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GMO's Grantham Sees Defensive Multinationals as Bubble Beaters

Jeremy Grantham, chief strategist at the portfolio manager G.M.O. and one of the few on Wall Street who merits the sobriquet "guru," warned in his latest quarterly letter to investors that the stock market may be forming a bubble, as noted here on Monday.

Bubbles are tricky and treacherous because they inevitably pop, but before they do they can reach valuations that range from high to scary/crazy high. With that in mind, Grantham, a longtime bear, outlined some options for investors with a stake in the market:

Play it safe and steer clear of stocks, avoiding potential disaster while also giving up further gains.

Stay invested, capturing more of the rally while risking being stuck if and when the collapse comes.

Try a third approach that's both and neither of the first two: Grantham finds defensive blue-chip stocks under-loved and undervalued - who wants a defensive investment when everyone's playing offense? - and he likes the growth prospects of companies in emerging markets, although he finds them far from cheap. He believes it's possible to get the best of both worlds by focusing on shares of multinationals that derive substantial portions of their sales in emerging markets. Here's some of his thinking:

"The global equity markets taken together are moderately overpriced, and the U.S. part is now very overpriced but not nearly so bad as it could be. Surprisingly, within the U.S. the large, high-quality companies are still a little cheap, having been left totally behind in the rally. They are unlikely to do very well in a bubbly environment, however long it lasts, but should be great in declines and in the end should win. A potential plus for quality franchise stocks in the next few years is that they are far more exposed to emerging countries and, as investors fall in love with all things emerging, this should be seen as an increasing advantage."
Grantham is a brilliant strategist and it's hard to fault his logic here. Still, there is something disturbing about his willingness to participate in a stock market - even a comparatively safe segment of it - that he sees as so dangerous. It reminds me of a remark made about a decade ago by another veteran investor who had been accorded guru status, a well respected strategist for a well regarded Wall Street firm (in the interest of fairness, I won't mention his name because I'm recalling the details from distant memory).

The strategist conceded that the Standard & Poor's 500-stock index was about 40 percent overvalued. Instead of advising investors to sell everything, buy canned goods and a shotgun and head for the hills, he encouraged them to stay in the market. Stocks were extremely expensive, he reasoned, but they were likely to become even more so.

I found it an astonishing recommendation. Reasonable people wouldn't buy houses that they thought were 40 percent overvalued (except maybe in 2005 with no money down and a subprime mortgage).

Nor would they go for cars, suits, televisions, books or anything else priced so extravagantly. So why would a conservative professional investor, with many years and several big market declines behind him, counsel being in a stock market that he was sure was so richly priced? It's not as if people are required to own stocks.

Whatever his reasons, it was a terrible call. The market soon collapsed, led by technology stocks. At least he had been right about it being extremely overvalued, and by way more than 40 percent.

Is Grantham making the same mistake? He's certainly more circumspect and selective than the other strategist was, and it's probably cheeky of me to question someone of Grantham's stature. But there's an adage that a bull market ends when the last bear has turned bullish. Grantham may be that last bear.

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