During his recent interview with Morningstar, Jeremy Grantham discussed the paradox of market euphoria and its aftermath. He observes that the most euphoric stock market periods—1929, 1972, the tech bubble of 2000, the 2008 financial crisis, and 2011—were followed not by strong economic growth but by some of the worst downturns in history.
Contrary to business school teachings, high price-to-earnings (P/E) ratios are expected to signal optimism and promising futures.
However, Grantham argues that these peaks in valuation have consistently preceded economic collapses, challenging the predictive power of high P/E ratios and underscoring the unpredictable and often counterintuitive nature of markets.
Here’s an excerpt from the interview:
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.
You can listen to the entire interview here:
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