U.S. stocks aren’t cheap: Grantham

By Rachel Koning Beals

CHICAGO (MarketWatch) — There’s nothing wrong with a little market optimism, but this just isn’t the time for it, asset manager and GMO co-founder Jeremy Grantham said Friday.

“It’s a very strange time, and I get this kind of Groundhog Day effect as if the news is just replaying and replaying,” Grantham said in a speech at the Morningstar Investment Conference here. “The EU just goes round and round in tortuous circles, [Federal Reserve Chairman Ben] Bernanke is talking the same game and the market just goes up and down.”

Jeremy Grantham

Yet being optimistic is “programmed” into human nature. History tells us things will turn around. After all, the financial-services industry has a “huge investment in being bullish,” he added.

As such, investors should be prepared to see a bullish bias in the U.S. stock market in normal situations.

“People like to stay in the pack. Sometimes the pack wants to go hurtling downward, and you can have a bearish bias to create a herding effect [that’s] far away from anything sensible and still with a bullish [underlying] bias.

“People think the U.S. stock market is cheap and we don’t, because we want it to be priced to normal earnings,” according to Grantham. “GMO ruthlessly normalizes earnings to long-term averages.”

The counterargument to this stance is that earnings are justified because there’s been a so-called paradigm shift to higher margins. “That’s what bulls like to say. We say other things being equal, we’ll always bet on the average,” the asset manager said. “We have high unemployment and a justifiably scary world and yet high profit margins.”

Grantham pointed to data showing that rising government-debt levels fuel higher profit margins for companies. When the government starts to pay down its debt, so go profit margins. “Right now, it’s an odd effect — a prop to the market,” he commented.

Stocks fell on Thursday, pushing government-bond prices higher and yields lower as a batch of worrisome U.S., euro-zone and Chinese economic data as well as fresh worries about bank-credit downgrades soured sentiment. Losses accelerated after Goldman Sachs issued a note recommending short positions in the S&P 500 Index SPX +0.75% .

On Friday, the major U.S. indexes rebounded in the wake of comments by the European Central Bank that it would take further steps to ease loan collateral for banks. Read about the day’s action in Market Snapshot.

The Federal Reserve this week disappointed Wall Street when the central bank refrained from a fresh round of aggressive stimulus measures. Instead, the Fed opted to extend “Operation Twist,” in which it sells short-term Treasurys and buys longer-dated bonds as a mechanism to hold down long-term borrowing costs.

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