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Jeremy Grantham is a well-respected thinker on financial markets, particularly ideas of reversion to the mean and bubbles. He is founder of the very successful asset manager GMO, based in the US – but remains a Brit!
He recent wrote in the GMO Quarterly newsletter a piece entitled “This Time Seems Very, Very Different” (https://www.gmo.com/docs/default-source/public-commentary/gmo-quarterly-letter.pdf?sfvrsn=44)
His main argument is that the price earning ratio on the S&P500 has, since 1997, settled around a higher level than it did in previous decades, and that this will continue.
After the tech bubble burst the PER only fell to touch the average PER of the pre-1997 period – not fall below it – then it rose again. “the failure of the market in 2002 to go below trend even for a minute should have whispered that something was different.”
The second element supporting his argument is that corporate profits have risen to a higher level than before – see next two charts. Grantham claims, “This is a large and sustained change.”
“With higher margins, of course the market is going to sell at higher prices.”
A younger Grantham thought that profit margins were mean reverting. But he now believes this stopped in 1997, at least not reverting around the old level. They have jumped to revert around a new higher trend.
Why increased margins?
- Increased value of brands where the US is particularly strong, allowing for higher returns on capital, especially if production is moved to say low-cost China.
- Increasing corporate power: over government, over barriers to new entrants, over regulations that benefit incumbents by creating insuperable barriers for smaller fry.
- Increased monopoly power.
- Lower real interest rates combined with higher leverage “Pre-1997 real rates averaged 200 bps higher than now and leverage was 25% lower. At the old average rate and leverage, profit margins on the S&P 500 would drop back 80% of the way to their previous much lower pre-1997 average”
These four are plausible causal factors for the rise in margins to this point in history. But the key issue is whether there are good probabilities that one or a number of them will be reversed over the next few years.
When a stock exchange is priced for so much perfection it will only take one of them to go wrong for a severe reaction. Consider each in turn:
- Brands. The most valuable brands in the world today were not very well known in the 1990s or even the 2000s, e.g. Amazon, Google, Facebook. Combine this idea with the observation that famous brands of yesteryear are fallen, e.g. Kodak, Nokia, Polaroid, Blackberry, AOL, Woolworths, and you might start to believe that brand power can be here today and gone tomorrow. Where is………………………………………………………………………………………………To read the rest of this article, and more like it, subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
