Fed-Driven U.S. Stock Advance Leaves Grantham Waiting for Bubble
by David Wilson
(Bloomberg) — Adjusting U.S. stock-market indicators for Federal Reserve policy since the 1980s shows a bubble has yet to come, according to Jeremy Grantham, Grantham, Mayo, Van Otterloo & Co.’s chief investment strategist.
The attached chart highlights one gauge, Yale University Professor Robert Shiller’s cyclically adjusted price-earnings ratio, that Grantham cited yesterday in a quarterly letter to shareholders. The P/E is based on average earnings for the previous 10 years, rather than four quarters of profit.
Shiller’s ratio averaged 24.4 from August 1987, when Alan Greenspan was first appointed Fed chairman, through last month. The period was marked by “the Fed’s habit (as in ‘addiction’) of pushing the market up in order to get a wealth effect,” or growth in consumer spending that reflects higher asset values, Grantham wrote.
The average P/E for what the Boston-based money manager defined as “the Greenspan era” was well above the comparable readings for earlier periods. Stocks were valued at an average of 14 times profit from 1900 to July 1987, as the chart shows.
Using the more recent figure as a benchmark would suggest stocks are “well on the way to bubble-dom but, clearly enough, not there yet,” Grantham wrote. The latest reading was 27.1 as of yesterday, according to Shiller’s website.
Grantham reiterated a view that the Standard & Poor’s 500 would reach a bubble at about 2,250, or 7.9 percent higher than yesterday’s close. He added that the threshold may be 5 percent to 10 percent higher after accounting for the Shiller P/E and another gauge, known as Tobin’s Q.
Tobin’s Q is a ratio of companies’ market value to the replacement cost of assets. The indicator is named for its creator, the late James Tobin, another Yale economist.