Jeremy Grantham – Bracing Yourself for a Near-Term Melt-Up

Smart Money

GMO – Bracing Yourself for a Possible Near-Term Melt-Up (A Very Personal View), January 3, 2018

  • Classic examples of the great bubbles of the past are not just characterized by higher-than-average prices
  • Among other factors, indicators of extremes of euphoria seem much more important than price
  • 2 months ago, Robert Shiller made the point that not nearly enough signs of euphoria were yet present to make this look like a late-stage bubble
  • This time, as the US market hit a 2-sigma level, it had almost none of the other more important bubble indicators of investor euphoria and even craziness. Similarly, early 1998 had none when we reduced our risk levels to a minimum based on price alone. In complete contrast, late 1999 and early 2000 had very many signs of bubbly, completely irrational behavior, just as mid, or even early 1929 had

Is a late bubble surge beginning?

  • Average time of the final bubble phase of the great equity bubbles is just under 3.5 years, with the average upcycle of real acceleration just 21 months
  • There is also an interesting symmetry – rising and falling at about the same rate
    • Average market declines are considerably faster than average advances
    • Historically, when dealing with real bubbles, being late has not been materially different in time and pain than being too early
    • Value managers are historically painfully too early over and over again
  • Until very recently it could justifiably be described as clawing its way steadily higher. But just recently, say the last 6 months, we have been showing a modest acceleration for a final possible assault on the peak
  • Fundamentals of recent years were disappointing and investors, far from being euphoric, had instead been climbing the wall of worry
  • Fundamentals are improving. Global economy is in sync for the first time in a dozen years and global profit margins are at a high; in the US, corporate tax cut is on the way which is unlikely to be quickly competed away, but very likely to further fatten the corporate share of the GDP pie and perhaps provide the oomph to keep stock prices rising

Increasing concentration and unusual outperformance of quality and low beta

  • Between them, I believe they are right behind acceleration in their effectiveness in warning of a late-stage bubble
  • Concentration is the essence of an escalating euphoria. By late-stage cycles, many buyers are fixating on “Winners” with the purchase motive being further stock gains, rather than any logic of long-term value
  • Outperformance of quality and low beta stocks in a rapidly-rising market: this is an odd behavior and is very rare in late-stage bull markets
    • I attribute the logic for this to Chuck Prince: “The market keeps going up faster and faster and there is no way commercially that I can play against it. So I have to keep dancing. But at least I don’t have to risk dancing off the cliff with a Pumatech.” “Rather, I will keep dancing with RCA or GE in 1929, Coca Cola and Avon in 1972, and Cisco and Microsoft in 1999”

Other asset classes making impressive bubbly moves

  • US housing market lacks the touchy-feely signs of euphoria that described it in 2004, 2005, and 2006 – the classic sign being the level of cocktail party bragging about condos in Florida that had just gone up 100% in price in a hurry
    • Exception to this might be in a few hot cities, this time San Francisco, Boston, and New York
  • But average US house price, as multiple of family income, is way higher than at any time before the great 3-sigma housing bubble of 2006. Those extraordinary and nationwide prices then perhaps serve to camouflage the current 2-sigma rise, as the outrageous prices of 2006 make today’s high prices seem less unreasonable
  • In a circular but probably accurate argument, just as rising house prices facilitate the development of an optimistic attitude for other assets, a US equity market melt-up, were it indeed to occur, would create exactly the right investment mood for another advance in house prices, with predictable consequences for the severity of the ensuing, more or less inevitable, crash

Extreme expensiveness

  • Extreme overvaluation plays a huge role in bubbles breaking: it is a necessary precondition
    • The more overvalued, the merrier
  • For judging the extent that bubbles will overrun fair value and for timing the break, value, sadly, is largely irrelevant
  • Current cycle already passes the necessary condition from a Shiller P/E perspective
    • It is a necessary but not sufficient condition for bubbles breaking

The Fed’s role in recent bubbles

  • Taking a different tack, we should look at the policy of the Greenspan-Bernanke-Yellen Fed: this policy of pushing down generally on rates –lower highs and lower lows – over 25 years, accompanied by a lot of moral hazard, has very probably helped push asset prices higher
  • The moral hazard – the asymmetric promise to help if times get tough but to leave you alone when times are rolling-had become increasingly well-understood, particularly during Greenspan’s first 15 years
    • Greenspan poetically argued in 1999 that the internet was driving away the dark clouds of ignorance and was issuing in a new era of permanently higher productivity
    • Think how encouraging this was to the bulls as the market in 1998 went past 21x peak of 1929 and climbed remorselessly to 35x
    • Even more statistically remarkable was Bernanke’s dismissal of a clear 3-sigma US housing market – a one in a thousand event normally – as “merely a reflection of a strong US economy” and that “US house prices had never declined”
  • Point here is that Yellen, too, sees no signs of dangerous stock prices and in general continues with the program of moral hazard
    • Yes, rates will rise, just as they rose from 2003 to 2006, but it is considered, to be cyclically normal in a tightening economy and so does not constitute a breach of contract
  • Why would the Fed stop its general asymmetric support before we reach a third bubble?
    • I would bet that a Yellen-like successor of the lower-rates-are-helpful variety will get the job done (Mr. Powell should fit the bill) and deliver a third in their series of Great Bubbles
  • A major shift in style of the Fed, on the other hand, based on an accumulation of new appointees who would turn away from the accommodating style of the last 30 years, would reduce the chances of a well-behaved classic bubble forming in the next year or two
  • Bottom line question is: Will this administration, when faced with either a market break or unexpected economic weakness, not push the completely independent Fed committee for lenient, lower-rate policies? Surely it will

The most difficult call: Are the more touchy-feely measures of market excess falling into place?

  • We know we’re not there yet, but we can perhaps see some early movement: increasing vindictiveness to the bears for costing investors’ money; the crazy Bitcoins of the world; and Amazon and the other handful of current heroes
  • Increasingly optimistic tone of press and TV coverage is also important. Now, the newspaper and TV coverage is considerably more interested in market events
  • Other items worth mentioning are IPO windows and new record highs for corporate deals
  • Keep an eye on what the TVs at lunchtime eateries are showing: when most have talking heads yammering about Amazon, Tencent, and Bitcoin and not Patriot replays – just as late 1999 featured the latest in – we are probably down to the last few months
  • Good luck. We’ll all need some

Summary of my guesses

  • A melt-up or end-phase of a bubble within the next 6 months to 2 years is likely (i.e. over 50%)
  • If there is a melt-up, then the odds of a subsequent bubble break or melt-down are very high (i.e. over 90%)
  • If such a decline takes place, I believe the market is very likely (over 2:1) to bounce back up way over the pre-1998 level of 15x, but likely a bit below the average trend of the last 20 years, as the trend slowly works its way back toward the old normal on my “Not with a Bang but a Whimper” flight path
  • Suggested action plan for everyone:
    • Own as much Emerging Market Equity as your career or business risk can tolerate, and some EAFE
  • For those individual investors willing to speculate:
    • Consider a small hedge of some high-momentum stocks primarily in the US and possibly including a few of the obvious candidates in China
    • In previous great bubbles, we have ended with sensational gains, both in speed and extent, from a decreasing number of favorites
    • If we have the accelerating rally that has typified previous blow-off phases, you should be ready to reduce equity exposure (even Emerging Market equities), ideally by a lot if you can stand it, when either the psychological signs become extreme, or when, after further considerable gain, the market convincingly stumbles

Image Source: Robert Shiller, Compustat, Worldscope, S&P, National Association of Realtors, GMO


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