Jeremy Grantham: it might be different this time
“It can be very dangerous to assume that things are never different”, warns Jeremy Grantham of GMO.
Mean reversion the idea that things are generally cyclical and will tend to return to their long-run average over time is a key belief in value investing. However, "it can be very dangerous to assume that things are never different", warns Jeremy Grantham of US wealth manager GMO. Since 1996, the average price/earnings (p/e) ratio of the US stockmarket has been 23.36, compared with 13.95 for the period from 1930 to 1995. The Shiller p/e, which averages earnings out over ten years, rather than taking just one year, tells a similar story: in the last 25 years, the market has spent only six months below its long-term trend.
So what's changed? Corporate profit margins are higher, which could justify higher valuations. This is partly due to the Federal Reserve keeping interest rates ultra low (and borrowing cheap) since 1997. Yet it's not all down to low rates, says Grantham. Corporate profits typically mean revert too so in a reasonably competitive world, "higher margins from long-term lower rates should have been competed away". Why haven't they? Because corporations have more power than they did. That's due to globalisation (which has increased the pool of available labour, and boosted the power of global brands), and increased regulation (which make it harder for competitors to muscle in on a market).
Grantham expects corporate margins to expand further this year, assuming a "moderate" cut in US corporate tax rates. Lower rates are "likely to be with us for years", so value investors will have to be patient we could well see "a 20-year limping regression that takes us two-thirds of the way back to the good old days pre-1997".
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