Jeremy Grantham, co-founder and chief investment strategist of Grantham Mayo van Otterloo, has a lot to say about market bubbles, pain and timing in his latest quarterly newsletter, released Thursday, and much (but not all) of it is highly specific.
“It is a sensible expectation that reasonable long-term value investors will endure pain in a bubble. It is almost a rule,” the market guru stated.
“The pain will be psychological and will come from looking like an old fuddy-duddy [by getting out of the markets when they are reaching bubble-like conditions] … looking as if you have lost your way in the new golden era where some important things, which you have obviously missed, are different this time,” he explained. And he states that this market run-up “will end badly” sometime in the fourth quarter of 2016.
For advisors and other professionals, this pain also could come “from loss of client respect, which always hurts, and loss of peer group respect, which can be irritating,” Grantham adds. But that’s the price of being a value investor, he says, who “invest exclusively on long-term values and long-term risks.”
How can investors and advisors best define a bubble?
GMO analysis suggests that “a two-standard-deviation (or 2-sigma) event might be a useful boundary definition for a bubble. In a normally distributed world, a 2-sigma event would occur every 44 years,” Grantham explains.
“GMO has spent a lot of time during the last 17 years making a considerable review of minor bubbles as well as the 28 major ones that we covered originally in 1997,” he added. “One thing was clear from the 330 examples we had studied: 2-sigma events in our real world have tended to occur not every 44 years, but about every 31 years.”
The six most important asset bubbles in modern times, in Grantham’s opinion, have been those of U.S. stocks in 1929, 1965 and 2000, U.S. residential property in 2005 and Japanese stocks in 1990, as well as Japanese commercial property in 1991.
The financial expert points out that in 2008, the U.S. housing market leapt past 2-sigma “all the way to 3.5-sigma (a 1 in 5,000-year event!).”
What also made 2008 unique, he adds, was “the near universality of its asset class overpricing: every equity market, almost all real estate markets (Japan and Germany abstained), and, of course, a fully-fledged bubble in oil and many other commodities.”
Though Grantham and his colleagues warned of a “first truly global bubble” in April 2007, they didn’t have the full statistical analysis of its significance until very recently.
The mess of 2008 is “unique in other ways,” he notes, adding that the housing market in 1929 was “more or less normal and the commodity markets were curiously very depressed.”
And today? Statistically, GMO analysis finds that we are “far off the pace still on both of the two most reliable indicators of value,” which the group says are Tobin’s Q (price to replacement cost) and the Shiller P/E (current price to the last 10 years of inflation-adjusted earnings). Both figures were at roughly a 1.4-sigma event at the end of March.
To get to 2-sigma, the S&P 500 would have to move to 2,250.
How likely is that?
Looking at the Greenspan Put, which Grantham says could be best described as the “Greenspan-Bernanke-Yellen Put,” he describes GMO’s analysis of the markets in relationship to the four-year election cycle.
“Enough professionals hear and understand the subtext of the Fed’s message: if you speculate in year one and two and something goes wrong, you are on your own. But in years three and four, and especially three, we at the Fed will do whatever we can to bail you out in a crisis,” he explained.
“And long before Greenspan – that ultimate Pied Piper who appeared to lead not the rats but perhaps the pigs – astute market players heard the message. So how much more they must have listened as the piping got louder and louder and the promises were more and more often delivered on in the Greenspan era,” Grantham stressed.
What Greenspan did, overall, is to tell investors he “would not interfere with bubbles” and instead but would “try to reduce the pain of bubbles breaking.”