Economic data indicates that we're in a slowly recovering economy, looking to get its feet back on solid ground. Yet it won't take much to knock this nascent recovery for a loop. While many folks look to brighter days ahead, at least one prominent guru is back to predicting doom and gloom, in the shape of yet another asset bubble forming right this very moment.
The bear growls
Jeremy Grantham, of institutional money manager GMO, doesn't like what he sees in the stock market. In a recent Wall Street Journal article, Grantham warns that a new bubble is taking shape, fueled by low interest rates and accommodative monetary policy. He predicts that while stock prices may rise in the coming months, their surge will be fueled by speculation. Grantham feels that the S&P 500 is overpriced above 850, which is about 22% below its current price. He is also predicting lean times ahead, with stocks producing below-average returns for roughly the next seven years.
While some folks may dismiss Grantham's rantings as those of a cranky perma-bear, it's important to note that he correctly predicted the asset bubble forming in 2007, and also called the market bottom in the spring of 2009. From that point, GMO's institutional stock funds have racked up gains, thanks to positions in highfliers like Microsoft (NASDAQ:MSFT) and Oracle (NASDAQ:ORCL). While his crystal ball isn't perfect, investors would be wise to at least consider his viewpoint.
Parsing the risks
Grantham is absolutely right that the Fed's current policy course, and the government's easy-money extravaganza, is inflationary. In theory, both help contribute to asset bubbles. We saw that happen several years ago, when historically low interest rates fed the housing bubble.
Unfortunately, the Fed will face considerable political pressure not to raise rates this time, at least until the economic recovery appears to be more solid. This means that the Fed will almost certainly overshoot its accommodative stance, leaving rates low for too long. How soon the Fed acts will likely be the largest determinant in whether a new bubble actually arises.
However, I don't necessarily agree that the next decade will be a downer for stocks. I do fully expect that the market will take a bit of a breather after the tremendous rally it's enjoyed since last March. A mild correction wouldn't be too much of a surprise. And I certainly don't think that stocks will continue to appreciate at the same rate they have in the past year.
Slow economic growth is the order of the day, and there's little reason to think that the market should outpace that rate of growth. But over the next decade, I still believe stocks will offer investors the greatest return potential of any asset class -- if you know where to look.
Bubble investing
I don't agree with everything Grantham sees ahead, but we are in agreement on where to invest now: high-quality blue chips. Grantham states that the outlook for high-quality U.S. stocks is significantly better than the rest of the market, and that their outperformance in the near future is "nearly certain."
Given that the current market rally has been primarily focused on riskier, low-quality stocks, I concur. Investors would be wise to stock up on some of these high-quality names, including the likes of Wal-Mart (NYSE:WMT), Johnson & Johnson (NYSE:JNJ), and Coca-Cola (NYSE:KO).
Grantham also sees good potential in markets abroad, although his models actually predict that both developed- and emerging-market stocks will underperform high-quality U.S. blue chips over the next seven years. While that may happen in the short run, I do think foreign markets have more long-run growth potential than most segments of the domestic stock market.
U.S. investors are typically underweight on foreign stocks. Make sure you've got a healthy dose of solid names from both developed and emerging countries, such as U.K.-based consumer goods producer Unilever (NYSE:UL) and Brazilian oil concern Petroleo Brasileiro (NYSE:PBR). This will ensure that you have exposure to the areas of greatest growth in the coming decade.
Ultimately, it's impossible to say for certain whether another asset bubble will form, how large it might get, or how much damage it could cause when it bursts. But by keeping near-term expectations in check, and stocking up on high-quality domestic and foreign names, investors can ease their ride through any volatility on the horizon.
What do you believe will be the next bubble to form? Leave a comment below and tell us what you think!
