Monetary ease, Grantham on overvaluation and the bubble in bubbles
The macro debate today is about secular stagnation and the correct policy response to deal with it if it exists. With that backdrop, it is interesting to read Jeremy Grantham’s latest quarterly letter to investors, which sounds a word of caution about monetary ease-fuelled asset prices. Is there a bubble? Comments below
The last two daily commentaries here were about the limits of monetary policy. See parts 1 and 2 here. These tie in very well to today’s topic because the conclusion I drew on the limits of monetary policy was that the global economy has relied excessively on monetary policy to fine-tune economic performance as policy makers became enthralled with an asset-based world view. The result has been increased private debt in developed economies in particular, which has resulted in turbulent and recurring crises, culminating in the Great Financial Crisis of 2007-2009.
I went on a bit of a twitter rant about this topic this morning and my comments there will be the framework lead in for this article:
- Tweet #1: The household savings ratio in the UK plummeted during housing bubble and re-adjusted after https://touchstoneblog.org.uk/2013/11/secular-stagnation-bubbles-inequality …pic.twitter.com/hsGK9TKFR5
- Tweet #2: The same decline in savings during the Great Moderation was true in the US https://www.creditwritedowns.com/2008/07/chart-of-day-household-debt-vs-savings.html …pic.twitter.com/1A4OkUjSck
- Tweet #3: I believe the savings rate dropped because of a secular leveraging driven by over-reliance on monetary policy https://www.creditwritedowns.com/2013/11/limits-monetary-policy-part-1.html …
- Tweet #4: Basically, the Great Moderation was simply a period of declining rates and private leveraging. The private sector is now re-adjusting
- Tweet #5: It can re-adjust by reducing debt, increasing income, or relying on net financial asset transfers from govt deficits or trade surpluses
- Tweet #6: When growth depends on declining rates and private leveraging, people with assets win. That’s a big part of income/wealth inequality
- Tweet #7: Corporations and wealthier households have more assets and benefit from asset-based economy https://touchstoneblog.org.uk/2013/11/secular-stagnation-bubbles-inequality …
- Tweet #8: Also read
@jamessaft on the incentive gap between households and business https://www.reuters.com/article/2013/11/19/column-markets-saft-idUSL2N0J321520131119 …
- Tweet #9: The incentive gap
@jamessaft describes is a direct outgrowth of the asset-based economic model that Larry Summers recently gave voice too
- Tweet #10: Note this piece on the Great Corporate Tax Shift. Further advances incentive gap of
@jamessafthttps://ow.ly/r0vW8 ht @rjocean
- Tweet #11: But hey, stocks and house prices are rising. And you can benefit from that… at least until the next recession
So, that’s where we are now. In a period now being described as a secular stagnation, stocks and asset prices are rising as monetary policy remains accommodative. The question is: where will this lead?
Below are my thoughts using quotes from Jeremy Grantham.
First, let’s look at what Grantham has said and done. During the tech bubble, Grantham correctly saw massive overvaluation and took his clients out of overpriced stocks. As the market continued to climb in the face of his retrenchment, the reaction from clients was brutal; he lost 40% of assets under management. For most money managers then, missing a bull market is a dismissible offense. But Grantham was right and performed so well subsequently that he won back all the funds to manage he lost during the mania and then some.
Of course, Grantham also saw the housing bubble, warned of it at the time, and before the crash in 2008 additionally warned that the credit crunch was far from over. As the carnage mounted, more and more stocks were priced for economic collapse and Grantham finally told us “Pull the trigger” in February of 2009, almost perfect timing for the next cyclical bull market.
Unfortunately, this bull market is built to a large degree on multiple expansion in part due to the greater value of future cash flows from low rates and the extrapolation of present conditions forward. Here is what Grantham is saying now:
“In equities there are few signs yet of a traditional bubble. In the U.S. individuals are not yet consistent buyers of mutual funds. Over lunch I am still looking at Patriots’ highlights and not the CNBC talking heads recommending Pumatech or whatever they were in 1999. There are no wonderful and inﬂuential theories as to why the P/E structure should be much higher today as there were in Japan in 1989 or in the U.S. in 2000, with Greenspan’s theory of the internet driving away the dark clouds of ignorance and ushering in an era of permanently higher P/Es. There is only Jeremy Siegel doing his usual, apparently inexhaustible thing of explaining why the market is actually cheap: in 2000 we tangled over the market’s P/E of 30 to 35, which, with arcane and ingenious adjustments, for him did not portend disaster. This time it is unprecedented margins, usually the most dependably mean reverting of all financial series, which are apparently now normal.)”
Basically, the bubble talk is a bit premature. Baryy Rithotlz calls all this talk the bubble in bubbles. People are not loading up on stocks the way they did in the late 1990s or the way they did housing in the 2000s. So we are not in a bubble… yet. But a bubble is coming – and in Grantham’s view this will all be about easy money:
“I would think that we are probably in the slow build-up to something interesting – a badly overpriced market and bubble conditions. My personal guess is that the U.S. market, especially the non-blue chips, will work its way higher, perhaps by 20% to 30% in the next year or, more likely, two years, with the rest of the world including emerging market equities covering even more ground in at least a partial catch-up. And then we will have the third in the series of serious market busts since 1999 and presumably Greenspan, Bernanke, Yellen, et al. will rest happy, for surely they must expect something like this outcome given their experience. And we the people, of course, will get what we deserve. We acclaimed the original perpetrator of this ill-fated plan – Greenspan – to be the great Maestro, in a general orgy of boot licking. His faithful acolyte, Bernanke, was reappointed by a democratic president and generally lauded for doing (I admit) a perfectly serviceable job of rallying the troops in a crash that absolutely would not have occurred without the dangerous experiments in deregulation and no regulation (of the subprime instruments, for example) of his and his predecessor’s policy.”
So, yes, easy money is bullish for stocks now. And you can try and time the market. But if you get blown up doing so, you will have no one to blame but yourself. That’s the message that Grantham and his associate Ben Inker are delivering. Grantham goes on:
“In the meantime investors should be aware that the U.S. market is already badly overpriced – indeed, we believe it is priced to deliver negative real returns over seven years – and that most foreign markets having moved up rapidly this summer are also overpriced but less so. In our view, prudent investors should already be reducing their equity bets and their risk level in general. One of the more painful lessons in investing is that the prudent investor (or “value investor” if you prefer) almost invariably must forego plenty of fun at the top end of markets. This market is already no exception, but speculation can hurt prudence much more and probably will. Ah, that’s life. And with a Fed like ours it’s probably what we deserve. “
He is cautious on the economic cycle. And as this market is predicated on that cycle continuing, he is looking:
“What can go wrong for the market? There is a slow and for me rather sinister slowing down of economic growth, most obviously in Europe but also globally, that could at worst overwhelm even the Fed. The general lack of ﬁscal stimulus globally and the almost precipitous decline in the U.S. Federal deﬁcit in particular do not help. What are the odds in the next two years? Perhaps one in four.
So to sum up: Stocks are overvalued but there is no bubble. If the economic cycle continues forward into further recovery, stocks can and will move higher, potentially into bubble territory. If the economy flags despite the best efforts of monetary authorities, then we are going to see some serious pain economically and in asset markets. Either way, all of this will have been brought on by Fed policy and its easy money. You can move heavily into risk on mode to capture the excess return, but know that doing so is not a strategy based on the fundamentals suggested by the earnings of underlying asset values. If the economy goes pear-shaped, you will have no one to blame but yourself (and the Fed).