can position their portfolios to profit from the downfall — and said US stocks are due for negative inflation-adjusted returns over the next seven year period.
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Ben Inker and John Pease have seen enough.

Growth stocks are in a bubble that is due to burst, say the two asset allocators at GMO, the investment firm founded by markets veteran Jeremy Grantham.

"On a price/sales basis, growth stocks are even more expensive than they were in 2000, and while they are not quite as extreme on a P/E basis, they are certainly far more expensive than any time before or since," Inker and Pease said in their Q3 letter. "At what point do you call that a bubble?"

The two charts show the metrics they reference above:

While the numbers are there to back up their assertion, they say that investor behavior this year was the factor that ultimately led them to their conclusion.

Compared to the last decade, which was a "boring" bull market, 2020's stock market recovery since the March bottom has brought out the type of "manic" behavior that leads to bubbles.

"Whether it was Hertz stock rising 10-fold in the spring as a high beta recovery play despite the fact that the company was bankrupt and shareholders wouldn't have benefitted from a recovery even if it happened, or Kodak stock rising 30-fold after announcing it was going to start making chemicals to enable the production of Covid-19 treatments, very odd and speculative things have been going on," they wrote.

Inker and Pease also lambasted Tesla's meteoric rise in 2020. 

"As a more traditionally Growth-y example, Tesla has risen some 800% since the fall of 2019 on the back of 17% growth in vehicles sold," they wrote. 

"It now has a greater market cap than the sum of all the other U.S. automakers, all the European automakers, and all the Korean automakers, with Honda, Mazda, and Nissan thrown in for good measure," they continued. "That collection of companies sold approximately 100 times as many cars as Tesla did in 2019."

But a bubble needs a catalyst to burst it. Inker and Pease say the most likely candidates to end the growth bubble are "a return to more normal economic times" if vaccine distribution goes smoothly, and an upward move in interest rates from a potential spike in inflation. 

However, they added that the catalyst could also very well be something no one in the market no one sees coming.

How to trade the growth bubble

To prepare their portfolios for an impending crash in growth stocks, Inker said GMO will be shorting the cohort while positioning themselves long in cheaper value stocks, most of all financials. 

He estimated this strategy will generate roughly 80% returns like it did when it was used as the dot-com bubble burst. 

Inker pointed to history as a guide for how value stocks will perform in coming years.

"Low relative valuations for cheap stocks have generally begotten higher relative valuations in the future," he said. 

He continued: "Though this is congruent with investors demanding a premium for holding stocks perceived to be risky, it is also the kind of phenomena we have come to expect from watching the cycle of a style performing poorly, becoming unloved, and then suddenly surprising on the upside as investors discover that their expectations, for one reason or another, were a little (or a lot) too low."

But while he likes value stocks around the world at the moment, Inker said that the best opportunities lie in emerging-market value.

"Though our emphasis up to now has been on value within the U.S., it is important to note that internationally – both in developed and emerging markets – value also looks like a remarkable bargain," Inker wrote.  

"In many cases, in fact, we have never seen cheap stocks looking cheaper than they do today," he added. "So, if the undergrowth of US value worries you too much, or if the quality of European value is not to your liking, or if you deem real rates in the developed world to be too low for value to win, we believe opportunities still abound to allocate to cheap companies at remarkably cheap levels elsewhere."

This estimation was reflected in GMO's most recent seven-year market outlook update. 

From now through 2027, the firm only sees positive returns from emerging-market value stocks, displayed in the chart below. 

"At today's valuations, we forecast that value-oriented equity portfolios will make good money over the next seven years, particularly strategies that avoid the egregiously expensive U.S. stock market," Inker said. 

He added: "But whether they make much money in absolute terms in the next two to four years really depends on whether the generally high valuations across the world prove sustainable, and we are far from certain that they will be."

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