79-year-old Jeremy Grantham has lived through - and successfully traded - a number of the market's most extreme emotional moments. Infamous for his call in 2000 that stocks would trade lower in price for a decade, his latest letter is a shot across the bow warning of the beginning of the end for one of the longest bull markets in history.
Critically, he says the market’s next move could take stocks higher. Dramatically higher.
“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 chief investment strategist for GMO in Boston which manages $74 billion, wrote in a letter to investors Wednesday.
Despite remarking that the current market is one of the highest-price in history, Grantham cited the recent acceleration of U.S. equity prices, a concentration of leadership in stocks and growing media coverage of events such as bitcoin’s surge and Amazon.com Inc.’s success as signs that the final phase of a bubble could be coming in the next six months to two years.
He warned investors to keep an eye on what is showing on television in restaurants.
“When most have talking heads yammering about Amazon, Tencent and bitcoin and not Patriot replays -- just as late 1999 featured the latest in Pets.com -- we are probably down to the last few months,” he wrote.
“Good luck. We’ll all need some.”
Grantham begins his letter with a warning: "brace yourself for a possible near-term melt-up"
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 previous 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.
Grantham begins his search by looking at the past moments of exuberance.
The classic examples are not just characterized by higher-than-average prices. Price alone seems to me now to be by no means a sufficient sign of an impending bubble break. Among other factors, indicators of extremes of euphoria seem much more important than price.
So, Grantham asks, is a late bubble surge beginning?
Let’s look at what is missing in the way of psychological and technical signs of a late-stage bubble and what is beginning to fall into place. On the topic of classic bubbles, I have long shown Exhibits 1 and 2. They recognize the importance of a true psychological event of momentum increasing to a frenzy. That is to say, acceleration of price. The average time of the final bubble phase of the great equity bubbles shown in Exhibit 1 is just under 3.5 years, with the average upcycle of real acceleration just 21 months. And the two smaller equity bubbles had gains of 65% and 58%.
They also show an interesting symmetry, don’t you think? Rising and falling at about the same rate, as did the real McCoy – the South Sea Bubble shown in Exhibit 2 – before them.
Yes, there is a real danger of being late. And in general, average market declines are considerably faster than average advances. But historically, when dealing with real bubbles, being late has not been materially different in time and pain than being too early, as you can see. Value managers are historically painfully too early over and over again, as I know better than most.
Recently an academic paper titled “Bubbles for Fama” concluded that in the US and almost all global markets, the strongest indicator – stronger than pure pricing or value – was indeed price acceleration. (This is perhaps the third time I have agreed with mainstream economists in the last 50 years. I have a firm principle of generously quoting them when they agree with me.)
Exhibit 3 shows what the market looks like today. Until very recently it could justifiably be described as clawing its way steadily higher. But just recently, say the last six months, we have been showing a modest acceleration, the base camp, perhaps, for a final possible assault on the peak.
Exhibit 4 represents our quick effort at showing what level of acceleration it might take to make 2018 (and possibly 2019) look like a classic bubble. A range of 9 to 18 months from today and a price rise to around 3,400 to 3,700 on the S&P 500 would show the same 60% gain over 21 months as the least of the other classic bubble events.
What of other indicators? I have previously defined a great bubble as being “Excellent Fundamentals Euphorically Extrapolated.”
And I have previously concluded that, in general, the fundamentals of recent years were disappointing and that investors, far from being euphoric, had instead been “climbing the wall of worry” as they used to say. But fundamentals are improving. The global economy is in sync for the first time in a dozen years and global profit margins are at a high; in the US, a corporate tax cut is on the way, which in today’s sticky, more monopolistic world, is unlikely to be quickly competed away as theory suggests, but very likely to further fatten the corporate share of the GDP pie and perhaps provide the oomph to keep stock prices rising.
In looking for signs of late bubble behavior, we have to reconcile to the fact that no two bubbles, even the classics, are the same.
They share the fact that there are many signs of investor euphoria, sometimes indeed approaching the madness of crowds, but the package of psychological and technical indicators has been different each time. The historian has to emphasize the big picture: In general are investors getting clearly carried away? Are prices accelerating? Is the market narrowing? And, are at least some of the other early warnings from the previous great bubbles falling into place?
At last, we come to value. Extreme overvaluation plays a huge role in bubbles breaking: It is a necessary precondition. The more overvalued, the merrier. But, for judging the extent that bubbles will overrun fair value and for timing the break, value, sadly, is largely irrelevant. Thus, it is a necessary but absolutely not sufficient condition. Exhibit 13 shows how handsomely the current cycle already passes the necessary condition.
The most difficult call: Are the more touchy-feely measures of market excess falling into place?
Anyone around in 1999 and early 2000 has had a classic primer in these signs. 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 (this is a true, crazy mini-bubble of its own I expect – it has certainly passed my “nephew test” of his obsessing about buying or not); and Amazon and the other handful of current heroes – here and globally – taking over more of the press coverage and a growing percentage of total market gains (Amazon +13%, the day before I started to write this, and Tencent doubling this year to a $500 billion market cap). The increasingly optimistic tone of press and TV coverage is also important. A mere six months ago, new market highs were hardly mentioned and learned bears were featured everywhere. Now, the newspaper and TV coverage is considerably more interested in market events. (This last comment reminds me of some advice for contrarians: There is usually a phase or two in each cycle where most investors expect a market gain or loss and it actually happens. The mass of investors usually ends up wrong in the end, but not all the time, for Heaven’s sake!) Other items worth mentioning are IPO windows and new record highs for corporate deals. We can have a satisfactory melt-up without them, but still one or the other is likely and both together are quite possible. I believe their presence would make a spectacular bust that much more likely.
Finally, my favorite advice once again: 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 Pets.com – we are probably down to the last few months.
So what would happen if the exuberance that Grantham believes awaits the S&P is, in fact, irrational?
To that question, Goldman has a ready answer: "We would deem it “irrational exuberance” if the S&P 500 during the next three years followed the exponential trajectory of stocks in the late 1990s."
In such a case, Goldman predicts that the S&P 500 would trade at 5300 by year-end 2020 (a 105% rise from today). If slightly "less irrational" bubble over the next three years would mean stocks instead trade at a similar forward P/E to the Tech Bubble (24x), and would imply a year-end 2020 index level of 4050 (57% above today). During the three years post Greenspan’s speech, S&P 500 EPS rose by 26% ($40 to $50). Translated to today, Goldman calculates such a growth rate would imply 2020 EPS of $166 compared with our estimate of $163.
And no discussion of bubbles would be complete without some allocation of blame...
The Fed’s role in recent bubbles
Taking a different tack, we should look at the policy of what I call 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. All three Chairmen at some time have specifically taken credit for helping the economy by generating a wealth effect from a higher market. Over the years we have come to believe that moral hazard is more important in raising asset price levels than the interest rate level and availability of credit, although they may also help. 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. It seems likely that such a policy as the Greenspan Put might culminate periodically in investment bubbles of the type it did indeed generate in the 2000 TMT bubble and the 2006 housing bubble. And the likelihood of bubbles forming no doubt increased because all three Fed bosses outspokenly denied that such bubbles were occurring even as they passed through 2-sigma levels. 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 the 21x peak of 1929 and climbed remorselessly (and at an accelerating rate!) 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!” That was accurate enough, but what it really meant – and was interpreted as meaning – was that US housing prices would not decline in the future. But, of course, the US housing market had never been tested by a 3-sigma bubble before! And the rest is history.
The 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, quite rightly, to be cyclically normal in a tightening economy and so does not constitute a breach of contract. (The recent rate rises, just like the 400-basis-point rise from 2003 to 2006, did not at all get in the way of rising stock prices any more consequently than the two recent rises of this cycle have.) So why would the Fed stop its general asymmetric support before we reach a third bubble? Nothing is certain in life, but 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. But if we have a strong head of steam up by next February, it might well happen anyway. We’ll deal with that when we get there. The bottom-line question is probably this: 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 Presidential Cycle of a very strong pre-election effect and a compensating weak “recycling” in post-election years one and two that existed in earlier Fed regimes did not come out of thin air, but presumably from deliberate influence. Since Greenspan was appointed, though, we seem to have lived, at least most of the time, stuck in a year-three phase of stimulus.)
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So to summarize - this is one of the most expensive markets ever but is not set to blow until the final melt-up phase has occurred... which Grantham sees as an acceleration to 3400-3700 through the end of this year... and Goldman considers over 4050 by 2020.
Summary of Grantham's guesses (described "absolutely my personal views")
- 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, very high, i.e., over 90%.
- If there is a market decline following a melt-up, it is quite likely to be a decline of some 50%.
- 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.
As Grantham concludes, "good luck, we're all going to need it" if these things come true.
Postscript: Possible Political Consequences
Living 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 subsequent and highly probable melt-down would seriously hurt it.