Veteran value investor Jeremy Grantham put a missive up on his firm’s website yesterday outlining his view that we won’t see an imminent end to the US bull market. He expects a melt-up, not a meltdown. But Grantham goes on to say that we will see an asset bubble implosion in 2019, with as much as 50% downside. Some thoughts below
My macro view
Before I get into Grantham’s piece, let me say that a lot of what he is saying mirrors what I am saying from a macro perspective. First, you need to see an economic catalyst for a bear market. I’m not talking about flash crashes or even the infamous 1987 crash. Longer term-bear markets are the result of faltering earnings, that in turn result from widespread macro-economic slowing. And right now, the global economy is booming. No recession, no bear market
But when you look at some of the other macro indicators, nothing is showing signs of economic fatigue yet. Curve inversion is the recession signal and the yield curve is flat, not inverted. The Fed is still hiking interest rates, where recessions occur after the Fed has ended its rate hike train. Jobless claims are still falling right now, whereas they are rising when a recession occurs. And money supply growth is still chugging along. Nowcast economic models show 3% growth. And the ISM manufacturing index is not just strong but unusually strong regarding new orders, its forward-looking subindex. From where I sit, all of this bodes well economically. There is no macro case for recession, and therefore, no macro case for a bear market— just the opposite.
Grantham’s thesis
Grantham is saying the same thing, but looking at the market internals data. He starts off this way:
I find myself in an interesting place for an investor from the value school. I recognize on one hand that this is one of the highest-priced markets in US history. On the other hand, as a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market. The data on the high price of the market is clean and factual. We can be as certain as we ever get in stock market analysis that the current price is exceptionally high. In contrast, my judgment on the melt-up is based on a mish-mash of statistical and psychological factors based on earlier eras, each one very different, so that much of the information available is not easily comparable. It also leans very heavily on a few US examples. Yet, strangely, I find the less statistical data more compelling in this bubble context than the simple fact of overpricing. Whether you will also, dear reader, remains to be seen. In any case, my task in this note is to present the evidence, both statistical and touchy-feely, as clearly as I can.
The data pointing to a melt-up in US equities instead of meltdown that Grantham enumerates are:
- Momentum: Bubbles end in a euphoric rapid acceleration phase. And Grantham only sees a modest acceleration of price in the last six months.
- Narrowing: Bubbles end with a narrow leadership as people pile into a select number of shares. He calls this the “essence of an escalating euphoria”. We don’t see this yet either. “The advance-decline line is clearly not delivering a threatening message yet.”
- Side bubbles: Equity bubbles don’t form in vacuum. You have a widespread mania that manifests itself in other asset classes. According to Grantham, we don’t see the levels of mania elsewhere that corroborate a true melt-up. He notes US house prices at 2 standard deviations above mean and says this is not enough to corroborate melt-up. He also mentions cryptocurrencies. My view: this is the weakest of his arguments because 2 standard deviations in housing and a mania in cryptocurrencies are definitely examples of a more widespread mania.
- Valuation: Extreme valuation is a necessary pre-condition for a bubble bursting. But it is not a signal on when the bubble will burst, Grantham says. Calling the top (or shorting high-flyers) during the melt-up phase is very tricky.
- Republican President: I reckon he’s being tongue in cheek here, but he notes that manias seem to end when a Republican President is in office!
His conclusion
- We will likely see as much as another 50% upside within the next 6 months to 2 years before the bubble bursts.
- If we do see a melt-up, the odds of it bursting and melting down are 90%
- If we do get a meltdown, we will likely see stocks cut in half.
- But, “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”
So what do you do, if you believe Grantham? He says overweight emerging markets as much as your ‘career risk’ and tolerance allows you. For individual investors, he says consider taking a side stake (I’m guessing he’s talking in the order of 5%) on high beta US shares or Chinese shares in order to benefit from the melt-up — and to minimize underperformance, if you are a value investor. But he warns, be ready to cut your equity exposure as the mania becomes extreme.
My thoughts
This is scary stuff. As a value investor, you’re supposed to use valuation as a guide, rotating into undervalued segments of the market as the market climbs. But when everything is overvalued, what do you do then? In the past, as the melt-up phase began, value investors took the value signal as a cue to underweight equities and sit out the blow-off phase. That is painful, especially if you look at it from a career risk perspective. Grantham shows a chart which says the penalty for being late to rotate is actually no greater than the penalty for being early because of the symmetry of the market move up and then down.
While being late is the best strategy from a career risk perspective, it is going to cause you a lot of angst as a value investor because your models will be telling you to sell. That’s one part that is scary.
Another scary part is the political economy of all of this. Now Grantham writes that “[l]iving in a hyper-political era, I should mention that if my best guesses are correct, a near-term meltup would obviously help the current administration at mid-term, just as the later and highly probable melt-down would seriously hurt it.” Maybe. It would certainly push people away from Trump.
My view is that the macro downturn that precipitates this fall in shares is where the pain for most people will come. The markets’ valuation ownership is dominated by the rich. Ordinary people will feel the pain through being thrown out of work, not being able to pay back student and auto loans, or seeing the value of their house decline. This could push people to support extreme policy choices that we haven’t even seen with Trump.
And finally, there’s the Fed. Grantham addresses the Fed’s role in all of this. Read his commentary in the link I give below. Let me say this on the Fed though: the Fed has a statutory role to pursue low inflation and unemployment. And it is going to do “whatever it takes” to meet those goals. That’s a reality I gave voice to yesterday. Please read that post. The problem is that (as Wynne Godley put the thinking behind the Eurozone’s structure) the macro strategy that’s been employed for the last three and a half decades assumes “economies are self-righting organisms which never under any circumstances need management at all”. When bad things happen, the central bank rides to the rescue with lower rates. And when rates reach zero percent, the central bank engages in quantitative easing. That’s the strategy — and it’s a recipe for disaster.
Look, right now, we are entering the melt-up phase. Shares are priced for perfection. And that means that Granthm’s 50% downside is not an unreasonable target after a meltup from here. From a business cycle perspective, I call this the most dangerous period because the risk for policy error is high. The Fed is going to be trying to reach its low unemployment and inflation goals against a backdrop of a brisk economic trajectory and market euphoria. To add fuel to the fire, we are getting tax cuts for corporations and the wealthy just as this is occurring. And while that will certainly help asset prices, it will make the likelihood of a policy error greater.
Enjoy the ride while it lasts. Expect expansion through 2018, but problems thereafter. And have hope the Fed threads the needle.
Source: Bracing Yourself for a Possible Near-Term Melt-Up (A Very Personal View) – Jeremy Grantham, GMO (pdf)
P.S. – Maybe the biggest question of 2018 is the one Nouriel Roubini asks:
Increasing gap between geopolitical depression – to use @ianbremmer term – and global economic expansion and euphoric markets. For now investors are dismissing geopolitical risks a low probability events. Rational or irrational behavior?
— Nouriel Roubini (@Nouriel)
If we do have a geopolitical event with serious economic implications in 2018, it would be a black swan that can’t be modelled, with unknowable consequences.