‘Extreme, illogical, and dangerous’: Jeremy Grantham warns of ‘bubble within a bubble’ in US stock market — but here’s what he still finds ‘relatively attractive’

AI bubble

The S&P 500 is up 81% since five years ago, but the journey was not always sunshine and rainbows. For instance, after a strong rally in 2021 — fueled by what Grantham calls "the COVID stimulus bubble" — the market entered a sell-off in early 2022.

However, Grantham noted that the deflating bubble in 2022 was “rudely interrupted” in December by the launch of ChatGPT. As investors began to recognize the potential of artificial intelligence, a new wave of enthusiasm emerged.

Reflecting on investors’ insatiable appetite for AI, Grantham said that “a new bubble within a bubble like this, even one limited to a handful of stocks, is totally unprecedented.”

Moreover, Grantham highlighted a paradox: the stock market's optimism contrasts sharply with a backdrop of geopolitical instability, democratic concerns, and significant long-term challenges, presenting a precarious situation.

“The stark contrast between apparent embedded enthusiasm and these likely problems seems extreme, illogical, and dangerous,” he said.

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4 opportunities

While Grantham is concerned about the risks facing the U.S. stock market, he also outlined a “reasonable choice of relatively attractive investments” for those who have to stay in that arena.

Quality

Grantham observed that quality U.S. stocks have a notable history: they tend to slightly underperform during bull markets but substantially outperform in bear markets, leading to what he describes as their "remarkable" long-term performance.

While the investor also acknowledged that these stocks are “not spectacularly cheap” at the moment, the payoff could be significant. He disclosed that at GMO LLC, the investment firm he co-founded, the Quality Strategy has outperformed 1.3% a year above the S&P 500 for the last 10 years.

What defines quality stocks?

Grantham explained in his report's footnotes, “The essence of a quality stock is a high stable return on equity and an impeccable balance sheet.”

Resource equities

Grantham advocates for resource stocks, pointing to the finite nature of natural materials and their potential for price appreciation.

He also emphasized that, over longer periods, resources “are the only sector of the stock market to be negatively correlated with the broad stock market,” offering valuable diversification opportunities. Additionally, Grantham described the sector as “particularly cheap.”

Climate-related investments

Grantham believes that climate investments can deliver revenue growth that’s “guaranteed to be above average for the next many decades.” He attributes this potential to escalating climate damage and a growing readiness among governments to intervene.

For those interested in climate investments, solar is a segment worth exploring. According to Grantham, solar stocks are currently priced “at over a 50% discount to the broad equity market.”

Deep value

Finally, Grantham contends that deep value stocks currently appear significantly undervalued compared to the broader market.

“The most expensive 20% of U.S. stocks are by definition always expensive, but today they are in the worst 10% of their 40-year range (compared to the top 1000 stocks). In great contrast, the cheapest 20% are in the best 7% of their range,” he said.