Pavlov’s Bulls – Are We in Bubble Territory?

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With the S&P 500, Nasdaq and Dow reaching record highs this week, I am minded to share this 2011 letter by Jeremy Grantham – titled Pavlov’s Bulls – on asset cycles and bubbles. As a value investor, he raises a couple of points that Grahamites will find interesting.


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We shouldn’t ignore bubbles

“I’ve also been pretty irritated by Graham-and-Doddites because they have managed to deduce from a great book of 75 years ago, Security Analysis, that somehow bubbles and busts can be ignored. You don’t have to deal with that kind of thing, they argue, you just keep your nose to the grindstone of stock picking. They feel there is something faintly speculative and undesirable about recognizing bubbles. It is this idea, in particular, that I want to attack today, because I am at the other end of the spectrum: I believe the only things that really matter in investing are the bubbles and the busts.”

If the S&P rises to 1500, it would officially be the latest in the series of true bubbles.

“As a simple rule, the market will tend to rise as long as short rates are kept low. This seems likely to be the case for eight more months and, therefore, we have to be prepared for the market to rise and to have a risky bias. As such, we have been looking at the previous equity bubbles for, if the S&P rises to 1500, it would officially be the latest in the series of true bubbles. All of the famous bubbles broke, but only after short rates had started to rise, sometimes for quite a while. We have only found a couple of unimportant two-sigma 40-year bubbles that broke in the midst of declining rates, and that was nearly 50 years ago.”

This is definitely something to think about – the Fed is expected to hike rates starting from December.

P/E and profit margins should be negatively correlated

“Now, the market should equal replacement cost, which means the correlation between profi t margins and P/Es should be ?1. Or, putting it in simpler terms, if you had a huge profi t margin for the whole economy, capitalism being what it is, you would want to multiply it by a low P/E because you know high returns will suck in competition, more capital, and bid down the returns (conversely at the low end). But what actually happens? Instead of having a correlation of ?1, our research shows it has a correlation of +.32. The market can’t even get the sign right! High profi t margins receive high P/Es and vice versa, and the correlation is much greater than +.32 at the peaks and the troughs. Right at the peak in 1929, we had record profi t margins and record P/Es. In 1965, there were new record profi t margins and record P/Es (21 times). Now, think about 2000. We had a new high in stated profi t margins and decided to multiply it by 35 times earnings, a level so much higher than anything that had preceded it. In complete contrast, in 1982 we had half-normal profi ts times half-normal P/Es (8 times). I mean, give me a break. We were getting nearly one-third of replacement cost at the low, and almost three times replacement cost at the high in 2000. This double counting is, for me, the great driver of market volatility and, basically, it makes no sense. Once profit margins start to roll, investors look around at the competition, who are all going along for the ride, and we get overpricing as a result. It is a classic fallacy of composition. For an individual company, having an exceptional profit margin deserves a premium P/E against its competitors. But for the market as a whole, for which profit margins are beautifully mean reverting, it is exactly the reverse. This apparent paradox seems to fool the market persistently.”


Current P/E of S&P500 is 24.5 which is very near the peak of the 1990s

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