Jeff Ptak: From the 30th annual Morningstar Investment Conference in Chicago, I'm Jeff Ptak, global director of manager research for Morningstar. I'm very pleased to be joined today by Jeremy Grantham. Jeremy is chairman of the board of GMO. 

Jeremy, welcome. Thank you again so much for participating in this year's Morningstar Investment Conference.

Jeremy Grantham: Nice to be here.

Ptak: I wanted to start off maybe getting you to update your views on a commentary that you published in January of this year describing some of the necessary preconditions of a possible melt-up, a scenario in which the market would rally very, very sharply, and then perhaps fall precipitously afterward. 

Given some of the activity that we've seen in the market and the ensuing four or five months, where do you stand now?

Grantham: The easy part of that is the bubble collapsing. Historically, in order to get the market to have a really major decline, 50 per cent in a couple of years, you've needed to have plenty of air in the pricing, a psychological energy. You need people to buy into some fairly preposterous thinking, it's revealed, from hindsight anyway. 

In '99 people believed it's a new golden era of the Internet. Greenspan described the Internet as driving away the dark clouds of ignorance. 1929, you had the same kind of euphoria. Without euphoria and crazy faith, without perfect fundamentals and an extrapolation that they'll go on forever, it's very hard to get a rapid decline of the kind that we had in 1929 and 2000, and to some extent in the housing market of '07 and '08. So that's the easy part. In other words, we're probably not going to have a rapid decline unless we have a blow off.

A blow off needs twice the rate of acceleration as normal, maintained for a little less than two years, like 21 months. In other cycles, that has produced enough oomph to be about 60 per cent or more. It looked like we could do that, and certainly by the end of January, it looked very promising. By the end of January, it was rising so fast that if it had covered another 10 points, another 10 per cent by the end of March, it would have been up 60 in the final 21 months. And that would have only been 3150 on the S&P.

If it moves slowly, that 60 per cent target moves on up. So if it takes a full nine months, it was 3400. If it took 18 months from last December, it was 3700, and the chances of that happening are not as good today as they were back in December, January. The reason is, that the uncertainty that's been produced by the administration on important issues like global trade has served to constantly rattle and make nervous the investors. Unusually, this is balanced on the other hand by strong profit margins, by rising profit margins, the highest globally they have ever been by a synchronized, reasonable global economy.

You have some good data on one hand and you have some nerve-wracking input on the other. This is quite unusual to create a kind of nervous balance. So 1 per cent forward, 1 per cent back, 2 per cent forward, 2 per cent back. In that environment is anathema, you know, in terms of a bubble. A bubble needs crazy euphoria. This is not the environment in which it can happen. Now, I haven't written my 50 per cent chance down below 35 or 30 for the following reason. If the midterms make the market relax a bit, but we also are entering the sweet spot of the presidential cycle, from October of this year through May of next year is an incredible period of seven months, which has averaged about 17 per cent a year since 1932, since FDR. That is our last best chance of having a bubble melt-up.

When that passes, I think time is not on our side, and we will not do that. So what will happen? Where do the probabilities go that I take away from a bubble and a bust? They moved to a relatively historically unusual format, which is bumping along. You go down 15 and up 10, you go down 17 and up 13, you come back in five years and the market is down 15 per cent or 20 per cent profits, and maybe up 10 or 15. And the P/Es are close enough for government work. Everyone always likes to think that's going to happen. It very seldom does happen. The market likes to go up a lot or down a lot in real life. But I do think with this kind of creative tension that we have, we may be able to pull that off.

Ptak: What's an investor to do given that outlook? I know there's a great deal of uncertainties.

Grantham: Well, from GMO's point of view, our first choice is a melt-up, jump out, and have it meltdown rapidly, and jump back in. Our second choice is the bump-along because we are out of the US equities, we're overweighted emerging and EAFE. There's nothing in my five-year forecast that says S&P down 20 to prevent emerging being up 20. It's easily cheap enough to have that sort of divergence with room to spare and maybe either up 5. That is a dismal market for a pension fund, but it's not a dismal market for GMO's relative performance.