Posted by on November 9, 2016 12:08 am
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Categories: Behavioral finance Bond Bubbles Central Banks Economic bubbles Economy Finance Financial crises Financial economics Global Economy japan Jeremy Grantham Market trend Mean Reversion money pdf Real estate S&P S&P 500 Stock market bubble US Federal Reserve

The first time GMO’s Geremy Grantham proposed the 2,250 “bubble bogey” in the S&P, was May of 2014. As readers may recall, in an article “How And When The Bubble Finally Bursts: Jeremy Grantham’s Take” the famous asset manager laid out what he believes is the maximum level for the S&P before a bubble burst is finally triggered, is roughly 2,250, roughly a 2-standard-deviation (2-sigma) point on historical data that has effectively separated real bubbles from mere bull markets.

Today, in a note, musing on the fate of the stock market bubble (full letter below), Grantham appears to have changed his mind, and no longer expects a “traditional bubble burst”, instead believes that the the S&P will fizzle in a “Japanese scenario” where it slowly, painfully grinds lower: “for bubble historians eager to see pins used on bubbles and spoiled by the prevalence of bubbles in the last 30 years, it is tempting to see them too often. Well, the US market today is not a classic bubble, not even close.” He adds that the “market is unlikely to go “bang” in the way those bubbles did. It is far more likely that the mean reversion will be slow and incomplete.”

In other words, a world in which bubbles grow and grow, but never burst, and merely deflate. While superficially that sounds like great news, according to Grantham for most investors it is actually very bad news:

The consequences are dismal for investors: we are likely to limp into the setting sun with very low returns. For bubble historians, though, it is heartbreaking for there will be no histrionics, no chance of being a real hero. Not this time.

Maybe he is right. On the other hand, in a world in which even the smallest dip in the US stock market has to be countered by more aggressive expansions of central bank balance sheets, and where central banks are running out of firepower, we would not be so confident that the “bubbles of yore” are gone for ever.

That said, if Grantham is right, and there is no violent burst, that also means his bubble bogey target is, as he puts it, a “red herring”.

The 2300 level on the S&P 500, which marks the 2-standard-deviation (2-sigma) point on historical data that has effectively separated real bubbles from mere bull markets, is in this case quite possibly a red herring. It is comparing today’s much higher pricing environment to history’s far lower levels. I have made much of the convenience of 2-sigma in the past as it has brought some apparent precision to the more touchy-feely definition of a true bubble: excellent fundamentals irrationally extrapolated. Now, when this definition conflicts with the 2-sigma measurement – ironically, it was chosen partly because it had never conflicted before – I apparently prefer the less statistical test. But you can imagine the trepidation with which I do this.

But while the equity market is less of a concern to the famous investors, there is another asset that is more troubling:

Hidden by the great bubbles of 2000 and 2007, another, much slower-burning but perhaps even more powerful force, has been exerting itself: a 35-year downward move in rates (see Exhibit 1), which, with persistent help from the Fed over the last 20 years and a shift in the global economy, has led to a general drop in the discount rate applied to almost all assets. They now all return 2-2.5% less than they did in the 1955 to 1995 era (or, as far as we can tell from incomplete data, from 1900 to 1995). This broad shift in available returns gives rise to the question of what constitutes fair value in this changed world; will prices regress back toward the more traditional levels? And if they do, will it be fast or slow?

Ah yes, the real question that matters: if and when central bankers deflate the bond bubble of the past three and a half decades, how will they keep yield from “regressing” in a stable fashion, without losing control of the long end? That may be the true $64 trillion question.

Grantham then poses another just as important question: whether abnormally high US profit margins will also regress, and, if so, by how much and how fast? “

Counterintuitively, it turns out that the implications for the next 20 years for pension funds and others are oddly similar whether the market crashes in 2 years, falls steadily over 7 years, or whimpers sideways for 20 years. The real difference in these flight paths will be, of course, over the short term. Are we going to have our pain from regression to the mean in an intense 2-year burst, a steady 7-year decline, or a drawn-out 20-year whimper?”

Grantham then leaves the reader off with some 37 observations on why the bubble will end with a “whimper” not a bang: “The caveat here is that while I am very confident in saying that we are not in a traditional bubble today, all the other arguments below are more in the nature of thought experiments or, less grandly, simply thinking aloud. I am asking you – especially you value managers – to think through with me some of these varied possibilities and their implications.”

Below we present Grantham’s first 8 cases for a “whimper, not a bang”

  1. Classic investment bubbles require abnormally favorable fundamentals in areas such as productivity, technology, employment, and capacity utilization. They usually require a favorable geo-political environment as well. But these very favorable factors alone are not enough.
  2. Investment bubbles also require investor euphoria. This euphoria is typically represented by a willingness to extrapolate the abnormally favorable fundamental conditions into the distant future.
  3. The euphoric phases of these epic bull markets have tended to rise at an accelerating rate in the final two to three years and to fall even faster. Exhibit 2 shows four of my all-time favorites. True euphoric bubbles have no sound economic underpinning and so are particularly vulnerable to sudden bursting when some unexpected bad news occurs or when selling just starts… “comes in from the country” as they said in 1929
  4. We have been extremely spoiled in the last 30 years by experiencing 4 of perhaps the best 8 classic bubbles known to history. For me, the order of seniority is, from the top: Japanese land, Japanese stocks in 1989, US tech stocks in 2000, and US housing, which peaked in 2006 and shared the stage with both the broadest international equity overpricing (over 1-sigma) ever recorded and a risk/return line for assets that appeared to slope backwards for the first time in history – investors actually paid for the privilege of taking risk.
  5. What did these four bubbles have in common? Lots of euphoria and unbelievable things that were widely believed: Yes, the land under the Emperor’s Palace really did equal the real estate value of California. The Japanese market was cheap at 65x said the hit squad from Solomon Bros. Their work proved that with their low bond rates, the P/E should have been 100. The US tech stocks were 65x. Internet stocks sold at many multiples of sales despite a collective loss and Greenspan (hiss) explained how the Internet would usher in a new golden age of growth, not the boom and bust of productivity that we actually experienced. And most institutional investment committees believed it or half believed it! And US house prices, said Bernanke in 2007, “had never declined,” meaning they never would, and everyone believed him. Indeed, the broad public during these four events, two in Japan and two in the US, appeared to believe most or all of it. As did the economic and financial establishments, especially for the two US bubbles. Certainly only mavericks spoke against them.
  6. Let me ask you: How does that level of euphoria, of wishful thinking, of general acceptance, compare to today’s stock market in the US? Not very well. The market lacks both the excellent fundamentals and the euphoria required to unreasonably extrapolate it.
  7. Current fundamentals are way below optimal – trend line growth and productivity are at such low levels that the usually confident economic establishment is at an obvious loss to explain why. Capacity utilization is well below peak and has been falling. There is plenty of available labor hiding in the current low participation rate (at a price). House building is also far below normal.
  8. Classic bubbles have always required that the geopolitical world is at least acceptable, more usually well above average. Today’s, in contrast, you can easily agree is unusually nerve-wracking.

The full letter which includes GMO’s full list of 37 “cases for a whimper” is below (pdf link)

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