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Jeremy Grantham: The Fed blows a bubble

Investment guru Jeremy Grantham has warned that US stocks are almost in bubble territory.

Jeremy Grantham, co-founder of asset manager GMO, rightly dismissed the 2003-2007 stockmarket rally as "the greatest sucker rally in history" and timed his March 2009 bullish market call perfectly. Now he is warning that US stocks are almost in bubble territory.

A recurrent theme in Grantham's writing in recent years has been the structural slowdown in America's long-term growth prospects due to a faltering working-age population and higher energy prices over the past 30 years. The credit crisis and low recent capital investment haven't helped either. But don't expect the current market and economic cycle to end just yet, says Grantham.

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"In our strange, manipulated world, as long as the [US Federal Reserve] is on the side of a strong market there is considerable hope for the bulls." The key point is that the Fed has been on the side of a strong market since the late 1980s, when it appeared to become official policy to stoke confidence by blowing up asset prices. The "wealth effect" is supposed to stimulate the economy.

The Fed first blew a bubble in US stocks; when that burst, it inflated the housing bubble. These were "by far the biggest" stock and housing bubbles in American history. The central bank made no attempt to temper the markets' irrational exuberance.Note that the cyclically adjustedprice-earnings ratio has been 60% higher, on average, since the late1980s than in the previous century.

Fed chair Janet Yellen has made clear that she is also keen to engender a wealth effect. So "absent a major international economic accident, the current Fed is bound and determined to continue stimulating asset prices until we have a fully fledged bubble". Bubble territory is still 8% or so away on the S&P 500, says Grantham, while the cycle is also unlikely to end before mergers and acquisitions hit a record and growth strengthens further.

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