Jeremy Grantham is a co-founder of Grantham Mayo Van Otterloo, a $70 billion global asset manager. He serves the firm’s chief strategist and is a member of GMO’s asset allocation team.

Mr. Grantham warned about both the dot-com bubble of 2000 and the housing bubble of 2007. This fall, he sounded a caution about a possible “melt-up” market — a massive rally marking the end of a stock bubble. InvestmentNews senior columnist John Waggoner interviewed Mr. Grantham on the state of the market and the world.

John Waggoner: So, is the stock market in a bubble?

Jeremy Grantham: Close, but no cigar. Given the nature of earnings, it has settled down to a relatively well-controlled, non-euphoric, extremely overpriced market.

And we’re hugely overpriced, not just by the standards of long ago, but even by the standards of the past 20 years. We’re very vulnerable on profit margins, which have gone off the scale, although those could go higher by the time tax reform and deregulation fully kick in. They are all conspiring to drive to a record high, but you can be sure that margins will eventually come down somewhat, and price-to-earnings ratios will come down.

JW: Do you still see a blow-off top — a “melt-up” — in stock prices?

JG: Do we have a last hurrah? I was confident in November and December when I was writing my January outlook. I’ve lowered that probability from an over-50% likelihood to an over-40% likelihood in the not-too-distant future.

JW: Why is that?

JG: In previous bubbles, the rapid growth phase was a 60% gain in the final 21 months. I was really impressed how the speculative spirits came out of the woodwork in January. Another month or two of that and we could have reached 3300 to 3700 on the Standard & Poor’s 500 stock index, and that would have been a 60% gain in 21 months.

Price is not enough. You must also have a surge of speculative interest. In January, every new high was talked about on TV and in the newspapers — it was a preview of a classic melt-up. I don’t think it was enough, although historians could say, ‘What were you thinking?’

The downturn in February was a shot across the bow. It was partly because of trade wars. Ninety percent of economists hate the idea of a trade war. If tariffs were to freeze at current levels, the effect would be miniscule, but it has the possibility of getting out of hand. It’s a dangerous game to enter when you don’t to, and we didn’t have to.

Also, the 30-year tailwind on interest rates is probably over — it’s now more neutral to negative going forward. Inflation is unlikely to be quite as well-behaved, and it’s likely to be a head wind, too. People are jumpy about inflation and the tightening of the credit cycle. I don’t think that ruins the case for a last hurrah in stocks, but it lowers the odds.

What has increased is the probability that we unravel in a series of minor moves, so that in five years, the market’s price is down 15%, earnings are up a disappointing 20%, and that combination gets the PE ratio down to a level where people feel comfortable to invest again.

This is something that almost never happens: The market prefers histrionics -— a big decline. But that doesn’t mean it can’t happen. I think that’s one outcome whose probability has increased in my mind, while the possibility of a big bubble top has diminished.

JW: What should advisers do if there is a melt-up?

JG: Brace yourself. If you’re a prudent, careful portfolio manager, you’ll find [client behavior] truly shocking if we have a melt-up. If the response is like what we had in 1929 and 1999, people get slightly hysterical, and this particularly applies to clients who want to keep up with their golfing buddies. When we were cautious in 1999, clients treated it like it was personal, as if we were trying to ruin them. They hated us for saying it was a bubble. And when the cataclysm arrived — we didn’t lose money in 2000-2002 — none of those clients came back. Not one solitary guy. That’s the nature of the beast, and it wasn’t a pretty sight. They treated us as if we had wandered off the path.

JW: What can you do?

JG: If the market hits you with a 30% sharp rise, you’ll regret minimizing your exposure. You have to keep a cool head. Our foundation has 0.8% of​ its assets in an out-of-the-money call because in case of a melt-up and the market goes up 30%, it makes about 10%. For about 0.8% of assets that’s, a​ lot of peace of mind. You put another 4% into the hair of the dog that’s going to bite you — bitcoin, Tencent, Amazon, the FANG stocks [Facebook, Amazon, Netflix, Google]. If the market goes up 30% to 80% and the option comes through, you’ll be a hero and make 25% overall.

JW: You urge emerging markets as one way to ameliorate the bubble. Don’t emerging markets stocks typically fall in sync with developed markets?

JG: Value matters a lot. In 1999, while we were pointing out that the end of the world was around the corner, we were recommending small-cap stocks. People said, ‘What are you smoking?’ But small-cap value stocks were up 3% when the S&P 500 was down nearly 50%. Small-cap was beautifully cheap on a relative basis.

So you start with that discrepancy. When you have a major decline, the knee-jerk response is that emerging markets will go down as much or more. But eventually the cheap asset becomes so cheap that investors dig their heels in. I’d be dollars to donuts that emerging markets go down substantially less than the U.S. market and will have a sharper rebound on the way back.

You could have a moderate U.S. recession unaccompanied by a recession in emerging markets. Given that our economic recovery is ancient, our stock market is an outlier and higher-priced. It sets up a situation that would be the first time since World War II where you can have some separation of economic performance. If the U.S. market does go down, there’s nothing to stop emerging markets from going up 20% and the MSCI [Europe, Australasia and Far East] index going up 7%.

If you have access to a value emerging markets fund, I would definitely tilt in that direction for the time being. It’s abnormally cheap. But I do have to point out that some of these new emerging markets technology funds do not look at all ridiculous. They’re growing at rates that make Amazon look like it’s in reverse. Tencent had earnings up 50% year-over-year. Like the FANG stocks, they are serious companies that are doing well, not idiot companies with no earnings.

JW: You noted in your January letter that Republicans are often at the heart of a bubble. Why is that?

JG: The serious answer is that there are not enough bubbles, not enough data points, to say that conclusively. It’s quite possibly just an artifact of the data. If I were a Republican, I’d say it was because Democrats have a tendency to overstimulate and the Republicans are the suckers who come in and pay the price. If I were a Democrat, I’d say that Republicans have a more carefree attitude toward regulation.

JW: What else are you worried about?

JG: I feel a moral imperative to point out that we’re treating climate change, global population growth and the ability to feed that population too lightly. It seems like we have generated a world where we’re going out of business at a much more rapid speed than we think. If so, we’re a very odd species and deserving of our fate. It certainly doesn’t bode well for the oil and chemical industries.