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GMO’s Grantham: Housing ‘Echo Bubble’ May Prompt New Crisis

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“The only thing that really matters in asset allocation is sidestepping some of the pain when the rare, great bubbles break,” writes Jeremy Grantham in GMO’s latest quarterly letter to investors, recounting his investment firm’s ability to tapdance around what he calls the three greatest bubbles of the past 100 years: the Japanese equity bubble of 1989; the 2000 tech bubble, and the financial crisis of 2008-2009.

“At other times, traditional diversification will usually be good enough,” he says.

So where are we now? Speaking of bubbles, Grantham concludes that “unlikely as it may sound, in 12 to 24 months U.S. house prices – much more dangerous than inflated stock prices in my opinion – might beat the U.S. equity market in the race to cause the next financial crisis.”

He argues that we may have thought that the notion of another real estate bubble occurring so soon after 2008-’09 would be “psychologically impossible” due to the “intensity of the pain we felt so recently,” but cites the rapidly rising home prices which “at this rate will reach one and three-quarters-sigma this summer” — sigma referring to the number of standard deviations from historical averages.

And the psychology argument? Many observers are missing the housing bubble, he says, “driven partly by the feeling that the substantially higher prices in 2006 (with its three-sigma bubble) somehow justify today’s merely one and one-half-sigma prices.”

Before reaching that conclusion, however, Grantham shares with readers a mea culpa on his misreading of the Chinese resources issue late last year and early this year, and discusses the sectors and specific asset classes that he thinks will perform well and which won’t.

The mea culpa: Grantham said that back in 2011—prompted by the notion that the world was running out of low-cost oil—he started to wonder “Why should we not run out of other finite resources?” So, he writes, “predisposed to see signs of finite resources running out, I saw in 2011 a set of remarkable resource statistics. The most extreme among them, iron ore, was measured as a 1 in 2.2 million possibility.”

That led him to believe that China’s economic growth, supplemented by increases in the world’s population, “was causing us to be facing ‘peak everything.’” He sheepishly admits that since his report then did so well in traffic, saying he got “many multiples of hits than a typical quarterly letter “ would normally receive, “I must have been right!”

Then the admission of fault. “But, alas, I was fooled—along with all of the CEOs of the miners—by China. The four- sigma event in mineral prices did not occur because those resources were running out. Not yet.”

Where Is the Stock Market Headed?

On equities, Grantham expects oil stocks to perform well over the next five years. The subsequent five to 10 years he thinks will be “more questionable,” and speaking as a long-term value investor, he thinks oil stocks after the next 10 years will perform “much worse.” (Grantham’s footnote to his outlook comments: “As always, my personal opinions.”)

Mining stocks, unlike oil stocks, won’t regain their losses, Grantham says, though based on their current low starting point they will “probably outperform.” While he expects the next two years to be “very risky” because of excess capacity, he points out that because they are “typically hated, for good reason,” they sell more cheaply. These stocks also do well when inflation rears its ugly head, noting they have been “proven to beat the market handsomely when unexpected inflation occurs,” which he calls a “critical portfolio advantage.”

He also favors two other ‘hard’ assets: farmland and forestry, with farmland being his “first choice for long-term investing,” while timber “should perform above aggregate portfolio averages and be less volatile than equities.”

As for the overall markets, Grantham says that as of writing the quarterly letter, “the threshold for a bubble level for the U.S. market is about 2,300 on the S&P 500, about 10% above current levels, and would normally require a substantially more bullish tone on the part of both individual and institutional investors.”

As for the presidential election and the economy, he thinks it unlikely that “this current equity cycle will top out before the election and perhaps it will last considerably longer.”

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