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.”
When looking at the related question of which investors truly believe in (and, by extension, follow up on) the Fed put, he notes that long-term value managers “are outnumbered by momentum managers – always were and probably always will be.”
Momentum managers are likely to play the game today “with even more enthusiasm” than before, says Grantham, “at least enough to drive the market to its 2-sigma level” of 2,250.
“And although nothing is certain in the market, this is exactly what I believe will happen.”
Taking a peak at John Hussman’s analysis, which indicates an overpricing for the U.S. markets that ranges from 75% overpriced to 125% at the end of March, the GMO expert says he agrees “with the spirit of this data.”
However, the GMO team prefers its seven-year forecast, which has the market overvalued at 65%. (At 2,250, however, which is GMO’s 2-sigma target, the market would be about 100% overpriced.)
Grantham acknowledges the relevance and strength of Hussman’s work and predictions.
Still, he concludes that they are “less likely than my suggestion of a substantial and quite lengthy last hurrah.”
For bears, Grantham points to the so-called January Rule, which argues that how the markets move in January predicts how they will end the year – and has been a strong predictor, like the Presidential Cycle.
And, the expert argues, this year could be difficult “with the February 1 to October 1 period being just as likely to be down as up, perhaps a little more so.”
However, after October 1, the market is “likely to be strong,” Grantham concludes, “especially through April and by then or in the following 18 months up to the next election (or, horrible possibility, even longer) will have rallied past 2,250, perhaps by a decent margin.”
Next, the election will come, and soon thereafter, the market bubble “will burst, as bubbles always do, and will revert to its trend value, around half of its peak or worse, depending on what new ammunition the Fed can dig up.”
The bull market, of course, can “come to an end any time,” Grantham admits.
The possible reasons for a drop include “disappointing global growth, profits sagging as deficits are cut, a Russian miscalculation, or, perhaps most dangerous and likely, an extreme Chinese slowdown.”
But, he puts the chance at a continuation of the bull run at over 50% for “at least a year or two and probably not before it reaches a level in excess of 2,250 on the S&P 500.”
That may be the good news for investors, for the next year and half.
But stay tuned, he adds, because this market uptick (like others in the past) at some point “will end badly.”
“Around the election [in 2016] or soon after, the market bubble will burst, as bubbles always do, and will revert to its trend value, around half of its peak or worse, depending on what new ammunition the Fed can dig up.”
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