We Asked GMO’s Head of Asset Allocation Why This Bubble is Easy — But Investors Will Get it Wrong

Summary

Excess Returns Podcast Summary

Episode: We Asked GMO’s Head of Asset Allocation Why This Bubble is Easy — But Investors Will Get it Wrong

Date: June 24, 2026 | Guest: Ben Inker (GMO’s Head of Asset Allocation)
Hosts: Jack Forehand, Justin Carbonneau, Matt Zeigler

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Episode Overview

This episode tackles how AI-driven speculation has led to a new "easy" bubble in US equities, according to Ben Inker from GMO. The discussion compares today’s market environment with previous bubbles, explores the concept of an "easy bubble" versus a "hard bubble," and dives into the mechanics behind asset allocation and return forecasting through the lens of recent GMO research. Particular attention is given to the dangers of ignoring earnings bubbles, the distortions of modern capital cycles, implications for private equity, and how investors can build robust portfolios in uncertain times.

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Key Discussion Points & Insights

1. Understanding “Easy” vs. “Hard” Investment Bubbles

• Easy Bubble Defined:
  An "easy bubble" is one where an investor, aware that certain assets are overvalued, can construct a portfolio with normal risk allocations without being forced to do something extreme (like move entirely to cash), while still avoiding the bubble’s worst pain.
  • Quote: “An easy bubble is one where you can take a normal amount of risk and still avoid most of the pain of the bubble.” — Ben Inker [05:01]
• Historical Context:
  • Internet Bubble (2000): Overvalued growth stocks were avoidable by owning small caps, REITs, emerging market equities/debt, etc. A normal 60/40 portfolio could be constructed while dodging the worst excesses.
  • GFC Bubble (2007): All risk assets globally were overheated, forcing true derisking (i.e., moving to cash), which is hard to justify unless the bubble bursts quickly.
  • 2021 Bubble: Both stocks and bonds were simultaneously overvalued ("everything with duration"); cash was unappealing due to inflation, and clients resisted all-cash strategies.
  • AI / Current Bubble: US large and small caps are overvalued, but non-US risk assets still look relatively attractive. Thus, it’s currently possible to avoid US bubble risk through global diversification without looking "crazy" if the bubble persists or bursts.

2. Risk-Return Tradeoffs and Portfolio Construction

• Risk-Reward Slope:
  In a well-functioning market, taking more risk should be rewarded with higher returns. Historically, this is visualized as a positively sloped line when plotting return vs. risk. In past bubbles, this positive slope weakened or inverted, indicating distorted incentives.

  • Quote: “The slope of that line should be positive... you should really see a positive slope to that line.” — Ben Inker [10:53]

• US vs. International Assets:

  • Non-US assets have improved in value, and their risk/return profiles are now relatively favorable versus US equities. However, as non-US and EM assets have performed well, the opportunity to capture undervaluation is closing.

3. Earnings Bubbles vs. Valuation Bubbles

• Earnings Bubble Warning:
  Much of the current elevated profit levels, especially in AI “data center” buildouts, may be unsustainable because earnings have been temporarily inflated by massive capital spending, which lifts revenue (and therefore, profits) in the short term but is not durable.
  • Quote: "This may be an earnings bubble...2000 was a little bit of that, but mostly a valuation bubble." — Ben Inker [22:07]
• Cycle Parallels:
  Investing cycles driven by new technologies (AI, railroads, internet, etc.) are frequently followed by profit disappointments as capital is over-invested, with returns often accruing to end-users rather than the builders.

4. Structural Risks: Supply, Demand, and Market Elasticity

• Inelastic Markets Hypothesis:
  Contrary to standard finance theory, even modest increases in supply (via IPOs, share issuance) can have large negative pricing impacts. The coming year may see an unprecedented amount of supply hit US equity markets due to major tech IPOs.

  • Quote: “Over the next 12 months we see more supply come into the US stock market than has been the case in living memory.” — Ben Inker [39:39]

• Circular/Ponzi Financing in AI Capex:
  Many high-profile deals are being financed in complex, often circular ways using equity, warrants, and debt, reminiscent of previous bubble excesses but at a much larger scale.

5. Return Forecasting Methodology

• GMO’s Approach:

  • Uses a seven-year mean reversion model, estimating asset income, expected growth, and valuation shift back to fair value.
  • Produces forecasts for both low and normal long-term interest rate environments.
  • Favors international over US equities, and value/deep value stocks over large cap growth, given current valuations.

• Portfolio Strategy: Benchmark-Free Portfolio

  • By discarding traditional tracking error constraints, GMO aims to optimize for actual risk and return rather than regularity with client benchmarks.
  • Emphasizes holding only those assets with favorable risk/reward — not those included out of benchmark inertia or fear.

6. Lessons from Private Equity Analysis

• Private vs. Public Equity Biases:
  • GMO’s research leveraging AI on 730+ LBOs showed LBO targets are overwhelmingly small-cap, lower profitability, and often high-debt companies ("kind of junk").
  • Investors allocating to private equity are unintentionally concentrating exposure to small and low-quality stocks—traits that have underperformed in public markets.
  • Suggests public portfolio adjustments: overweighting quality, underweighting junk to balance private equity biases.

7. Why Investors Will Get This Bubble Wrong

• Client/Advisor Behavior:

  • Real-world investment decisions are constrained by client patience, fear of underperformance, and the tendency to fire managers for short-term lagging even when strategies are correct in the long run.
  • Quote: “The real problem with these situations is if you need to run a portfolio that is going to look very stupid, if the world fails to fall apart quickly, your client is going to fire you.” — Ben Inker [18:03]

• Understanding Why You Get Paid in an Asset:

  • Knowing the risk premium basis for an investment is critical in avoiding “stupid mistakes” — i.e., being lured by superficially attractive but fundamentally dangerous strategies.
  • Quote: “Understanding why you are getting paid for the activity you are doing is really crucial.” — Ben Inker [68:47]

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Memorable Quotes & Timestamps

• "An easy bubble is one where you can take a normal amount of risk and still avoid most of the pain of the bubble." — Ben Inker [05:01]
• "Just because something changes the world doesn't necessarily mean the profits accrue to the people who built it." — Ben Inker [28:56]
• "Earnings bubbles can exist. One of the things that can drive them is rapid increases in investment." — Ben Inker [22:39]
• "Over the next 12 months we see more supply come into the US stock market than has been the case in living memory." — Ben Inker [39:39]
• "Clients would fire us and hire the aggressive growth managers. And so they made less money on the way up and they lost more on the way down." — Ben Inker [18:30]
• "What have we learned living through four bubbles in 26 years? ... Timing this stuff is tough, and they can go on longer than you ever thought possible." — Ben Inker [19:59]
• "Owning non-US dollar currencies for US-based investors is going to be a tailwind because of the overvaluation of the dollar." — Ben Inker [50:34]

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Important Timestamps & Segment Guide

• [03:43] — Defining “easy” vs. “hard” bubbles (Internet Bubble, GFC, 2021 Bubble, AI Bubble)
• [09:54] — Explaining risk/return scatter plots and positive slope interpretation
• [17:15] — Why optimizers and client realities diverge; the pain of being "right" too soon
• [21:09] — Today vs. 2000: Valuation vs. earnings bubbles
• [27:27] — Historical perspective on capex/technology cycles (AI compared to railroads, electrification, internet)
• [31:56] — Circular and debt-based financing in the AI investment cycle
• [38:19] — Effects of increasing supply (IPOs, share issuance) on market valuations
• [43:45] — GMO’s methodology behind 7-year asset class return forecasts
• [49:03] — International vs. US equities, value vs. growth
• [53:33] — Concept of “benchmark-free” portfolios and their rationale
• [60:19] — In-depth findings from GMO’s research on private equity/LBOs
• [68:47] — Knowing “why you get paid” in an asset class for smarter investing

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Summary: Takeaways for Investors

• Current market bubble shares traits with past bubbles but is avoidable through global portfolio diversification and careful asset selection.
• Today’s “AI bubble” may be less about price and more about earnings, which are at cyclical highs due to heavy investment — dangerous for those not paying attention.
• Large surge in equity supply from IPOs and share issuance, paired with complicated and potentially unstable financing, poses real risk for US stocks.
• Private equity exposure is akin to a concentrated small-/junk-stock bet — public portfolios may need an offsetting quality tilt.
• Investors who understand the risk premium and behavioral/career constraints are best positioned to avoid common, costly mistakes.

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Final Thought:
Ben Inker and the GMO team advise a grounded, thoughtful approach: focus on value-driven, globally diversified portfolios and resist being swept up by narratives, especially during times of euphoria and abundant capital. The real challenge isn't spotting a bubble—it’s surviving it with your investment discipline and relationships intact.

Transcript

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[Ben Inker]

A tricky thing about today is we

[Jeremy Grantham]

worry that this may be an earnings bubble. 2000 was a little bit of that, but mostly a valuation bubble. We saw earnings bubbles in Europe in,

[Ben Inker]

you know, in 2007, 2008, where like the earnings had just gone up 100% over four years and even today they are struggling to make it back up on an index basis to those levels. We are likely to be in a

[Jeremy Grantham]

situation where over the next 12 months we see more supply come into the

[Ben Inker]

US stock market than has been the case in living memory. Understanding why you are getting paid for the activity you are doing is really crucial.

[Jeremy Grantham]

Just because something changes the world doesn't necessarily mean the profits accrue to to the people who built it.

[Podcast Host]

Ben, welcome back to Excess Returns. Thank you for joining us.

[Ben Inker]

Very happy to be here.

[Podcast Host]

We were just talking. It was 2021 the last time you were on the podcast. It's hard to believe it was that many years ago, but we always appreciate having you or the other folks at GMO on with us in our audience. You know, you spend your time managing portfolios and building investment strategies, but you and your team also think deeply, read extensively about markets, valuation, asset allocation, stock market history and a number of other investing topics. And today what we thought we would do with you, and we're excited to do this, is kind of look at some of the recent research that you've put out, the firm has put out and sort of just work through those items with you. I think we're going to start with the AI sort of boom and you know, possibly bubble that we're in and kind of talk about how that I guess correlates to, you know, past market bubbles. And then we'll get into some of the research that you've done on private equity and some long term return forecasting expectations. So it's looking forward to a good, thoughtful discussion with you today. So where I want to start with you is related to a recent piece of research that you put out. And it was sort of looking at where we are today in the market with AI and looking at it from like an investment bubble perspective, where valuations are the markets, you know, the speculation that's sort of underneath. And one of the things that you said is that it's one of the easy, easy bubbles, easy ones, as you put it, for an agnostic investor to handle. So can you just explain sort of, I guess, what would, what would be the difference between an easy bubble and a hard one to understand and kind of what you meant by that?

[Ben Inker]

Yeah.

[Jeremy Grantham]

So for us, you know, an investment bubble is a situation where at least

[Ben Inker]

some important asset out there has risen to a level where it feels pretty close to unownable. That's not the only definition of a bubble. But from the standpoint of putting together a portfolio, that's a useful one.

[Jeremy Grantham]

And we've had a number of those

[Ben Inker]

in the last 25, 26 years.

[Jeremy Grantham]

Um, and what makes some of them different from others is if you believe the situation that we believed at the time. So we believed we were in a

[Ben Inker]

bubble in each of those times.

[Jeremy Grantham]

How hard is it to put together

[Ben Inker]

a portfolio that can avoid the worst of the pain

[Jeremy Grantham]

and yet allow you to retain your clients? Because the problem with some bubbles is that avoiding them means running a portfolio where if the world was normal, that

[Ben Inker]

portfolio would make no sense.

[Jeremy Grantham]

An easy bubble is one where you can take a normal amount of risk

[Ben Inker]

and still avoid most of the pain of the bubble.

[Jeremy Grantham]

So my example of an easy bubble

[Ben Inker]

in the last quarter century was the Internet bubble.

[Jeremy Grantham]

In the Internet bubble, growth stocks around the world were horrendously overvalued. The S&P 500 was the most expensive

[Ben Inker]

it had ever been in history. And even today, it has still never passed those valuation points, at least on most normal valuation metrics.

[Jeremy Grantham]

But it wasn't that hard a bubble to navigate because you could actually own

[Ben Inker]

a normal amount of stocks. If kind of normal is a 6040 portfolio.

[Jeremy Grantham]

You could run a portfolio that was

[Ben Inker]

60% in stocks and yet not have to own any of the really overvalued stocks. You just had to say, okay, instead

[Jeremy Grantham]

of owning large cap growth, I'm going to own small caps, I'm going to own REITs.

[Ben Inker]

I'm going to own emerging equity. I'm going to own emerging debt.

[Jeremy Grantham]

You're still owning risk assets. And the crucial thing about the fact that you're still owning risk assets is let's imagine for a second that you

[Ben Inker]

were wrong and the world was completely normal, right?

[Jeremy Grantham]

You still own a portfolio that has a normal amount of risk assets. You still own a portfolio where if everything is normal and you'll get a normal return, there'll still be plenty of tracking error versus the cap weighted portfolio. But you are not necessarily giving up

[Ben Inker]

long term returns for the sake of, of saving you from, from the pain.

[Jeremy Grantham]

So that was a bubble that was relatively easy to navigate. The next bubble in the global financial crisis was a lot harder because it didn't just affect large cap growth stocks,

[Ben Inker]

it affected all risk assets everywhere around the world.

[Jeremy Grantham]

As near as we can, we could tell at the time, every single risk asset was substantially overpriced. And that meant in order to save

[Ben Inker]

yourself from the pain, you really needed to not own risk assets.

[Jeremy Grantham]

That is an incredibly hard thing to

[Ben Inker]

do because if you're wrong, you are giving up a tremendous amount of return for your clients.

[Jeremy Grantham]

And if you are not raw, if you are not right quickly, your clients

[Ben Inker]

are going to really lose patience with you. The next bubble, which from our perspective occurred at the end of 2021, was

[Jeremy Grantham]

an even harder one to deal with because stocks and bonds were simultaneously really overvalued. That was a time where everything with duration was really overvalued. So avoiding losing money didn't just mean moving to high quality bonds from stocks,

[Ben Inker]

but it meant moving to cash or something. Cash like.

[Jeremy Grantham]

And the problem with that is everybody

[Ben Inker]

knew cash was going to lose to inflation.

[Jeremy Grantham]

And the other thing is, if you've

[Ben Inker]

got clients, you guys have clients, we have clients.

[Jeremy Grantham]

The one thing they don't want you to own for them is cash.

[Advertiser/Commercial Voice]

Right?

[Jeremy Grantham]

You do not need a professional money

[Ben Inker]

manager to own cash.

[Jeremy Grantham]

You can do that in the bank. So moving your clients to cash, you

[Ben Inker]

have the shortest potential leash there in terms of time. So that's a really difficult bubble to deal with.

[Jeremy Grantham]

The AI bubble, we think that this

[Ben Inker]

is really a bubble in US stocks writ large.

[Jeremy Grantham]

So large caps, yes, but small caps in the US still look pretty overvalued. The good news is if you move outside of the US you can still own plenty of risk assets which are priced to deliver a decent return. So this is one of those times where you can put together a portfolio of stocks and bonds that avoids most

[Ben Inker]

of the peril from the bubble we think exists today and yet isn't an

[Jeremy Grantham]

insane portfolio to own if you're wrong

[Ben Inker]

and everything is actually normal.

[Podcast Host]

And we'll put these risk and return charts in here so people can see them because you have all these different asset classes both in 2000, 2007, I think, and then you have it as of late 2025. What does the just talk. I mean, maybe you could just explain what we're looking at. It's kind of obvious based on what's the chart. But I think it would be good to Ben, to just walk through that real quick and then talk about the difference between, I guess, what is this? Does the slope tell us anything? How the slope is positive on two of them and then negative in 07. Can you just talk to that? Maybe that's to the valuation point, but I'll let you explain.

[Jeremy Grantham]

Yeah, so the charts you're talking about are charts we have built of the forecast we were showing to clients at the time.

[Ben Inker]

So this is not some sort of data mine backcast, but the forecast we were showing our clients at each of

[Jeremy Grantham]

those times, we're showing them as a risk reward scatterplot. So the horizontal axis, as you go

[Ben Inker]

out farther from the origin, you're getting

[Jeremy Grantham]

to riskier and riskier assets, vertical.

[Ben Inker]

The higher you are on the page, the higher the expected risk return.

[Jeremy Grantham]

And the importance of that risk reward

[Ben Inker]

line, of that regression line is that's

[Jeremy Grantham]

basically telling you how much are you

[Ben Inker]

getting paid for taking risk.

[Jeremy Grantham]

The slope of that line should be positive, right? In a rational, properly functioning capital market, you should get paid for taking more risk. Now, risk isn't exactly the same thing as volatility, but it's close enough for

[Ben Inker]

this purpose that you should really see a positive slope to that line.

[Jeremy Grantham]

Under normal circumstances, if everything was priced fairly, we think that that line would

[Ben Inker]

have a slope of about 0.7.

[Jeremy Grantham]

So if you look at that line

[Ben Inker]

in 2000 and say that line has a slope of 0.4 that's still positive,

[Jeremy Grantham]

it still means you are getting paid for taking risk somewhat less than normal,

[Ben Inker]

but not an utter disaster scenario.

[Jeremy Grantham]

And so when we look at a

[Ben Inker]

risk reward line like that, we say,

[Jeremy Grantham]

okay, well you probably don't want to

[Ben Inker]

own more risk assets than normal at

[Jeremy Grantham]

a time like that, maybe you want to shade a little bit less. But this is not a time where

[Ben Inker]

de risking your portfolio is a crucial thing because you are getting paid for taking risk. If we looked at the world in 2007 that had been completely turned on

[Jeremy Grantham]

its head, you were paying for the

[Ben Inker]

privilege of taking risk.

[Jeremy Grantham]

This was the first truly global bubble.

[Ben Inker]

As Jeremy Grantham was saying at the

[Jeremy Grantham]

time, every single risk asset we could find looked massively overvalued versus history and not that mispriced relative to each other. So one other crucial thing that was going on in 2000 was the average

[Ben Inker]

risk asset looked much better than the half weighted stock market.

[Jeremy Grantham]

So if you were prepared to own

[Ben Inker]

a risk asset portfolio that looked different

[Jeremy Grantham]

from the market, you could make a

[Ben Inker]

lot more money that way.

[Jeremy Grantham]

In 2007, you couldn't.

[Ben Inker]

That equal weighted portfolio of risk assets looked almost exactly the same as the cap weighted portfolio. So you couldn't diversify your way out of the pain. You needed to move up that line.

[Jeremy Grantham]

You needed to move towards the origin. Now, in one sense, like an optimizer

[Ben Inker]

would say, well, that's easy.

[Jeremy Grantham]

All of the low risk assets have higher expected returns and lower volatility.

[Ben Inker]

Man, this is a piece of cake.

[Jeremy Grantham]

I can just put together a portfolio of just bonds and cash and I'm fine. But as you guys well know, justifying that to your clients is really hard.

[Ben Inker]

Justifying it to your optimizer is easy,

[Jeremy Grantham]

but justifying it to your clients is really hard. In 2021, we didn't have a situation quite like that. You were not paying for the privilege of taking risk. The slope of the risk reward line

[Ben Inker]

was positive, but everything was really below zero.

[Jeremy Grantham]

So. So the across the length and breadth

[Ben Inker]

of assets, just about everything had a negative expected return in real terms. And that to us seemed, well, that's not a sustainable situation. There really needs to be a positive real return to investing over time.

[Jeremy Grantham]

And so what you want is to

[Ben Inker]

own assets where a repricing is going to be as painless as possible. And that means you need to own stuff with really short duration, right? A repricing of stocks is devastating if it's a repricing downward, because stocks have

[Jeremy Grantham]

a really long duration to them.

[Ben Inker]

Bonds have a long duration. Real estate has a long duration. Infrastructure had a long duration. Everything that has private in front of it, well, maybe not private credit, but other things have a long duration.

[Jeremy Grantham]

So what you needed to do was avoid duration. Again, an incredibly difficult thing to do. As of this fall, we thought US equities looked really overvalued.

[Ben Inker]

The rest of the world looked just fine.

[Jeremy Grantham]

It was easy to put together a

[Ben Inker]

portfolio that took a normal amount of risk and looked pretty good. The bad news since then is that a portfolio like that has really done quite well, right? The non US risk assets have done well and their pricing is somewhat less attractive than it was then. The slope of that risk Reward line was 0.4. Then it's 0.1 now.

[Jeremy Grantham]

Now it's still about 0.4 if you excluded US equities and for our part

[Ben Inker]

we kind of want to, at least in the portfolios where we're allowed to.

[Jeremy Grantham]

So in that world, yeah, you are

[Ben Inker]

getting paid for taking risk, but it

[Jeremy Grantham]

is getting to be a tougher environment.

[Ben Inker]

And again, it got there the good way by having emerging do well, having non US equities do well, having emerging debt do well, having almost all risk assets do pretty well.

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[Podcast Co-host/Interviewer]

about like what's obvious to the optimizer, what's obvious to the like the person is like the opposite of each other effectively. And I guess like client behavior and expectations is the sort of the gap between those two things. Like even if it's obvious for an optimizer to own like the risk free asset or something, you can't actually do that in the real world.

[Ben Inker]

Yeah, it's very difficult to do that in the real world. And one of the things the optimizer doesn't know that your client cares a lot about is there is some risk you are wrong.

[Podcast Co-host/Interviewer]

There's a risk it'll keep going too. Even if you know, even if you're right in the long run, there's a risk it's going to go on for a number of years.

[Jeremy Grantham]

Yeah. I mean and that's pain. If you really believe you are going

[Ben Inker]

to be right in the end, you can put up with that pain.

[Jeremy Grantham]

But it is so difficult for the

[Ben Inker]

client to have that faith.

[Jeremy Grantham]

Look, I can tell you, as someone

[Ben Inker]

who has lived through these bubbles and believed this stuff going in, as the

[Jeremy Grantham]

market is moving against you, it is hard to maintain that confidence yourself. And if this is merely, you know,

[Ben Inker]

a professional that you hired, because, I don't know, you liked the story they told and you liked some of their historical track record, your level of faith is going to be a lot lower than my level of faith in myself is.

[Jeremy Grantham]

So the real problem with these situations is if you need to run a

[Ben Inker]

portfolio that is going to look very stupid, if the world fails to fall apart quickly, your client is going to fire you. That is bad for you.

[Jeremy Grantham]

It is also bad for your client because your client is overwhelmingly likely to fire you and hire the person who

[Ben Inker]

was doing the exact opposite of you.

[Jeremy Grantham]

And so we saw this in the Internet bubble. Clients would fire us and hire the aggressive growth managers.

[Ben Inker]

And so they made less money on the way up and they lost more

[Jeremy Grantham]

on the way down.

[Podcast Co-host/Interviewer]

Have you learned anything about, like, how to manage that? I mean, Jeremy told some great stories when he was on recently about this, you know, the late 90s and clients firing you guys and things like that. Like, have you learned anything about how to maybe make clients, like, stick with a strategy better? I mean, part of this is human nature that you probably can't adjust. But I mean, have you learned anything this time relative to what you went through that time?

[Jeremy Grantham]

So we've learned a few things.

[Ben Inker]

I think. I hope one of them is about in managing the portfolio.

[Jeremy Grantham]

And so in the 2000 event, we were running more de risked portfolios than

[Ben Inker]

we needed to,

[Jeremy Grantham]

and it worked out just fine because bonds did well.

[Ben Inker]

And, you know, the path for stocks was a little bit bumpy, even those stocks that. That went up.

[Jeremy Grantham]

But in retrospect, we didn't need to

[Ben Inker]

be as underweight stocks as we were.

[Jeremy Grantham]

And that is certainly something we are keeping in mind today. We are trying to make sure we don't own any assets that we don't

[Ben Inker]

think are giving a decent risk reward ratio.

[Jeremy Grantham]

But we are trying to hold on

[Ben Inker]

to those risk assets we think we can afford to hold. Because what have we Learned? Living through four bubbles in 26 years is, man, timing. This stuff is tough, and they can go on longer than you ever thought possible.

[Schwab Advertiser]

And

[Ben Inker]

having a portfolio that only makes sense if the bubble bursts quickly, it's a tough way to make a living.

[Jeremy Grantham]

So we've tried to do some stuff

[Ben Inker]

in terms of making Bayesian adjustments to our forecasts and trying to build portfolios that are robust to that. Another thing we're doing is being very open about what we're doing, why we're doing it

[Commercial Voice (Botox)]

and

[Ben Inker]

you know, what, what the likely consequences are to the portfolios. But man, if there was a way to do this without the career risk, without the client firing you risk, this would be a much easier business.

[Podcast Co-host/Interviewer]

How would you Contrast like the 2000 period to today in terms of one of the, one of the questions a lot of people have like, I mean many people will agree like the AI type stocks are in a bubble like environment, but some will argue now like the more large cap stocks that represent most of the index are at least, that may be expensive but at least at like non bubble like valuations. And they'll Contrast that with 2000 where they'll say those, those types of stocks were at bubble like valuations. I mean, do you think that's fair?

[Jeremy Grantham]

Yeah, it is certainly the case. If you look at, you know, the,

[Ben Inker]

the, the giant stocks,

[Jeremy Grantham]

most of them are not trading at crazy valuations.

[Ben Inker]

So let's hold SpaceX aside, let's hold Tesla aside, let's hold Palantir aside.

[Jeremy Grantham]

But you know, if you look at Microsoft, hey, Microsoft is trading at much lower valuations than it was six or nine months ago. And the valuations don't seem crazy relative to earnings.

[Ben Inker]

A tricky thing about today is we

[Jeremy Grantham]

worry that this may be an earnings bubble. 2000 was a little bit of that, but mostly a valuation bubble. We saw earnings bubbles in Europe in,

[Ben Inker]

you know, in 2007, 2008 where like the earnings had just gone up 100% over four years. And even today they are struggling to make it back up on an index basis to the those levels. We saw the same thing in em, in kind of 2012.

[Jeremy Grantham]

Earnings bubbles can exist. One of the things that can drive

[Ben Inker]

them is rapid increases in investment.

[Jeremy Grantham]

Because the thing about investment in the

[Ben Inker]

long run, what matters with investment is what is the return on investment of that?

[Commercial Voice (Botox)]

Right.

[Ben Inker]

What's the ROIC in the near term?

[Jeremy Grantham]

If you think about investment is it's done after the income statement is over, right.

[Ben Inker]

I am Microsoft.

[Jeremy Grantham]

I'm spending $200 billion on data centers.

[Ben Inker]

Well, none of that comes out of my income.

[Jeremy Grantham]

But all of that spending winds up somebody else's revenue.

[Ben Inker]

Eventually I'm going to have to depreciate it, but I depreciate it over time. So as investment is going up that kind of mechanically makes earnings higher than they would otherwise be.

[Jeremy Grantham]

And actually right now we're in one

[Ben Inker]

of these situations where if it takes

[Jeremy Grantham]

three years to build the data center, until that data center is complete, there is no depreciation. And right now, given how rapidly the

[Ben Inker]

investment has ramped up, a ton of

[Jeremy Grantham]

that investment is not just only depreciating

[Ben Inker]

1/6 or 1/7 of the spending, but

[Jeremy Grantham]

hasn't started depreciating yet at all. So this is a very good time for corporate profits. We think probably an unsustainably good time for corporate profits. But relative to 2000, a smaller portion

[Ben Inker]

of the market is trading at insane valuations.

[Podcast Co-host/Interviewer]

Yeah, that earnings bubble thing is so important because people don't think. People always think about price bubbles, but they never ever think about earnings bubbles. And if you do get into a situation where earnings are just unsustainably high, then you can seem to have reasonable valuations but still be in a bubble, which I think is tough for people to understand.

[Jeremy Grantham]

Yeah, I mean, I think people are. I mean, not that anybody cares about this anymore, but let's say you are

[Ben Inker]

looking at resource companies.

[Jeremy Grantham]

Everybody knows you don't buy resource companies

[Ben Inker]

when their PEs are really low.

[Jeremy Grantham]

Their PEs are really low because you

[Ben Inker]

are in kind of a peak earnings

[Jeremy Grantham]

situation and the capital cycle is about

[Ben Inker]

to come around and bite you on the axe.

[Jeremy Grantham]

You buy resource companies when the PE

[Ben Inker]

is high because the earnings have collapsed.

[Jeremy Grantham]

We are in the midst of an

[Ben Inker]

amazingly large capital cycle associated with AI, and I think we're going to be in a situation where before the end, the SK hynixes and microns of this world will look really cheap on a trailing PE basis, but turn out to be lousy investments.

[Podcast Co-host/Interviewer]

Yeah, I was thinking about the semis is exactly what I was thinking about when you said that, because semis have traditionally been cyclical businesses. But the argument now, which is probably a bubble like argument, is the not anymore. You know, we have this new thing, AI driving everything. And this is no longer a cyclical business.

[Ben Inker]

Yeah. And of course it has to be a cyclical business. I mean, one of the things about, you know, the memory makers is it's

[Jeremy Grantham]

not exactly a commodity, but, ooh, it

[Ben Inker]

has had all of the characteristics of a commodity business.

[Jeremy Grantham]

And so the commodity cycle and the capital cycle tends to be really painful. You can get situations where that cycle turns into a super cycle.

[Podcast Host]

Right.

[Ben Inker]

We had this iron ore super cycle

[Jeremy Grantham]

when from 2005 to 2012, companies were

[Ben Inker]

investing to be able to deliver more iron ore. But it still kept working out because China's growth in demand was just higher than anybody ever expected. Eventually those companies got smashed, but it took a lot longer than anybody expected. What we don't know right now is how long it is going to take for supply to keep up, to catch up to demand.

[Jeremy Grantham]

If it doesn't, then why this will

[Ben Inker]

be like this weird failure of capitalism

[Jeremy Grantham]

that we've never seen before could happen,

[Ben Inker]

but that would truly be a this time is different situation.

[Podcast Co-host/Interviewer]

I want to ask you about AI CapEx in general because I know you guys have studied history a lot and all of us are trying to figure out what to make of this whole thing with this amount of spending. I'm just wondering in a historical context, like how do you think about this? I mean, if you look at capital cycles in the past, I mean, this doesn't necessarily bode well for the people that are doing the building of this in terms of how it's going to work out. But then people argue this is intelligence, this is different, this is something that's going to replace human intelligence. So we can't really analyze it in that way. How do you think about that?

[Jeremy Grantham]

Yeah, so I mean, for one thing in terms of scale, right, this is a big capex cycle, but it is

[Ben Inker]

certainly not an unprecedented one. I think if you look at the, the data center spending this year, it's kind of forecast to be, I don't

[Jeremy Grantham]

know, 700 billion I think is the most recent number I saw and that's

[Ben Inker]

like 2.2% of US GDP.

[Jeremy Grantham]

So it's a big number, a little bit bigger than the fiber optic spend

[Ben Inker]

in the late 1990s, about half this

[Jeremy Grantham]

size relative to GDP. As the railroad spend was in kind

[Ben Inker]

of the middle and second half of

[Jeremy Grantham]

the 1800s, probably pretty similar to the electricity buildout kind of near the turn of the century. So it's big and there aren't a

[Ben Inker]

lot of things that have been that big, but there have been things that relative to the economy have been of

[Jeremy Grantham]

reasonably equivalent size historically. They haven't worked out well. And that's for a couple of reasons. One is if you've got a transformational technology, it is actually not hard for people to understand.

[Ben Inker]

Man, this is going to change the world.

[Jeremy Grantham]

And you know, whether it was canals or railroads or electrification or the Internet or automobiles, people were right.

[Ben Inker]

It really did change the world.

[Jeremy Grantham]

The tricky thing is just because something changes the world doesn't necessarily mean the profits accrue to the people who built it, right? Railroads change the world. Railroads didn't change the world because being

[Ben Inker]

a railroad was awesome.

[Jeremy Grantham]

They changed the world because they completely

[Ben Inker]

collapsed the cost of long distance transportation, which meant you could have much more specialization in manufacturing, you could have much

[Jeremy Grantham]

more specialization in agriculture, and you could move people across the country.

[Ben Inker]

Right.

[Jeremy Grantham]

California couldn't really have existed before the railroads, but running a railroad has never

[Ben Inker]

been an amazing ROI activity.

[Jeremy Grantham]

And when you get a ton of investment, that tends to depress the ROI

[Ben Inker]

in that area to begin with. Right. The UK did this before the us.

[Jeremy Grantham]

In the uk, you know, the first company that built a railway line between

[Ben Inker]

London and Manchester, if it had stopped there, they would have made a lot of money.

[Jeremy Grantham]

Unfortunately, they were followed by five other companies. And once you have six railway lines going from London to Manchester with huge overcapacity, it's not just that the marginal dollar invested is going to have a lousy return, you will destroy the return

[Ben Inker]

of all of that capex.

[Jeremy Grantham]

So what has almost always happened when

[Ben Inker]

you have a situation where you've got this transformational technology and really good early

[Jeremy Grantham]

ROI is you get way too much

[Ben Inker]

investment and you destroy that roi.

[Jeremy Grantham]

It doesn't mean that the technology doesn't change the world. The world railroads did, electricity did, autos did, the Internet did that fiber investment was a lousy roi, but it did enable the world we live in today. The tricky problem is, unless you are stopped from doing it, the natural response

[Disney Movie Promoter]

by

[Jeremy Grantham]

capitalists is to throw enough money

[Ben Inker]

at the opportunity that you are going to destroy the return on investment.

[Podcast Co-host/Interviewer]

Yeah, when you were saying that, I was thinking about how this has been funded. And one of the differences here between fiber and what's going on now is at least at the beginning this was funded through cash flow as opposed to debt. But now you're seeing that debt get added on. And so I'm wondering if that plays into your idea of like they're just going to keep throwing money at it. Even if it might have been initially funded by cash flow, they're still going to pile the debt on and they're still going to keep throwing money at it to the point that it doesn't make sense.

[Jeremy Grantham]

Yeah, I mean, I think that is going to happen unless it's stopped by something.

[Commercial Voice (Botox)]

Right.

[Jeremy Grantham]

If we are fundamentally incapable of providing enough electricity to these things. And so as much as people would want to build an infinite number of

[Ben Inker]

data centers, they're stopped.

[Jeremy Grantham]

Well, maybe they can kind of be saved from themselves, but otherwise capital will flow. And you know, one of the things

[Ben Inker]

my former colleague Ed Chancellor, who's kind of one of the premier economic historians of bubbles points out exists in bubbles is the financing gets to be really sketchy. You get Ponzi finance, you get Circular

[Jeremy Grantham]

finance and my God, this cycle we have seen some incredible deals from the standpoint of of strange ways to finance purchases. What they have in common is they are structured in a way to look as profitable as possible initially. So OpenAI makes a deal to buy

[Ben Inker]

tens of billions of dollars worth of AMD GPUs.

[Jeremy Grantham]

Now if you look at the way that deal is structured, OpenAI is being

[Ben Inker]

given warrants on an AMD stock which is worth half of them.

[Jeremy Grantham]

So effectively they are buying these GPUs half from shares of AMD that they are being granted.

[Ben Inker]

AMD could have given them a 50% discount instead, right? That would have been a more straightforward way to do the the deal.

[Jeremy Grantham]

But this one's going to make AMD

[Ben Inker]

look a lot more profitable

[Jeremy Grantham]

and still

[Ben Inker]

deal with the fact that OpenAI simply did not have the money to pay full price for all of these chips, even if they had wanted to. You know the recent deal with Anthropic

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[Jeremy Grantham]

Offering to lease $36 billion worth of

[Ben Inker]

of Alphabet TPUs where Broadcom is stepping in and promising to buy back the TPUs in the event that anthropic defaults in order to give this a an investment grade rating.

[Jeremy Grantham]

Well, it's structured in a way that this does not show up entirely as

[Ben Inker]

a liability on Broadcom's balance sheet because it's viewed as low probability. But it does benefit from Broadcom's credit rating.

[Jeremy Grantham]

And you can be sure that in this deal Broadcom is being paid for

[Ben Inker]

the fact that they are making the deal possible.

[Podcast Co-host/Interviewer]

It is, it's interesting as an. For the average investor, it is very hard to have any idea what's going on with any of this stuff. Like the circular nature of the circular deal with this company and this company and then this company's over to this company. It's like unless you're in the weeds of this stuff, this is very, very hard to figure out what's going on.

[Jeremy Grantham]

Yeah, and some of it really relies on the fact that the accounting isn't

[Ben Inker]

going to keep up.

[Jeremy Grantham]

And you know, we saw circular financing in the Internet bubble, but a lot

[Ben Inker]

of that was, I don't know, tamer.

[Podcast Co-host/Interviewer]

Right.

[Jeremy Grantham]

It was two dot com firms putting

[Ben Inker]

ads on each other's sites and declaring that as revenue.

[Jeremy Grantham]

This actually involves lots, lots more money

[Ben Inker]

and creates more risk of problems when things go wrong. One of the nice things about the Internet bubble,

[Jeremy Grantham]

the Internet part was funded

[Ben Inker]

basically entirely through equity. So there were no systemic problems when it went wrong. The housing bubble was funded through debt and there's lots of systemic problems when debt goes bad this time around. It's a combination. Plenty of it used to be funded with equity, but increasing amounts are being funded with debt. I think the hyperscalers have doubled their debt ratios in the last nine months. I mean they are taking out huge amounts of debt.

[Jeremy Grantham]

They're still very high quality companies and

[Ben Inker]

I'm not saying they're going to default on this debt, but they're taking on debt really rapid.

[Podcast Co-host/Interviewer]

Just one more quick question on this before we go to your return forecasts. The idea of all this issuance coming out now you've got these big IPOs, you've got companies that were buying back shares and now issuing shares. How do you think about that? How do you put that in context in terms of how you think about that and what it means for the market?

[Ben Inker]

Yeah, I think that's a really big deal. And one I hadn't understood how important it was until I started to. A couple of years ago, there was this good paper. I can't remember who wrote it anymore, but the Inelastic Markets Hypothesis that showed

[Jeremy Grantham]

that the way traditional finance treats the

[Ben Inker]

financial markets is that they really should be very elastic, that if a little

[Jeremy Grantham]

bit of demand comes in or a

[Ben Inker]

little bit of supply comes in, that should have a very small impact on prices.

[Jeremy Grantham]

And what this paper purported to show was, no, actually, supply and demand really matter a lot.

[Ben Inker]

And so one of my colleagues, John Pease, presented that paper internally and then tried to replicate their findings and found, yeah, it's really true.

[Jeremy Grantham]

The supply and demand matters a lot. There are natural experiments.

[Ben Inker]

You can look at where the supply

[Jeremy Grantham]

or demand are there, but we know

[Ben Inker]

there is no information flow associated with them. And it still has an impact on prices. And right now we are likely to be in a situation where over the

[Jeremy Grantham]

next 12 months we see more supply

[Ben Inker]

come into the US stock market than has been the case in living memory. If we just get SpaceX and OpenAI and anthropic and maybe a few other of the companies in dollar terms don't matter that much, we could be talking about 5 or 6% of aggregate US market cap coming in as supply.

[Jeremy Grantham]

Now, the thing is, it doesn't come in instantly, right?

[Ben Inker]

SpaceX went public a little while ago

[Jeremy Grantham]

now, but they only sold $75 billion

[Ben Inker]

worth of shares, and they sold that at a $1.8 trillion market cap.

[Jeremy Grantham]

So there wasn't very much additional supply that came online. As more of the holders become freed

[Ben Inker]

up from their lockups, a lot more will be able to change hands and a lot more effective supply comes in.

[Jeremy Grantham]

So if you look at the impact

[Ben Inker]

on the stock market, it's not when

[Jeremy Grantham]

an IPO occurs, it's kind of in

[Ben Inker]

the 12 months afterwards because it takes a while

[Jeremy Grantham]

for those lockups to expire

[Ben Inker]

and the stock to change hands.

[Jeremy Grantham]

But kind of the rule of thumb,

[Ben Inker]

if you looked at history, is that

[Jeremy Grantham]

a 1% increase in supply is associated

[Ben Inker]

with a 7 and a half percent worse return over the subsequent year. And if that held up in a linear fashion, and we're talking about 5 or 6%, well, that would be a pretty ugly return.

[Jeremy Grantham]

I don't know that it's going to be that extreme. At that level, it is hard to

[Ben Inker]

disentangle from the fact that the two highest points of supply that we've seen in the US market in the last 50 years were 2000 and 2021.

[Jeremy Grantham]

And both of those were also times when the markets were kind of crazy frothy. So pulling apart, how much of this was driven by the supply and how

[Ben Inker]

much of this was driven by, you know, bubbles burst, I'm not sure. But right now we're getting behavior that looks very bubbly. We are seeing a lot of supply or we are going to see a lot of supply. And that may be a real challenge to the market.

[Podcast Co-host/Interviewer]

It's interesting. Like that inelastic markets hypothesis paper. It's come up on the podcast before, but it came up with Mike Green talking about the flows from 401ks into the market and the impact that some of that can have that maybe is a lot more than people expect.

[Jeremy Grantham]

Yeah, I mean, and it is something you really have to as an investor continually keep in mind. Like where is the supply coming from? Where is the demand coming from? How price sensitive is that demand? One of the things, you know, when the money is flowing in from 401ks

[Ben Inker]

and let's say they're buying the S&P 500.

[Jeremy Grantham]

Well, the S&P 500 is trying to buy the same percentage of Nvidia as it does gm. But if the holders of Nvidia are

[Ben Inker]

less price sensitive than the holders of gm, it's still going to have a bigger impact on Nvidia.

[Jeremy Grantham]

And when you think about growth stocks, the holders of growth stocks are for

[Ben Inker]

perfectly reasonable reasons, less price sensitive than the holders value stock.

[Jeremy Grantham]

So even if, even if net supply

[Ben Inker]

is coming into the market in a completely passive fashion with no views associated with it, it will have different impacts on different kinds of stocks.

[Podcast Co-host/Interviewer]

I want to shift to your asset class return forecast here and before we all put the chart up right now, but before we get into the actual forecast, I wanted to maybe have you talk about how you do this. So like these returns that we're seeing in front of us right now, like what is the process that goes into calculating these.

[Jeremy Grantham]

Yeah, you know, let me talk about

[Ben Inker]

the basic idea first and part. All we're really saying is that things will eventually trade at fair value.

[Jeremy Grantham]

We use a seven year forecast because historically seven years has been decent estimate of how long that takes on average,

[Ben Inker]

even though things can be much faster or shorter than that.

[Jeremy Grantham]

So the way we calculate the forecast,

[Ben Inker]

the way we build it, is by

[Jeremy Grantham]

looking at the income it's reasonable to expect from an asset. The growth you can expect from that asset and then adding an additional term

[Ben Inker]

for the gain or loss associated with the valuation shift that is required for that asset to come back to fair value. And we kind of assume it's going to come back 1/7 of the way each year.

[Jeremy Grantham]

Now there's plenty that can go wrong

[Ben Inker]

with that, as in any kind of forecasting,

[Jeremy Grantham]

but one of the things I like about it is it sort of is assuming that capitalism is going to

[Ben Inker]

work in the long run.

[Jeremy Grantham]

You know, it would be weird if we lived in a world where the return on capital in the cost of

[Ben Inker]

capital did not come into alignment with each other. That's what capitalism is supposed to do.

[Jeremy Grantham]

And if capitalism is going to do

[Ben Inker]

that, you're going to get this kind of gradual mean reversion in valuations.

[Podcast Co-host/Interviewer]

You chose to break out low interest rate environment from a normal interest rate environment in this. Why did you do that?

[Jeremy Grantham]

So I said we think things revert to fair value. What I glossed over was okay, well

[Ben Inker]

what is fair value?

[Jeremy Grantham]

And the reality is it is much easier to come up with a fair value for assets relative to each other

[Ben Inker]

than in some absolute sense. So, and again, even just take a step further back, fair value to us

[Jeremy Grantham]

is a valuation level from which you can get a fair return to that

[Ben Inker]

asset without having to have valuation shift.

[Jeremy Grantham]

And so what's a fair return? Well, what's a fair return to stocks?

[Ben Inker]

I don't know. Tell me what the alternatives to stocks give.

[Jeremy Grantham]

The way we tend to think about it is let's start from cash. Let's start from kind of the ultimate

[Ben Inker]

risk free asset and say, well, how much more should I get paid for owning this asset because of its greater risk.

[Jeremy Grantham]

So bonds are somewhat more risky than cash. They should probably give a return associated with that. We assume you're going to get somewhere

[Ben Inker]

around 100 basis points of term premium for owning a bond instead of cash.

[Jeremy Grantham]

Now stocks are a lot riskier than that. And in particular they tend to lose you money at really unpleasant times.

[Ben Inker]

They tend to lose you money when the economy is going badly and your

[Jeremy Grantham]

income from other sources is likely to be lousy.

[Ben Inker]

So you should get paid a good deal more for owning stocks than bonds.

[Jeremy Grantham]

We cuff that is around 4 and

[Ben Inker]

a half percent for stocks relative to cash. So maybe 3 and a half percent relative to high quality bonds.

[Jeremy Grantham]

The thing none of that can tell you is what should the return on holding cash be?

[Ben Inker]

And as near as we can tell,

[Jeremy Grantham]

there is not easy conceptual answer to

[Ben Inker]

the platonically correct return on cash.

[Jeremy Grantham]

So what we do is we come up with a couple of different scenarios in which all of the asset classes are priced reasonably one to another. But where we can say, you know what, either of these scenarios could make

[Ben Inker]

sense as a long term equilibrium for the interest rate environment.

[Jeremy Grantham]

Today our best guess is that we are in that low interest rate environment. So the return to cash in the

[Ben Inker]

long run will be somewhere around zero

[Jeremy Grantham]

in real terms, maybe a little bit positive, but around zero in real terms.

[Ben Inker]

So after inflation, stocks need to deliver four and a half points better than that. In order to do that they need to be trading at a normalized BE

[Jeremy Grantham]

of somewhere around 21 times. If we are in a world where

[Ben Inker]

cash is going to return more than that, and it used to return more

[Jeremy Grantham]

than that, then stocks need to return

[Ben Inker]

more than four and a half. And if they're, if, if we mark,

[Jeremy Grantham]

push everything up by one to one

[Ben Inker]

and a half percent in terms of

[Jeremy Grantham]

required return, well then equities can't trade at 21 times normalized earnings.

[Ben Inker]

They need to trade at 16 times normalized earnings. So that's why the interest rate environment matters.

[Jeremy Grantham]

It changes the fair value for everything. And man, life would be convenient if

[Ben Inker]

I knew which of those scenarios we were in, but I don't. So we publish both of them so that the clients understand

[Jeremy Grantham]

some of what can drive,

[Ben Inker]

you know, different returns from assets in the long run.

[Podcast Host]

What is interesting about the chart is clearly it shows that, you know, international over US and so I think some of the highest conviction sort of ideas here or where the most, the, the possible best returns are sort of coming from this, this value and deep value cohort of the equity market.

[Ben Inker]

Yeah.

[Jeremy Grantham]

So today we see a big gap between the US and the rest of the world.

[Ben Inker]

Now it hasn't always been the case

[Jeremy Grantham]

that the rest of the world has looked more attractive than the US it got there the hard way by underperforming

[Ben Inker]

for a long period of time.

[Jeremy Grantham]

But U.S. stocks have outperformed over the last, whatever, 10 to 15 years. Some of that has been truly deserved

[Ben Inker]

because of better fundamental growth. But it's also been associated with rising relative valuations.

[Jeremy Grantham]

This idea that the US should trade at a valuation premium to the rest

[Ben Inker]

of the world, it didn't exist 15 years ago.

[Jeremy Grantham]

There was no history of the US

[Ben Inker]

trading at a premium to the rest of the world as of 2010. Today everybody assumes it is the way the world should be.

[Jeremy Grantham]

The other thing that has happened that has been important is a rise in

[Ben Inker]

the value of the dollar.

[Jeremy Grantham]

As of 2012 the dollar was really undervalued. Today it looks substantially overvalued. So when we're building our portfolios, we

[Ben Inker]

want to take into account the fact that non US equities trade significantly cheaper than the us. That's going to be a help.

[Jeremy Grantham]

Owning non US dollar currencies for US

[Ben Inker]

based investors is going to be a tailwind because of the overvaluation of the dollar.

[Jeremy Grantham]

And then within that,

[Ben Inker]

from a style perspective, today small looks cheaper than large pretty much everywhere.

[Jeremy Grantham]

And value looks somewhere between quite cheap

[Ben Inker]

and extraordinarily cheap, depending on the market you're looking at around the world.

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[Podcast Host]

available on third party ordering platforms.

[Podcast Co-host/Interviewer]

Tax extra.

[Podcast Host]

A lot of times with these expected return projections, it's, it's hard because you know, you, you see something like, like the large cap growth and how, you know, how I guess low or negative those returns are. But it's not like, it's not like the, you know, annualized return is likely to be in that range, you know, year over year. A lot of times like you can, you can be in this environment and then you get like a bear market or big drawdown and then sort of that's how those returns actually come to fruition. You see what I'm saying?

[Ben Inker]

Yeah.

[Jeremy Grantham]

Certainly we are not expecting that the

[Ben Inker]

market is going to go in a straight line from here to fair value over seven years. The way these things have tended to play out is yes, you will have a really bad year. Right.

[Jeremy Grantham]

2022, the stock market went down 17%.

[Ben Inker]

That's, you know, that's really bad.

[Jeremy Grantham]

But inflation was also really hot. So in real terms it fell by a lot more and that made it a lot cheaper.

[Ben Inker]

It didn't make it cheap in the case of the US and some of the other markets, it really did. But yes, a sharp bear market changes things quite quickly. And if that bear market happens to occur at the same time that we are experiencing higher than normal inflation, you can have a profound change in valuations pretty quickly.

[Podcast Host]

What's the idea or the concept behind the benchmark free portfolio? I'm guessing it's like you don't have to necessarily have a benchmark like the S and P. You can maybe have your own benchmark. But I'll let you kind of explain what you're trying to get out of that.

[Jeremy Grantham]

Yeah, so there's. People tend to put together their portfolios

[Ben Inker]

for a couple of different reasons which are not fully compatible with each other.

[Jeremy Grantham]

The 6040 portfolio kind of took form as some sort of happy medium because

[Ben Inker]

it was a nice blend of risk and return. It was a level of risk that in general people could live with. And because stocks and bonds under a lot of circumstances can be natural complements, it was a reasonably sweet spot in the, in the risk reward trade off.

[Jeremy Grantham]

And so when we were building portfolios for our clients back in the late 90s, 6040 was kind of a traditional way.

[Ben Inker]

They would want us to build multi

[Jeremy Grantham]

asset portfolios, but they would give us a benchmark. And the strange problem we were faced with in 1999 was we were running these portfolios for a bunch of clients.

[Ben Inker]

All of them were unhappy with us because we were underperforming. And your clients will always be unhappy with you when you were underperforming.

[Jeremy Grantham]

But we got two very different complaints from the clients.

[Ben Inker]

One set of clients was saying, okay, I'm looking at your portfolio, I'm looking at my benchmark. My benchmark is 50% s and P. You own 25 points in US large cap stocks. So I understand the fact that you don't like the US stock market, but that single bet is overwhelming everything else.

[Jeremy Grantham]

How can it possibly make sense for

[Ben Inker]

you to spend that much of your risk budget on this one bet?

[Jeremy Grantham]

That's stupid. We had another set of clients in the same portfolio that was looking at the portfolio and saying, wait a minute, you've got a negative expected return for the next 10 years for US large cap stocks. Why are you wasting 25% of my portfolio in an asset that is risky and has a negative real return? And so we realized we were running one portfolio, but our clients were thinking

[Ben Inker]

about it two different ways.

[Jeremy Grantham]

For the clients who were really concerned with tracking error, we were taking way

[Ben Inker]

too Much tracking error on a single

[Jeremy Grantham]

bit for the clients who were really saying, okay, 6040 kind of makes sense from a risk framework, but what I

[Ben Inker]

really care about is absolute risk and absolute return. We weren't wasting a piece of their portfolio.

[Jeremy Grantham]

Why do we own 25 points in US large caps? It was out of fear that they

[Ben Inker]

might do well despite the fact that we hated them.

[Jeremy Grantham]

So that was a piece of the portfolio that was not doing any good

[Ben Inker]

from an absolute risk and absolute return perspective.

[Jeremy Grantham]

From a tracking error perspective, it was. But if you cared about absolute risk and absolute return, you could put together

[Ben Inker]

a much better portfolio.

[Jeremy Grantham]

And so what we started showing to

[Ben Inker]

the, to the port, to the clients in the fall of 1999 was, hey,

[Jeremy Grantham]

this is what your portfolio would look

[Ben Inker]

like if we didn't have a benchmark.

[Jeremy Grantham]

And it was the fall of 1999

[Ben Inker]

and nobody was really interested, even the people who hadn't fired us yet.

[Jeremy Grantham]

We're not saying, yeah, what we want to do is get even more of

[Ben Inker]

what you guys are doing.

[Jeremy Grantham]

But 1999 turned into 2000 and 2000 turned into 2001. And by 2001, the first couple of clients started saying, hey, this benchmark free, that makes some sense. So we launched the strategy in 2001. It's designed to take similar risk to a 6040 portfolio. But what we promise is we're not going to waste any of the portfolio

[Ben Inker]

in assets that the reason why they're there is fear they might go up despite the fact that we don't like them. Everything in that portfolio has to make sense on its own without worrying about tracking error.

[Jeremy Grantham]

And so it's a portfolio that isn't going to take an insane amount of absolute risk. But it feels no obligation to look

[Ben Inker]

like a traditional 6040 portfolio. We feel no obligation to own US stocks if they're not attractively priced. We feel no obligation to own bonds if they're not attractively priced. We're going to own whatever is out there that makes sense from a risk reward.

[Podcast Host]

And with that portfolio, like kind of generally follow like how your expected return, that chart that we were looking at, kind of look like, yeah, it's going

[Jeremy Grantham]

to move somewhat more slowly. One of the things about our forecasts is they are value driven. And one thing a value manager can

[Ben Inker]

tell you is man value gets you into and out of everything too early.

[Jeremy Grantham]

So we rather intentionally move

[Ben Inker]

by a

[Jeremy Grantham]

slower moving average of those forecasts. And there are some things that we will invest in that we simply cannot forecast.

[Ben Inker]

So, for example, within liquid alt space One of the things we like today is merger arbitrage. Now I can't come up with a seven year forecast for merger arbitrage.

[Jeremy Grantham]

These deals are all either going to complete or fall apart within the next three to 12 months. It doesn't make sense to think about

[Ben Inker]

a seven year forecast for an activity like that.

[Jeremy Grantham]

But it does make sense to ask

[Ben Inker]

the question, are you getting paid adequately

[Jeremy Grantham]

for taking the risk of merger deals blowing up? If the answer is yes, this is an interesting asset and we will put

[Ben Inker]

it in the portfolio.

[Podcast Host]

In the last few minutes here, while we have you, I wanted to spend some time on some of the research that you have done on private equity. So I know from one of your papers, I think you looked at close to or maybe even over 700, 700 leverage buyouts going back to 1981. And what did that research project, what did that actually show that the typical private equity portfolio sort of looked like?

[Jeremy Grantham]

Yeah, so for one thing, that that

[Ben Inker]

analysis was one of those examples of things artificial intelligence is quite useful for.

[Jeremy Grantham]

And we do believe artificial intelligence is useful. You know, one of the things we

[Ben Inker]

think about, we talk about super analyst,

[Jeremy Grantham]

we, we talk about, okay, what would

[Ben Inker]

you do if you had an unlimited number of investment interns?

[Jeremy Grantham]

And one of the things you could do is, all right, look through the last 50 years at all the LBOs

[Ben Inker]

that have ever occurred.

[Jeremy Grantham]

A useful thing about that for us is we look at the characteristics of publicly traded companies. We don't have that kind of detailed

[Ben Inker]

information on the privately held companies. But the nice thing about LBOs is

[Jeremy Grantham]

they're all companies that were once public. And so we can look at their

[Ben Inker]

characteristics when they were bought or just prior to them being bought.

[Jeremy Grantham]

And so we thought that that was a useful thing to do because lots

[Ben Inker]

of our clients have very significant allocations to private equity. They in general understand the fact that that private, that private. Qualifier aside, this stuff is equity. And so it must embody economic risk. They think they should get paid an equity like return from it, hopefully more than an equity like return. But they get the fact that this is equity like risk.

[Jeremy Grantham]

What they tend not to do is dig further in and say, okay, well beyond the fact that this is equities,

[Ben Inker]

what kind of equities is it?

[Jeremy Grantham]

And some things are pretty obvious.

[Ben Inker]

Even without doing the work.

[Jeremy Grantham]

The one group of companies that you

[Ben Inker]

could not LBO is giant companies, right?

[Jeremy Grantham]

Private equity firms can buy lots of things. They are not going to buy a trillion dollar company.

[Ben Inker]

You just can't do it.

[Jeremy Grantham]

So we knew before doing this analysis

[Ben Inker]

that it was going to skew small,

[Jeremy Grantham]

we didn't quite understand how small it skewed. In the history of LBOs in the US there was one LBO that occurred

[Ben Inker]

in a company that could have been called Mega Cap at the time, which was the RJR Nabisco deal. Otherwise it's all been mid caps or smaller and hugely skewing small.

[Jeremy Grantham]

So you kind of know that. But when you think about that from

[Ben Inker]

a risk and profitability standpoint, one thing that has occurred in the US over the last 40 years is the return

[Jeremy Grantham]

on capital of large cap stocks has

[Ben Inker]

been on this really nice upward trend.

[Jeremy Grantham]

The return on capital of small cap

[Ben Inker]

stocks has been a straight line now,

[Jeremy Grantham]

a straight line with a lot of volatility.

[Ben Inker]

But there has been this increasing wedge built between the profitability of very large companies and the profitability of small cap companies.

[Jeremy Grantham]

And a lot of this has occurred,

[Ben Inker]

we think, because of increasing amounts of monopoly power and just market power among large cap companies.

[Jeremy Grantham]

Well, if you can't buy large cap

[Ben Inker]

companies, you're not going to benefit from that.

[Jeremy Grantham]

So one thing about small caps over

[Ben Inker]

the last 40 years, they have gradually

[Jeremy Grantham]

had decreasing relative quality versus the market

[Ben Inker]

because their profitability has been coming down,

[Jeremy Grantham]

their leverage has also been coming up. One thing that was a little bit surprising to us when we did look

[Ben Inker]

at this data, not utterly shocking, but a little bit surprising, is that these

[Jeremy Grantham]

companies, when they were bought, were less

[Ben Inker]

profitable than

[Jeremy Grantham]

and they had relatively high amounts of debt. So these companies before they got LBO'd,

[Ben Inker]

were kind of junk.

[Jeremy Grantham]

Now, on the one hand, maybe that's not a complete shock because private equity says, hey, we can run these companies better. And what kind of company should you

[Ben Inker]

be able to generically run better than it was run as a public company, a badly run company.

[Jeremy Grantham]

So maybe it's not a shock that

[Ben Inker]

these companies were not particularly profitable and were reasonably low quality when they got taken out. But it's still pretty striking.

[Jeremy Grantham]

And given if for kind of the

[Ben Inker]

average endowment or foundation in the US

[Jeremy Grantham]

maybe half of their equity exposure is coming from privates in one form or another, that means they have this monstrously large bet in favor of small and

[Ben Inker]

in favor of junk within equities.

[Jeremy Grantham]

And you probably don't want to have

[Ben Inker]

a bias in favor of small, maybe

[Jeremy Grantham]

you could justify it. On the back of 100 years you could say small is outperformed, but on

[Ben Inker]

the back of 40 you can't.

[Podcast Co-host/Interviewer]

Right.

[Ben Inker]

And junkie companies have never outperformed. I mean, they're more volatile, they are higher beta. So they sometimes outperform, but they've been a horrible group to own.

[Jeremy Grantham]

So it is not a group you

[Ben Inker]

would want to preferentially own. And lots of people either by mistake have done it and they can't get out of it now. So the question we are asking or we are suggesting to investors that they might want to ask is what should they do in their public portfolio

[Jeremy Grantham]

to

[Ben Inker]

compensate for the biases they're getting in their private portfolio?

[Podcast Host]

And how are you answering that? How are you addressing it?

[Jeremy Grantham]

Well, I mean, you can do a few things kind of in the pure passive situation.

[Ben Inker]

You could go long S&P 500 or S&P 100. In short, the Russell 2000. That gives you both the size and the quality bias you want, particularly the S&P 100.

[Jeremy Grantham]

The issue is it doesn't necessarily have

[Ben Inker]

a particularly positive expected return associated and it is going to take up a bunch of capital.

[Jeremy Grantham]

We do think that high quality companies, particularly if bought with some eye to

[Ben Inker]

their valuation, do perform surprisingly well.

[Jeremy Grantham]

So we would argue biasing your portfolio

[Ben Inker]

towards quality is a good idea. And on the negative side, junky stocks,

[Jeremy Grantham]

particularly expensive junkie stocks, really do amazingly

[Ben Inker]

badly in the long run.

[Jeremy Grantham]

So if you've got a bias towards

[Ben Inker]

small cap junkie stocks in your privates portfolio, I'd argue privates is the place

[Jeremy Grantham]

you would want to put those stocks

[Ben Inker]

because maybe you can make them better

[Jeremy Grantham]

managed in the public portfolio.

[Ben Inker]

They're a disaster. So kind of going long quality and

[Jeremy Grantham]

short expensive junk is a nice way to balance some of the risk that

[Ben Inker]

is embedded in your private equity portfolio while generating in the long run at least a positive expected return.

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[Podcast Host]

One of the themes of your work is understanding why you should be getting paid on the given asset you know, that you own. And we were kind of talking about that a little bit before we even started this discussion today. But, you know, how would you take that idea and put that to work in today's market? Like, how would you sort of marry those two things right now?

[Ben Inker]

Yeah.

[Jeremy Grantham]

So I do think understanding why you're

[Ben Inker]

getting paid for the activity you are doing is really crucial.

[Jeremy Grantham]

To be clear, it is not crucial

[Ben Inker]

because that is the way that is going to get you rich.

[Jeremy Grantham]

The way you get rich, the way

[Ben Inker]

you massively outperform is by predicting the future better than somebody else or everybody

[Jeremy Grantham]

else or just getting lucky.

[Ben Inker]

And this doesn't really help you with that.

[Jeremy Grantham]

What I think it really can help you with is avoiding doing stupid things if you've got an activity which you have been sold as an amazing risk reward trade off. So let's say for example, you've got somebody who's saying, man, I can sell

[Ben Inker]

you a tail risk hedging portfolio that has a cash like return. Well, I'd rather not lose money in bad time. So I'd love to have something that gives me a cash like return and has that nice kind of correlational problem that sounds cool. And plenty of people have done it.

[Jeremy Grantham]

And the vast majority of people who have done it have wound up really disappointed in it. And why? Well, if you stop and think somebody on the other side has to be willing to put up with this horribly

[Ben Inker]

nasty correlated return, I am going to

[Jeremy Grantham]

lose a ton of money when the

[Ben Inker]

world is falling apart.

[Jeremy Grantham]

And in return I'm only going to get a cash return. It does not make sense for the

[Ben Inker]

person on the other side to continually do that.

[Jeremy Grantham]

So you should be really skeptical of someone who is promising you that you

[Ben Inker]

can get that lovely return.

[Jeremy Grantham]

Same thing, somebody who says, man, what you really need to do is just buy call options on the market because

[Ben Inker]

you've got the limited downside and you've got unlimited upside. Well, somebody's gotta be selling you those call options. And how does it make sense for them to want to sell to put up with that set of returns without getting paid something in return?

[Jeremy Grantham]

And so it makes you think, huh? Well, you know, maybe actually the return

[Ben Inker]

to being long call options isn't going to be that great in the long run. Let me look at that.

[Jeremy Grantham]

And when you look at it, you

[Ben Inker]

say, oh yeah, if you're long call options, you basically get a cash return

[Jeremy Grantham]

even though you're getting all that upside because you are just paying enough each time you buy that option to suck

[Ben Inker]

out all of the goodness of the stock market. So it helps you avoid expensive mistakes. And where you are saying something that kind of requires investors to be a little bit odd, right? I'm saying low quality companies underperform in the long run. Well, that's a little weird. They have more downside at the bad times, right? Highly volatile companies that have levered balance sheets are more likely to go bust in the bad times. So you should get paid for them.

[Jeremy Grantham]

So if I'm going to say I think this group of stocks underperforms in

[Ben Inker]

the long run, there's two things I need to do.

[Jeremy Grantham]

One is I need to see yes, they are priced in such a way

[Ben Inker]

that they are going to underperform that

[Jeremy Grantham]

the return from their fundamentals is going to be disappointing and I need to be able to look at any given time or are they still priced that way right? Because any horrible group of stocks, if priced cheaply enough, becomes a wonderful group of stocks and it helps you understand like value.

[Ben Inker]

I I love value from a conceptual

[Jeremy Grantham]

basis, but value stocks can become overvalued

[Ben Inker]

and there is nothing more supremely useless than overvalued value stock. They are something that has no virtue in your portfolio whatsoever.

[Jeremy Grantham]

So by kind of asking these questions, I think you can avoid doing some

[Ben Inker]

very damaging things isn't the secret to success, but I do think it can keep you out of a lot of painful kinds of failure.

[Podcast Host]

Excellent, excellent discussion, Ben. Thank you very much for joining us. We really appreciate it.

[Jeremy Grantham]

Yeah, it was a lot of fun.

[Windows 11/Microsoft Advertiser]

Thank you.

[Podcast Host]

Thank you for tuning in to this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess returns [e-mail] if you have any feedback or questions, you can contact [e-mail] no information on this podcast

[Jeremy Grantham]

should be construed as investment advice. Securities discussed in the podcast may be

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holdings of the firms of the hosts.

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