Playing with Fire (A Possible Race to the Old Highs)
By Jeremy Grantham
April 25, 2010
Grantham criticizes the Fed's zero interest rate policy, arguing that it incents investors to speculate, rewards the banks, and penalizes savers. Bernanke has created a moral hazard problem, in that investors (speculators) have come to expect a prolonged period of low interest rates following a market crash, in order to revive the markets.
Grantham is convinced that this excessive market response has occurred because stocks are far more sensitive to both low rates and the Fed’s promises than is the economy. He said the economy is "limping back into action," but expects a slow recovery ("seven lean years"), due to problems in residential and commercial real estate, private equity deleveraging and other areas.
Slow recovery and high unemployment, the most likely economic scenario, will cause Bernanke to keep interest rates low, which Grantham said would cause stocks to rise even higher. Grantham said Bernanke appears to be insensitive to bubbles, such as might be forming in the US equity markets, and believe they can "take care of themselves."
A strong recovery would lead to weaker equity markets and a diminshed likelihood of an equity market bubble.
Additional risks the global economy faces include default risk in Greece and the weaker European countries and weakness in the Chinese economy, which "today acts as the main prop to global growth."
Another reason why the equity market rally is likely to continue is that, in October, we enter the third year of the Presidential terms, which historically has been very strong for the market.
The most likely scenario is "a market move in the next 18 months or so back to the old highs, say, 1500 to 1600 on the S&P, accompanied by an equivalent gain in most risk measures, followed once again by a very dangerous break."
Global markets are "moderately overpriced" and the US market is "very overpriced but not nearly as bad as it could be." US large-cap high-quality companies are cheap.
Grantham comments on the SEC v. Goldman case, the UK and Australian housing bubbles and global warming. He also provides a partial copy of speech he gave at the Columbia Business School last October on value investing.
To read the full commentary, go to www.gmo.com