Jeremy Grantham: What's Coming is WORSE Than a Recession

Do you think we're in a major bubble now at right now in the United States? And do you think that the tech bubble has burst sufficiently so that the tech bubble burst is over?

Throughout his over 50-year career, billionaire investor Jeremy Grantham has developed a reputation as somewhat of a doomsday oracle. He has become famous for predicting some of the biggest stock market crashes of all time, such as the dot-com crash in 2000, the financial crisis in 2008, and most recently, the tech bubble in 2021. Here in 2023, the U.S. stock market is once again bumping up against all-time highs, and this has Grantham warning that the market is dangerously overvalued.

Here's what he had to say: "You are well known in the investment world for saying that sometimes there are bubbles, and bubbles should be avoided. Do you think we're in a major bubble now, at right now in the United States? And do you think that the tech bubble has burst sufficiently so that the tech bubble burst is over?"

"I think we are descending from the 2021 bubble, which was one of the great bubbles, and this should be normally the deflationary period—a function of will the earnings decline, will profit margins decline, will the economy go into recession, and will we have a recession running perhaps deep into next year, with an accompanying decline in stock prices? So, the recession that you're predicting is probably not going to happen in 2023 but maybe may start in 2023."

The Federal Reserve recently said that they think we've kind of cleared the recession hurdle, and they don't really project a recession any longer. Do you disagree with the Fed on that?

"Yeah, I think the Fed's record on these things is wonderful; it's almost guaranteed to be wrong. They have never called a recession, particularly not the ones following the great bubbles. They prided themselves in stimulating the bubbles. They took credit for the beneficial effect of higher asset prices on the economy. They have never claimed credit for the deflationary effect of asset prices breaking, and they always do."

Now, you said not too long ago that you weren't a big fan of Jay Powell and the way he's been handling inflation, is that correct?

"Yes, that's correct."

And you think he's done a better job recently in getting inflation under control?

"I think it's largely out of his hands—the forces work. I suspect inflation will never be as low as it averaged for the last 10 years. We have re-entered a period of moderately higher inflation and, therefore, moderately higher interest rates. In the end, life is simple—low rates push up asset prices, and higher rates push asset prices down. We're now in an era that will average higher rates than we had for the last 10 years."

The U.S. stock market has soared for the last nearly 15 years. Take a look at this chart here. This chart actually shows the performance of the S&P 500 index over the last couple of decades. For background, the S&P 500 is generally regarded as a proxy for the U.S. stock market. We can see here that the S&P has skyrocketed from roughly 1,000 in February 2009 to its current level of approximately 4,500.

The last 14 or so years have been one of the best time periods in the history of the stock market for investors. But the concern that Grantham and many others have is that the market has soared to unsustainably high levels. One of the biggest drivers pushing the stock market to potential bubble territory was historically low interest rates. Interest rates in the U.S. spent the better part of the last 15 years at near zero percent, and these low rates acted like jet fuel for the stock market.

Let me explain: to truly appreciate Jeremy Grantham's comments, you first have to understand the relationship between interest rates and asset values. Asset values are just a fancy way of saying things people own because it produces income for them. Think stocks, bonds, and real estate as the most common types of assets the average investor owns in their portfolio. The value of any asset, including stocks, is based on the cash it will generate for you as the owner, discounted back to the present day using an interest rate.

At first, I know this may sound super complicated, but trust me, it's actually a relatively straightforward concept. Let's say you buy a stock that produces thirty dollars a year in cash for you every year for ten years. At the end of the ten years, you can then sell the stock for three hundred dollars. You know how much cash the stock will be able to produce for you as the owner, but there's one last step in finding just how much that stock is worth today: you have to discount those cash flows back to the present day using an interest rate.

The reason you have to discount the cash flows is because a dollar today is not worth the same as a dollar ten years from now. Let me ask you a question to demonstrate this point. If you had to choose between receiving ten thousand dollars today or ten thousand dollars ten years from now, which one would you pick? Well, obviously, you would want that money today as opposed to ten years from now. This concept is referred to in investing as the time value of money.

For the sake of this example, I'm going to start out by using a 20% interest rate. Using that 20% yields a stock price of 174 dollars per share. To show exactly what I mean when I say lower interest rates are jet fuel to stock prices, let's see what happens when we decrease that rate. Bringing it down to 15% gives us a new stock price of 225 dollars. If we bring it down further to 10%, the stock price continues to soar all the way to 300 dollars. If we bring it down to 6%, the stock continues to skyrocket, with the price hitting 388 dollars per share.

Notice how the amount of cash the stock produces stays exactly the same. The only thing that changed was the interest rate. The declining interest rate was powerful enough to push our stock price from 174 dollars a share at a 20% rate all the way to 388 dollars per share at a 6% rate. This is an increase in the value of the stock of a whopping 123%, all of which the stock didn't even make a single additional dollar of cash flow.

Now you can see why low interest rates can push stock prices to mind-boggling levels. While this example demonstrates how low interest rates can contribute to a bubble forming, there is also a decidedly human element to it. Listen to Grantham explain: "They were likely to go into a recession probably next year, though it could start this year. The tech bubble burst that we saw beginning, let’s say, last year has not yet completely played itself out, right? And we have a little mini bubble in artificial intelligence. In a way, not so many. They were very big moves in a dozen very big stocks, and many— and many in the sense that it's not affecting the overall economy as much as the whole tech market."

"No, no, that's right. In comparison to 2021 and 1929, it's so much… So what is it about human nature that makes them feel they want to participate in a bubble? They see the stock market going up, and they think they're going to miss something. Even the famous Sir Isaac Newton participated in a bubble."

"Yes, he did. He thought he was missing something. He mortgaged his house and put all his money into the South Sea Corporation and lost all of his money. So even somebody as smart as that was unable to resist the bubble. Why is it that humans can't resist being in bubbles? I always like to say there's nothing more supremely irritating than watching your neighbors get rich. It is just irresistible to try and join in. And when enough people hit the inflection point, it sucks in everybody. And they're the great bubbles; they're the ones that are interesting."

"Mostly, there's a nice balance between bulls and bears, and once in a blue moon, every 20 years or so, you'll hit an inflection point where enough people become bullish that people stop thinking about fundamentals. Bubbles form in large part due to FOMO, or fear of missing out, as people see their neighbors getting rich and they want a piece of the action."

"This dynamic has been around as long as financial markets have existed. John Pierpont Morgan, better known as JP Morgan, was one of the most powerful bankers and industrialists at the turn of the 20th century. You probably know him as the founder of what is now the banking empire known as JPMorgan Chase. John Pierpont Morgan saw frequent booms and subsequent busts all too commonly in the early days of the stock market, prompting him to utter the now infamous line: 'Nothing so undermines your financial judgment as the sight of your neighbor getting rich.'"

"Even in the brightest minds of all time can fall victim to the prospect of easy money. The epitome of this is Isaac Newton and the story of the South Sea bubble. For those of you that may not know, Newton is universally regarded as one of the greatest scientific minds to have ever lived. The man literally invented the theory of gravity. As if that wasn't enough, he also invented calculus and the three laws of motion upon which all mechanics is based. Despite all of that intelligence and accomplishment, Newton still lost it all in a financial bubble."

"In the year 1711, Newton invested a substantial portion of his wealth in the South Sea Company, the British trading company established to reduce the national debt and exploit lucrative trade opportunities in the South Seas. It was the talk of the town, promising unimaginable riches to its investors. Newton's involvement in the South Sea bubble was initially profitable, and he reaped significant gains as the company stock soared to dizzying heights. Letting greed get the best of him, though, Newton mortgaged his house to go all in on the stock. However, the speculative frenzy reached unsustainable levels. In 1720, the bubble finally burst, sending the South Sea Company stock plummeting in what is now considered one of the most infamous financial crashes in history."

"Newton's incredible intellect couldn't shield him from the devastating consequences of this market collapse. He famously remarked, 'I can calculate the motion of heavenly bodies, but not the madness of people.' In the aftermath of the crash, Newton's investments in the South Sea Company became nearly worthless, and he suffered substantial financial losses. While Isaac Newton's contributions to science remain unparalleled, his involvement in the South Sea bubble serves as a reminder of the unpredictability and irrationality of financial markets, affecting even the most brilliant minds of their time."

"If Isaac Newton—one of the most brilliant minds ever—wasn't smart enough to avoid a bubble, who are we to think we are able to navigate it? Thankfully for us, Grantham has some advice on what to do now in the year 2023."

"So, if I said to you, 'Look, I'm not that wealthy. I have a hundred thousand dollars. I'd like to put it somewhere where I'm not going to lose it. What would you recommend? The person just a index fund or something else?'"

"No, no. I think a global index fund that had most of its money outside the U.S. And if they were up to it, I would say only invest outside the U.S. for the time being because this overpricing in the market is mainly a U.S. event. The markets outside the U.S. are not particularly overpriced."

According to Grantham, the stock market bubble is concentrated in the U.S. for the most part. One way to get a sense of where valuations in the stock market stand is by what is referred to as a price-to-earnings ratio, or P/E ratio for short. Think of a P/E ratio as the price you must pay per unit of current earnings. So, if a stock is trading for twenty dollars and their stock produces one dollar per share of earnings, the P/E ratio is 20.

Put another way, you have to pay twenty dollars for each dollar of current earnings the stock produces. As a general rule of thumb, the higher the P/E ratio, the more "expensive" a stock is, and the lower the ratio, the more "cheap" the stock. Just like individual stocks, entire country stock markets can have P/E ratios.

Let's take a look at different P/E ratios for countries around the world to see if Grantham is correct about the U.S. stock market being overvalued. As we can see here, as of the making of this video, the U.S. stock market trades at a P/E ratio of 22 times. This is one of the highest P/E ratios in the world. The only country with a significantly higher P/E ratio is India at nearly 24 times.

Let's see how the U.S.'s P/E ratio of 22 times stacks up against some other major economies. France trades at a P/E ratio of roughly 16 times; Australia, 15 times; Canada and Japan are closer to 14 times; Germany trades at roughly 13 times; the United Kingdom is at 10 times; China is at 9 times; Italy at 8 times; and Brazil is at a P/E ratio of just 6 times.

I think you're starting to get the point. The big difference between the P/E ratios of the U.S. and these other large countries certainly seems to support Grantham's argument about the U.S. stock market being overvalued.

However, this only tells part of the story. The U.S. stock market contains many of the world's largest and most profitable companies. Additionally, investors across the world invest substantial sums of money in U.S. companies, pushing stock prices up even further. All of this to say that it is also important to see how the U.S. stock market's P/E ratio compares relative to its historical levels.

Using the S&P 500 as a proxy, we can see that it trades at a P/E ratio that is comparable to levels it has traded at for the last 30 years. It's plausible that Grantham is wrong and the U.S. stock market stays at these levels for years to come.

So there you have it. Make sure to like this video and subscribe to the channel because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon.

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