Elite investor Jeremy Grantham warns the stock market's rally this year is a 'head fake' - and a recession is still coming

• Jeremy Grantham says AI hype has prevented the tech bubble from collapsing.
• The GMO cofounder is wary of US stocks, real estate, and commodities.

There's a historic bubble in stocks that's about to burst — and the US economy will most likely suffer a recession, Jeremy Grantham has warned.

"A dozen giant American stocks have had a hell of a run on the back of AI, and that has certainly created the impression that it's game over," he said, speaking at an investor event held by Livewire Markets in Sydney this week.

"The problem is prices are incredibly high and basically the economy is beginning to unravel," the cofounder and long-term strategist of asset manager GMO continued. "So it's a head fake, but it's a hell of a head fake."

Grantham, who's been sounding the alarm since the summer of 2020, suggested the buzz around artificial intelligence has delayed the deflation of the current tech bubble. Stocks tumbled in 2022, but have rebounded this year as investors bet big on key AI players including Nvidia, Tesla, Alphabet, and Microsoft.

The veteran investor, who oversees his foundation's $1.5 billion of assets, said overseas stocks appear far less overvalued than American ones. If people do want to invest in US equities, they should prioritize high-quality companies that tend to be less indebted and more resilient to an economic downturn, he noted.

"I'm very nervous about an eventual financial trouble," Grantham said, echoing his warning earlier this year that the collapse of Silicon Valley Bank and other regional lenders this spring could herald a "rolling financial stress."

The market historian also touted companies involved in fighting climate change as compelling investments.

"I love climate-change stocks," he said. "They will have an incredible top-line revenue growth, driving forward like Tesla and electric vehicles versus the dopey VWs and old-fashioned cars."

As for the housing market, Grantham advised steering clear. He pointed out that two decades of declining mortgage rates have driven prices to "really crushing" high multiples across large parts of the developed world. "I wouldn't touch real estate," he said.

Grantham also cautioned against owning commodities. "Bear in mind every commodity is a royal pain to own because it has totally unpredictable and shocking drops along the way," he said, recommending them only to investors whose "nerves are strong."

Recession is still on the table

During the Livewire Markets event, Grantham was asked what he thought the probability of a US recession was in the next 18 months. He replied that it was over 50%, and if he had to be more specific, about 70%.

Inflation has slowed from a historic high of over 9% last summer to below 4% in recent months, fanning hopes that the Federal Reserve will reverse its interest-rate hikes and relieve pressure on the economy. Goldman Sachs sees only a 15% chance of a recession in the next 12 months, and the Fed's staff economists don't expect one either.

"The Fed and the economic establishment, the financial establishment, they always underestimate the probability of a recession," Grantham said. "You always have them, and yet they always say everything will be fine."

"This is not unusual, it's absolutely inevitable, and here they go again," he continued. "I think it would be unique if we don't have an extended problem with the economy."