At 82 years old, investment manager Jeremy Grantham has seen his fair share of market cycles. And as a U.K. native now living in the U.S., he maintains a balanced perspective. In an interview last week, Grantham shared his unvarnished view of the U.S. market. “American capitalism has become fat and happy,” he said. And the U.S. stock market is in a bubble which will likely burst within “weeks or months.”
I don’t believe anything should be judged over the span of just one week. To the extent, though, that the market did drop almost immediately after the interview, Grantham does appear prescient. But let’s back up a little and understand Grantham’s concerns. He cited two.
The first concern: valuations. “We’re in the highest 5% of P/E’s [price-to-earnings ratios], and we’re in the lowest 5% of economic conditions.” In other words, we’re in a recession, but the market is inexplicably flying high. “There’s never been anything like that in history,” he added.
Grantham’s second concern: “signs of truly crazy behavior.” In his experience, high valuations alone don’t cause bubbles to burst. But when high valuations are combined with increasingly risky investor behavior—then, Grantham says, the end may be near. And that, unfortunately, is what he is seeing now. He cites these examples: investors piling into Tesla shares, causing them to quadruple this year, or driving up the price of Hertz shares despite the company being in bankruptcy. And then there’s the recent boom in special purpose acquisition companies (SPACs), otherwise known as “blank check” companies. Grantham equates SPACs to the South Sea Bubble: “Give us your money, and trust me, I’ll do something useful.” His characterization, in my view, is not unreasonable.
For both of these reasons—high valuations and risky behavior—Grantham thinks investors should get out of the U.S. stock market. While he allows for a few exceptions, ideally, Grantham says, investors should “avoid the U.S. entirely.”
Instead, he recommends investors shift to emerging markets countries, including China, Russia and India. “It’s growing far faster” than developed markets like the U.S. and Europe. “It’s cheap, it’s a great opportunity.”
So is this the solution? Should you abandon the U.S. stock market in favor of emerging markets? While I don’t disagree with some of Grantham’s concerns about the U.S. market, I do disagree with his prescription—for three reasons:
1. If you need to pay your bills in a particular currency, it’s prudent to have your assets in that same currency. For investors in the U.S., I think you want to have most of your assets in dollars. While it’s often overlooked, currency moves can materially impact the value of an international investment. Consider, for example, a popular index fund (ticker EWZ) that tracks Brazil’s stock market. According to the fund company’s website, EWZ was down more than 40% through the end of last quarter. But Brazil’s market isn’t really down 40%; it’s down less than 20%. But because Brazil’s currency has depreciated this year, the results have been far worse for American investors. Of course, this can cut both ways. If a currency appreciates, it can boost returns. But investing is unpredictable enough without worrying about currencies too. That’s why I wouldn’t jump into emerging markets stocks with both feet.
2. Valuations on some domestic stocks are high, but not all. These days, the big technology stocks—Amazon, Apple, etc.—get all the attention. And they certainly carry valuations that look stretched. But within the S&P 500, there are still more than 280 stocks that are in negative territory year-to-date. So it strikes me as an overreaction to say that you’d have to leave the U.S. entirely to find reasonably priced stocks. In fact, all you’d have to do would be to add a simple value-stock fund to your portfolio. In Vanguard’s Value Index Fund (ticker VTV), for example, more than two-thirds of the holdings are down year-to-date. These stocks offer demonstrable value, and they’re all domestic.
3. While the U.S. isn’t perfect, many emerging markets countries have policies that should give investors pause. Some have authoritarian regimes. Others exhibit little respect for intellectual property and have shown a willingness to confiscate or nationalize businesses. Corporate governance and accounting rules are also more lax across emerging markets.
Should you diversify your stock portfolio outside the U.S.? Absolutely. The data definitely do indicate a diversification benefit. I just wouldn’t take it to the extreme that Grantham recommends. Personally, I suggest allocating 20% of a portfolio to international stocks. Others prefer more of a market-weighted approach, with something closer to 50% outside the U.S. That’s fine too. There is no historical data that dictate a specific percentage. The best approach, in my view, is the simplest: Diversify broadly and avoid going to any one extreme.
I should note that Grantham does recommend one other investment category. “If you insist” on investing the U.S., he recommends venture capital. This is an interesting recommendation, but as one prominent venture capital insider acknowledged, the best venture capital firms are closed to everyday investors. And because of the dispersion in quality among VC firms, as I described a little while back, you really don’t want to be invested in lower-tier funds. So while venture capital can work well, unfortunately it’s not really a feasible option for most people.
