“I think it is likely (better than 50/50) that all previous deal records will be broken in the next year or two.”
Jeremy Grantham, one of investment management’s few absolutely must-read investment strategists, is out with his latest essay in GMO LLC’s quarterly investor letter. In it, Grantham posits that we’re not quite in a stock market bubble but well on our way. At 2250 on the S&P 500, he’d be willing to sew on the Scarlet “B” and call it what it is.
Grantham’s main point, however, is that the next few years should see a deal-making frenzy the likes of which we’ve never seen before, eclipsing the excesses of the previous two cycle peaks because capital is now cheaper and the economic cycle itself is still young enough, whereas by the M&A peaks of 2000 and 2007 it was already aged and tired…
These are my reasons. First, when compared to other deal frenzies, the real cost of debt this cycle is lower. Second, profit margins are, despite the first quarter, still at very high levels and are widely expected to stay there. Not a bad combination for a deal maker, but it is the third reason that influences my thinking most: the economy, despite its being in year six of an economic recovery, still looks in many ways like quite a young economy. There are massive reserves of labor in the official unemployment plus room for perhaps a 2% increase in labor participation rates as discouraged workers potentially get drawn into the workforce by steady growth in the economy. There is also lots of room for a pick-up in capital spending that has been uniquely low in this recovery, and I use the word “uniquely” in its old-fashioned sense, for such a slow recovery in capital spending has never, ever occurred before. The very disappointment in the rate of recovery thus becomes a virtue for deal making.
Previous upswings in deals tended to occur at market peaks, like 2000 and 2007, which in complete contrast to today were old economic cycles already showing their wrinkles. Worse than being in full swing, they were usually way over capacity. Thus, 2000 was helped along by the bubble in growth stocks to over 60 times earnings, allowing companies like Cisco, possibly correctly, to believe they were dealing with a near-zero cost of capital in making deal after deal for their massively overpriced stock.
Grantham is somewhat bearish on US equities over a forward seven-year period given where valuations are today, but he is thoughtful enough to admit what could very well happen if in fact we’re in a secular bull market and earlier in the economic cycle than the rest of the bears suspect (most of his bearish peers didn’t even foresee this up-cycle arriving at all, so their opinions as to its endpoint are essentially useless anyway).
Now don’t get too excited, as the end of Grantham’s story is a massively inflated bubble following by an eventual pop and all of the mass destruction that comes along with it for the real economy. He’s in the camp that says the Fed should have learned to work on bubble prevention, not just preparing to clean up the wreckage each time a speculative mania blows itself out.
Summer Essays Volume 2
GMO Quarterly Letter – Second Quarter 2014