Jeremy Grantham is seriously bearish again. In part 2 of his latest quarterly newsletter, he departs from the peak resources argument he made in part 1 and focuses on the overvaluation in stocks. His advice: sell!
He starts in on what value managers are all about:
A word on being too early in investing: if you are a value manager, you buy cheap assets. If you are very “experienced,” a euphemism for having suffered many setbacks, you try hard to reserve your big bets for when assets are very cheap. But even then, unless you are incredibly lucky, you will run into extraordinarily cheap, even bizarrely cheap, assets from time to time, and when that happens you will have owned them for quite a while already and will be dripping in red ink. If the market were feeling kind, it would become obviously misvalued in some area and then, after you had taken a moderate position, it would move back to normal. That would be very pleasant and easy to manage.
The problem is that bubbles are everywhere – and have been everywhere for most of the last few decades. How do you deal with that. Grantham says:
But my career, like most of yours, has been filled with an unusual number of real outliers. That certainly makes for excitement, but it also delivers real pain for even a disciplined value manager. Following is a snapshot of some of those outliers. In 1974, the U.S. market fell to seven times earnings and the U.S. value/growth spread hit what looked like a 3-sigma (700-year) event. U.S. small caps fell to their largest discount in history, yet by 1984 U.S. small caps sold at a premium for the first time ever. By 1989, the Japanese market peaked at 65 times earnings, having never been over 25 times before that cycle! In 1994, emerging market debt yielded 14 points above U.S. Treasuries, and by 2007 had fallen to a record low of below 2 points. By 1999, the S&P was famously at 35 times peak earnings; in 2000, the value/growth spread equaled its incredible record of 1974 (that I, at the time, would have almost bet my life against ever happening again). Equally improbable, in 2000, the U.S. small/large spread beat its 1974 record and emerging market equities had a 12 percentage point gap over the S&P 500 on our 10-year forecast (+10.8 versus -1.1%). Further, as the S&P 500 peaked in unattractiveness, the yield on the new TIPS (U.S. Government Inflation Protected Bonds) peaked in attractiveness at over 4.3% yield and REIT yields peaked at 9.5%. Truly bizarre. By 2007, the whole world was reveling in a risk-taking orgy and U.S. housing had experienced its first-ever nationwide bubble, which also reached a 3-sigma, 1-in-700-year level (still missed, naturally, by “The Ben Bernank”). Perhaps something was changing in the asset world to have caused so many outliers in the last 35 years. Who knows? The result, though, for value players, or at least those who wanted to do more than just tickle the problem, was overpriced markets that frightened them out and then, like the bunny with the drum, just kept going and going.
We know how this story ends though. Here’s how I put it in 2008:
By 1987, excess money had again led to asset price inflation worldwide. The bubble came to a timely demise with the Crash of 1987. Monetary easing worked wonders and we recovered from a near-miss calamity.
A US-Centric Global Economy
Unfortunately, the only lesson Alan Greenspan learned from this calamity is that monetary easing can result in a soft landing in an overheated economy. For Greenspan, the Fed cannot stop bubbles; it can only ease the pain in the aftermath. Witness Greenspan’s comments in the Wall Street Journal from December 11, 2007.
As a result, the Fed has acted like a one-trick pony ever since. Greenspan pulled us from the jaws of recession in 1995 and again in 1998 by lowering interest rates and increasing the money supply. From the very beginning, the excess liquidity created by the U.S. Federal Reserve created an excess supply of money, which repeatedly found its way through hot money flows to a mis-allocation of investment capital and an asset bubble somewhere in the global economy. In my opinion, the global economy continued to grow above trend through to the new millennium because these hot money flows created bubbles only in less central parts of the global economy (Mexico in 1994-95, Thailand and southeast Asia in 1997, Russia and Brazil in 1998, and Argentina, Uruguay, and Brazil in 2001-03). But, this growth was unsustainable as the global imbalances mounted.
Until the 1997-1999 period, the U.S. bubble was ‘manageable’ (of a similar magnitude to the 1987 bubble), despite unprecedented gains in the U.S. stock market. However, with the post-Asian Contagion monetary injection in 1997 followed by the bailout of Long-Term Capital Management in 1998 and the Y2K monetary injection in 1999, the crisis came home in the form of the ‘Nasdaq-Tech-Telecom misallocation of capital bubble.’ Because global growth was built on the quicksand of excessive credit creation and concomitant increases in debt, once the bubble infected the U.S. economy – the global growth engine — this massive house of cards was destined to collapse under the weight of excess capacity and mountains of debt.
An inflationary monetary policy and Keynesian government spending stimuli are not a panacea to a post-bubble depression. This is a lesson the Fed has failed to take on board.
The Fed is at it again!!! But this time rates are zero percent and so it must resort to quantitative easing. The Fed can flood the markets with money all it wants. It’s not going to work. It might reflate the bubble a ways but eventually the mis-allocation of resources and misspent capital must be written down. Right now we are bubblicious mode. It won’t last.
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