AI craze stokes ‘bubble within a bubble,’ says GMO’s Jeremy Grantham

The U.S. stocks appear expensive after investor mania surrounding artificial-intelligence interrupted the bursting of an initial market bubble that was deflating in 2022, according to GMO’s Jeremy Grantham.

The U.S. stocks appear expensive after investor mania surrounding artificial-intelligence interrupted the bursting of an initial market bubble that was deflating in 2022, according to GMO’s Jeremy Grantham.

“Prices reflect near perfection, yet today’s world is particularly imperfect and dangerous,” Grantham, who co-founded Boston-based investment firm GMO in 1977 and is known for calling bubbles, said in a new paper. 

Pointing to “the current AI bubble,” Grantham said that “a new bubble within a bubble like this, even one limited to a handful of stocks, is totally unprecedented, so looking at history books may have its limits.”

In January 2022, Grantham warned that the U.S. was nearing the end of a “superbubble” across major asset classes. Both stocks and bonds plunged that year as the Federal Reserve aggressively hiked interest rates in a bid to tame surging inflation. But the launch of ChatGPT in late 2022 paused the deflation of the equities bubble that he saw, according to his note.

“We paused in December 2022 to admire the AI stocks,” he said. “Even though, I admit, there is no clear historical analogy to this strange new beast, the best guess is still that this second investment bubble — in AI — will at least temporarily deflate and probably facilitate a more normal ending to the original bubble.”

The U.S. stock market has risen to records this year, with the S&P 500 SPX booking an all-time closing peak on March 7 and the technology-heavy Nasdaq Composite COMP scoring a fresh closing high at the start of this month. The Dow Jones Industrial Average DJIA also notched a record close this year, on Feb. 23.

“What happened to our 2021 bubble?” Grantham wrote. “The COVID stimulus bubble appeared to be bursting conventionally enough in 2022 — in the first half of 2022, the S&P declined more than any first half since 1939, when Europe was entering World War II.”

But now the broad U.S. stock market is expensive, with a Shiller price-to-earnings ratio of 34 as of March 1, which is “the top 1% of history,” while total profits are also near record levels, he said.

“The paradox that worries me here for the U.S. market is that we start from a Shiller P/E and corporate profit margins that are near record levels and therefore predicting near perfection,” Grantham wrote.

“If margins and multiples are both at record levels at the same time, it really is double counting and double jeopardy — for waiting somewhere in the future is another July 1982 or March 2009, with simultaneous record-low multiples and badly depressed margins.”

The U.S. stocks appear expensive after investor mania surrounding artificial-intelligence interrupted the bursting of an initial market bubble that was deflating in 2022, according to GMO’s Jeremy Grantham.

“Prices reflect near perfection, yet today’s world is particularly imperfect and dangerous,” Grantham, who co-founded Boston-based investment firm GMO in 1977 and is known for calling bubbles, said in a new paper. 

Pointing to “the current AI bubble,” Grantham said that “a new bubble within a bubble like this, even one limited to a handful of stocks, is totally unprecedented, so looking at history books may have its limits.”

In January 2022, Grantham warned that the U.S. was nearing the end of a “superbubble” across major asset classes. Both stocks and bonds plunged that year as the Federal Reserve aggressively hiked interest rates in a bid to tame surging inflation. But the launch of ChatGPT in late 2022 paused the deflation of the equities bubble that he saw, according to his note.

“We paused in December 2022 to admire the AI stocks,” he said. “Even though, I admit, there is no clear historical analogy to this strange new beast, the best guess is still that this second investment bubble — in AI — will at least temporarily deflate and probably facilitate a more normal ending to the original bubble.”

The U.S. stock market has risen to records this year, with the S&P 500 SPX booking an all-time closing peak on March 7 and the technology-heavy Nasdaq Composite COMP scoring a fresh closing high at the start of this month. The Dow Jones Industrial Average DJIA also notched a record close this year, on Feb. 

“What happened to our 2021 bubble?” Grantham wrote. “The COVID stimulus bubble appeared to be bursting conventionally enough in 2022 — in the first half of 2022, the S&P declined more than any first half since 1939, when Europe was entering World War II.”

But now the broad U.S. stock market is expensive, with a Shiller price-to-earnings ratio of 34 as of March 1, which is “the top 1% of history,” while total profits are also near record levels, he said.

“The paradox that worries me here for the U.S. market is that we start from a Shiller P/E and corporate profit margins that are near record levels and therefore predicting near perfection,” Grantham wrote.

“If margins and multiples are both at record levels at the same time, it really is double counting and double jeopardy — for waiting somewhere in the future is another July 1982 or March 2009, with simultaneous record-low multiples and badly depressed margins.”

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‘Can’t get blood out of a stone’

When the price of an asset doubles, its future return is halved, Grantham said in his latest paper.

“The simple rule is, you can’t get blood out of a stone,” he wrote.

To Grantham’s thinking, the long-term prospects for the U.S. stock market look “poor” as it’s generally overpriced and never has seen “a sustained rally starting from a 34 Shiller P/E.”

“The only bull markets that continued up from levels like this were the last 18 months in Japan until 1989, and the U.S. tech bubble of 1998 and 1999, and we know how those ended,” he said. “Separately, there has also never been a sustained rally starting from full employment.”

While AI seems likely to be at least “as powerful and world-changing as the internet,” tech revolutions tend to see “early massive hype and a stock-market bubble,”  according to Grantham.

He cited Amazon.com Inc. AMZN, 2.01% as an example of speculation in the late 1990s, noting its stock plunged before the company rebounded into the giant online retailer it is today.

“As the most remarkable example of the tech bubble, Amazon led the speculative market, rising 21 times from the beginning of 1998 to its 1999 peak, only to decline by an almost inconceivable 92% from 2000 to 2002, before inheriting half the retail world!” Grantham wrote.

In his paper, the GMO co-founder didn’t stop at warning about looming dangers for U.S. stocks should the “AI bubble” burst and finish the job deflating the “original bubble” that had worried him.

“It also seems likely that the after-effects of interest-rate rises and the ridiculous speculation of 2020-2021 and now (November 2023 through today) will eventually end in a recession,” Grantham cautioned.

On a brighter note, Grantham said there’s “a reasonable choice of relatively attractive investments” in the  U.S. equities market, such as “quality” stocks. He also cited resource equities, “climate-related investments,” such as solar stocks, and “deep value” as areas of the market to consider.

“U.S. quality stocks have a long history of slightly underperforming in bull markets and substantially outperforming in bear markets,” he said, “although they did unusually well in the recent run-up.”

The GMO U.S. Quality ETF QLTY, which the firm launched in November, has gained 9.2% this year through Monday, according to FactSet data. That exceeds the S&P 500’s year-to-date gain of 7.3%.