What Signals to Look for to Spot a Market Bubble
Christine Benz: We wanted to start by talking about bubbles, and you are a student of bubbles. I was listening to an interview that you did where you talked about your entry point into investing. You were looking for the places where your fellow business school grads were having the most fun, and you homed in on micro-caps. I’m curious, is the inverse kind of a signal to you today when you’re on the hunt for bubbles or on the lookout for bubbles? Do you look for those areas where people seem to be having the most fun and use that as a signal that perhaps there’s some froth there?
Jeremy Grantham: I think that’s not a bad idea. Bubbles and enthusiasm, ecstasy, they’re all kind of closely related. And I like to say it’s not an accident that the most euphoric periods in the market’s history, all four of them really—1929, 1972, tech bubble of 2000, the great financial crash 2008, and you could add 2011 December. Those are the five euphoric points, and the first four, it’s not an accident, they’re all followed, not by the best economic times and the best market returns. They are followed by the four worst economic setbacks and the four worst periods of stock market return. What a strange coincidence.
We all learned at business school that high P/Es are meant to be reflecting the best possible future. And what we find is the highest four P/Es, highest amount of euphoria, are precisely followed by the four worst economic outcomes: the Great Depression, the Great Recession of ‘73-’74, the worst since the Depression, the crash and the recession after the tech bubble burst, and the real moment of truth when the great financial crash occurred when the whole financial system of the developed world teetered on the edge of total meltdown. So, what a strange paradox that the market’s predictive power is precisely, perfectly the opposite of what we were taught.
Why AI’s Explosion Looks Different Than 2022’s Market Bubble Burst
Dan Lefkovitz: Well, we had a major downturn in 2022, but then in 2023, the market bounced back and the first half of ‘24 was quite exuberant as well. Obviously, a lot of enthusiasm about artificial intelligence. Do you see two bubbles having formed, one that burst in 2022 and then reinflated, or is it all part of the same bubble?
Grantham: No, this is unique. These are two fairly distinct events, one merging almost into the other. We had a classic bubble in every way, perfectly ordinary in the context of the other four in 2021. And melting down the first half of 2022 was the worst market for stocks and bonds since 1939, the year after I was born. That’s quite a long time. And then in November of that year, October or November, when they introduced the Chat, a handful of stocks that happened to be very large that had a future that they could relate to AI took flight. The rest of the market drifted lower as a matter of fact for another 10 months. And all of the gain, plus a little, was in the hands of the “Magnificent Seven,” all of which had an AI story to tell.
And then finally, impressed by this steady advance, and also impressed by AI itself, the broader market jumped on board in late ‘23, the other day really, and we had a broader market advance. So, this is unique as if you came in in 1932 with some magnificent new invention, some really cheap fusion or something. And AI is serious. It will change everything. And therefore, it’s not surprising the market took it seriously.
The bigger the new idea, the bigger the new invention, the more the market becomes overpriced, the more it attracts euphoria. It’s not accidental. Really great things happen in the internet phase, ‘98-’99. But they overdo it. They overdid it with the canals apparently in England. They overdid it magnificently all over Europe, particularly the UK, but also the US with railroads. They were spectacular bubbles. The canals were huge; the railroads were even much more profound—changed everything. They were serious, but that didn’t stop them from attracting too much capital, charlatans, putting eight different railroad lines between Manchester and Liverpool, or planning them and raising capital for them when one or two was clearly enough. And the result was a bubble that broke for canals and railroads, and then somewhat the same with automobiles and radio and so on in 1929. Electrification of everything and development of mass markets for a lot of them.
And then the internet. The internet was serious. We all use the internet. We can’t live without our iPhones, and yet it was overdone. Everyone knows that Amazon went up multiple times in ‘99. I forget how many times, but several times. It was the star of ‘99, which was a great year to be a star. And then in the break, they went down 92%. Very few people realize that. Amazon, a huge success, went down 92%. And then it rose from the wreckage, as did a handful of them, and inherited the earth. But how many, what fraction of those stars of ‘99 survived? I think 80% of the internet stocks just ceased to exist. Some were bought for scrap iron price. Basically, they ceased. And a handful of super leaders emerged.
So, the fact that it’s a real idea doesn’t say that there won’t be a crash. It’s quite the reverse. The more important the idea, the more guaranteed almost it is, historically, that it will attract too much short-term attention, then there will be a crash, and then the railroads will change the world, the internet will change the world, AI will change the world. But it would be classic for it to be overdone. That’s what the history book is shouting at us. And to have that come in the middle, if you will, in the middle of a gentile old-fashioned bubble forming and breaking, is to create a very novel and complicated twist. But it happens. That’s what life is all about. Every now and then something really weird happens, and a guy catches the football on the back of his helmet. They do happen. And this is it.
So, where we go from here, I think, is back to the history books. When you have these great developments, they overdo themselves in the short term, they crash in the intermediate term, and then they come out of the wreckage and change the world in the long term. And that’s what I expect will happen this time.
How AI Companies Compare With Companies in the Late ‘90s Internet Bubble
Benz: You referenced the late ‘90s period and that basket of internet stocks, many of which were pretty junkie companies. I wanted to see if you could contrast that with the AI companies, which seem to be a higher-quality basket of companies. And you have been interested in quality for many years. You launched GMO’s Quality Strategy Fund 20 years ago, and GMO recently launched an ETF around quality. So, could you contrast the fundamental characteristics of the AI companies with some of those technology companies that led the bubble in that late ‘90s period?
Grantham: This seems like a Ph.D. paper question. There were obviously a lot of Pets.com ideas on the internet—lightweight companies. There are probably quite a few. This time, and history will decide which ones they are, but the very nature of quality is monopoly. Let’s face it. We define quality and always have as high stable returns. The only way in a competitive society you have high stable returns is to find a nook or a cranny that is not that competitive—i.e., you have a monopoly. You have a defensive moat. So, what we’re talking about is the dramatic emergence in the last 10 years or so of what you might call great global monopolies, almost instant in some cases, where winner takes all, first come, first served, they grab the market, they defend it brilliantly, ferociously. It’s what capitalists do. It’s what they’re paid to do. And it’s what all the brilliant leaders manage to achieve.
The role of government, one might argue, is to try and maintain a world where they don’t become too powerful, where it isn’t a license to charge any price because you have a monopoly. And there is no question that the government’s actions against monopoly have basically been soundly asleep for about 20 years until very recently. And now in the US and Europe, they come out of their deep sleep, and they start to poke around some of the great new monopolies. But that’s the essence of quality, a monopoly feature. It used to be Coca-Cola, and yes, it was a duopoly with Pepsi, but you get my point. You couldn’t easily compete with these guys. They had wonderful brands.
And here we are with a couple of handfuls of brilliant, basically, monopolies and the introduction of the internet and everything related to the internet in the last 20 years has facilitated, first come, first served, the first mover, or the first best person to scale up has a huge advantage. And if they defend it cleverly, up to the letter of the law and perhaps a little beyond, in the end, these things are up for interpretation, they can build a monopoly much more quickly than they ever could in the past. And they have to. And that is a major, major issue going forward. Will governments allow these basically American giant monopolies to rule the roost? Or will they break them up or act in some way that moderates their profit margins? We’ll find out.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
