When’s the next crunch?

“Why are stockmarket prices so high?” asks Jeremy Grantham of US asset manager GMO in his latest newsletter. A well-known value investor, Grantham can be forgiven for feeling frustrated. You may question valuation indicators such as the cyclically adjusted price/earnings ratio or Tobin’s Q (which looks at what it would cost to build all the firms in the market from scratch, versus their current market value) or even Warren Buffett’s favourite, the stockmarket-capitalisation/GDP ratio. But you can’t deny that US stocks in particular are very pricey compared with nearly any other period that wasn’t a bubble market – such as 1929 or 2000. So what’s keeping them at these levels, and how long can it continue?

The answer, in essence, says Grantham, is that investors are irredeemably irrational. For example, if you look back over time, corporate profit margins are mean-reverting. So when margins are unusually low, investors should expect them to rise, and so should be happy to pay a bit more for stocks (meaning higher price/earnings, or p/e, ratios).

When margins are high, they should expect them to fall, and thus be more cautious (so p/es will be lower). But that, notes Grantham, is not how it works in real life. Instead, investors shun stocks when margins are low, resulting in low p/es, while they are happy to pay up for high-margin stocks – meaning that these end up trading on high p/es, as happened during the tech bubble in 2000.

P/es also tend to be higher when inflation is low. Investors dislike inflation, even though in the long run it should have no effect (on stocks, as opposed to bonds) as companies pass costs on to consumers. P/es are also elevated when growth is stable (not high – investors prefer even modest growth to rapid growth, as long as it’s stable). In short, says Grantham, “I have in general been over-intellectualising the working of the market for a few decades… [It]… appears not to care at all about the past or to learn much from it.”

Some might argue that this is the sound of the last bear throwing in the towel, and thus signals imminent collapse. That would be both ironic and rather unfair – Grantham has a track record of well-timed caution, rather than perma-bearishness (he called the bottom in March 2009). But he is likely to be right. Until inflation takes off (forcing investors to fret about rising interest rates) or margins fall (destroying faith in a new era of disruptive monopolies created by “network effects”), then the market can remain expensive. For how long? Grantham sees no imminent trigger for higher inflation or lower margins. But at least we know what to look for.