GMO’s James Montier tackles the issue of whether or not we’re in the advent of a “cynical bubble” in the group’s February insights report.
“That the U.S. equity market is obscenely overvalued can hardly be news to anyone,” writes Montier, a member of GMO’s Asset Allocation team, referring to a chart showing the recent rise of the Shiller price-to-earnings ratio.
“Only a handful of what we might call valuation deniers remain. They are dedicated to finding new and inventive ways to make equities look reasonable, and they have never yet met a bull market that they didn’t love,” Montier explained.
Plus, he points out, the latest Bank of America Merrill Lynch survey shows “the highest level of those citing ‘excessive valuation’ ever.” And this survey finds fund managers overweight in equities.
“This gives rise to the existence of that strangest of creatures: the fully invested bear,” Montier said. “The most common rationale for such a cognitively dissonant stance is ‘the fear of missing out on the upside.’”
Fully invested bears appear to agree with Jeremy Grantham’s market melt-up scenario, he explains.
Grantham argues that many of the classical bubble elements are missing: There’s no euphoria associated with the great bubble peaks.
But not all bubbles are the same, Montier states.
Four Bubble Types
1. The first type is the “fad” or “mania” bubble in which investors “really do believe that this time is different,” Montier says.
“These are the great bubbles of history: The [dot-com] bubble, the Japanese bubble, the U.S. housing bubble, and the Roaring ’20s all stand out as shining examples of delusional new-age thinking,” he explained.
2. The intrinsic bubble is associated with earnings that grow at an unsustainable rate. This leads to extrapolation and overcapitalization by investors, according to Montier.
“Financials during the U.S. housing bubble were a good example of this kind of bubble. Their earnings were inflated by the economic bubble in the housing market, and this wasn’t recognized by many investors,” he explained.
3. The near rational bubble or greater fool markets are cynical bubbles in which investors “don’t really believe they are buying at fair price (or intrinsic value), but rather are buying because they want to sell to someone else at an even higher price before the bubble bursts,” the analyst says.
Former Citibank CEO Chuck Prince, for instance, described the July 2007 market as follows: “As long as the music is playing, you’ve got to get up and dance. We are still dancing.”
4. The informational bubble involves investors who are not acting based on private information and rather are acting on information revealed by others.
This means investors who might think valuations are high but who jump in anyway, thinking “all these other investors can’t be wrong,” according to Montier.
While many of the traditional psychological markets of a fad or mania bubble are absent, he says, today we are in a cynical bubble, “built not on faith in a new era, but on over-optimism about the ability to get out before everyone else.”
For Montier, we are in dangerous territory.
Fund managers agree the U.S. market is expensive “but still they choose to own equities — a cynical career-risk-driven position if ever there was one,” he writes. Investors insist they “have to own U.S. equities.”
The latest Merrill fund manager survey shows, for instance, that close to 70% of fund managers anticipate equity markets will peak at this year.
Plus, in an experiment Montier set up, he found that was “incredibly hard” for the 1,000 participants actually to be one step ahead of all other players.
What to Do?
Cynical bubbles, he reminds investors, are based on the mistaken belief “that one can get out before everyone else,” which “is simply impossible.”
Just like when you play musical chairs, “Crowded exits don’t end well — inevitably some are crushed in the stampede,” he said.
There may be some asset managers with great timing. But for Montier, “I prefer to leave the party early, in the knowledge that I can walk away with ease.”
He reminds investors of economist John Maynard Keynes’ remark: “It is the nature of organized investment markets… that, when disillusion falls upon an over-optimistic and overbought market, it should fall with sudden and catastrophic force.”