GMO co-founder and chief investment strategist has been arguing for months that we are witnessing the creation of an enormous asset bubble, but that it will likely run for a couple more years before it finally busts. Now he’s found another reason for the current bull market to keep running even though he thinks valuations are already too high: a frenzy of new deals.
“Don’t tell me there are already a lot of deals. I am talking about a veritable explosion, to levels never seen before,” he writes in GMO’s second quarter letter.
The disappointing recovery will drive an explosion in new deals: Grantham
The first two reasons that he gives are fairly straightforward. The real cost of debt remains very low, so if other conditions push companies toward more M&A activity, rock bottom interest rates will seal the deal. Second, profit margins are high and are expected to remain there for the foreseeable future, so dealmakers have a lot of cash on hand to work with.
But the real reason that Grantham expects an explosion in M&A activity is that the economy still looks like it’s in the early stages of the cycle with lots of slack in the employment market and capital spending that continues to be depressed during a very tepid recovery.
“The very disappointment in the rate of recovery thus becomes a virtue for deal making,” he writes.
Even if there is an asset bubble, that doesn’t mean it will burst soon
Bullish investors, which is most people at this point, would probably argue that the reason the economy appears to be so much younger than Grantham believes is because stock prices aren’t unreasonable and the market still has plenty of room to grow before we need to be worried. But it’s this market sentiment, and the factors the influence, that Grantham is really trying to nail down.
It’s not enough to say that securities are overvalued, they can stay that way for years. The real question is when the rest of the market will react to high prices and make a hard turn. Grantham is saying that even if you’re a value-oriented bear like he is, there is plenty of economic data to keep bullish dealmakers happy for a few more years, so you don’t want to start betting against them just yet.
Full PDF here GMO_QtlyLetter_2Q14