Take nothing on faith
In this post I will comment on the declaration by GMO that there is a bubble in growth stocks.
I have just read a one pager dated October 2021, published by GMO titled: “GROWTH BUBBLE: Making Money on Companies That Make No Money’. It may be read here.
Evidence for bubble in ‘growth’ stocks
The essence of the report is that there is a true bubble in growth stocks. The primary evidence they rely on is a chart that shows the percentage of ‘growth’ companies with negative trailing twelve month earnings. Their argument is that ‘growth’ stocks are way outperforming the market and yet losing money.
GMO is a large, well known money manager with offices around the world. It was founded by Jeremy Grantham. It is well known for making macro calls about the state of the stock market and the outlook for different asset classes.
History of bubble calls
For the last four years GMO has been consistently declaring that we are in the blow-off phase of a stock bubble.
For example, in a note dated January 3, 2018, Jeremy Grantham wrote: “…as a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market.”
Nullius in verba
Investors must think for themselves. One’s motto should be ‘Nullius in verba’. This is taken to mean ‘take nobody’s word for it’. I want to look at the evidence and make up my own mind.
Bubbles are an exception
Normally I am not concerned about the state of the stock market, nor about its outlook. The only exception is to deal with stock bubbles. True stock bubbles are very rare. There have been perhaps three in the last century.
GMO’s evidence in context
The GMO chart above shows three peaks highlighted with dotted red circles. The red circles show periods when the largest number of Russell 3000 ‘growth’ stocks are showing losses.
Now look at the following chart which shows price earnings ratios of the S&P 500 over the years. There are three peaks at exactly the same time as the GMO three peaks. So for example, the price earnings ratio of the S&P 500 peaked in 2009 at over 100x. The explanation for the peak is that companies incurred huge write-offs on a trailing twelve month basis as a result of the recession that came with the great financial crisis. The Macrotrends chart has highlighting that shows when the economy was in a recession. The rapid increases in the price earnings ratio that occurred as a result of recessions is clearly shown.
The same phenomenon can be seen in the years 2000 and 2020. The peaks are at the same time as the peaks in the GMO chart. These peaks in part come from company losses during a recession.
My thoughts about GMO’s note
GMO’s case is based on a high percentage of growth companies showing losses. There is an irony. If you reflect on the great financial crisis era, the best time to invest in every kind of stock was in the spring of 2009 when companies were showing massive losses and the S&P 500 index was trading at a price earnings ratio over 100x. The same could probably be said of the year 2020. In the 2020 recession, the S&P 500 price earnings ratio got up to the mid-30s.
My thought is that GMO using trailing twelve months earnings that are impacted by a recession is a mistake.
There are other issues. In an era where the majority of company investment is in the creation of intangibles assets of lasting value and where this investment is written off against earnings but doesn’t show on balance sheets, reported corporate earnings need a rethink. As well, attempts to make a distinction between ‘growth’ and ‘value’ stocks is fundamentally misguided. My writing on these issues can be searched in the Tags index on the Motherlode home page.
The GMO note doesn’t convince me of anything. I agree that today some particular stocks are ridiculously overpriced. But this is pretty normal. I am still keeping a wary eye open for a generalized stock bubble.
To read more deeply about asset management issues surrounding bubbles take a look at the Motherlode Part 5: Asset Management
That Part contains the following chapters:
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