The investment bubble that never burst

published 18 December 2006

The real hangover from the dotcom party may still be to come, says Magnus Grimond in The Times. Like a number of commentators last week, he picks up on a recent presentation by the highly respected Jeremy Grantham of investment managers GMO, which he finds "unsettling". Grantham's research has identified 27 financial bubbles, in which it eventually turned out that "not one was a new paradigm or a new era" and that "all were mean reverting". In other words, "despite talk of a fundamental change justifying enormous prices at the time, eventually values have returned to the long-term trend". However, there is one exception to this pattern, at least so far the run-up in the S&P 500 during the late 1990s. "Having thundered back to earth after the bubble burst, the market bounced, as we know, in 2003, without crashing through the trend, as it should have done on past form," says Grimond.

Why did this happen? The reason is that "the Fed has thrown literally trillions of newly printed dollars at the US economy", says David Fuller on Fullermoney.com. "But Grantham still expects mean reversion for the S&P eventually." This does not imply that the absolute level of the S&P 500 will fall to pre-bubble levels, but that valuation measures, such as p/e ratios and dividend yields, will return to long-term trends. "Even though the S&P p/e has come a long way down from its peak of 35 in 2000, it is still 17.73 today, compared to the geometric average of 14.7." Such a process will take a long time to complete, says Grantham. He identifies 2010 or 2014 as likely dates for the final stage of the reversion, which will involve "not just a valuation contraction", but a "persistently downwards" trend in the market, says Fuller.

Meanwhile, what about the shorter-term outlook for the market? From Grantham's work, there are plenty of warning signs on display. The biggest is the exceptionally high level of corporate profit margins. For example, US profit margins stand at a 75-year record of 7.7%. "Profit margins are the most reliably proven mean-reverting measure in capitalism," says Grantham; from these levels, a decline to the 4.9% long-term average is likely in the medium term. Consequently, Grantham has increased the weighting of cash and safe bonds in clients' portfolios to about 45%, although, "as he would be the first to admit, timing the next downturn is extraordinarily difficult", says Grimond.