As we mentioned this weekend, I will be on CNBC this morning at 11:03 am discussing a bubblicious concept — that the entire world is now bubble — a situation likely to eventually get out of hand.
That is the view of Jeremy Grantham in his quarterly letter to investors as GMO’s Chairman of the Board. He oversees quantitative products and is director of investment strategies. In Grantham’s 1Q 2007 letter to
clients, he discusses how market bubbles form, why it’s
so difficult to pinpoint when a bubble will burst, and looks at potential catalysts for
that event.
To give you a sense of GMO, they run $141 billion for mostly insitutional clients (and U.S. VP Dick Cheney). In their Equity portfolio of $125 billion, $93 billion
of it is non-U.S. holdings. Grantham developed sometihng of a reputation as a bear — despite running a mostly long-only portfolio.
Why does anyone care what Grantham thinks? In additon to outperforming most of his peers, his qaurterly letter reveal him to be a smart quantitative investor, who relies on the simple mathematical concept of mean reversion. Based on that thesis, in June 2000, he noted in a Forbes debate with Henry Blodget that markets were still way over-valued:
"We basically believe that, from their highs, the S&P 500 will decline 50%;
the Nasdaq, 70%; and the nonearnings Nasdaq, 80%. The safest thing to say is
sooner or later. The great bear markets do not hurry. They have often had
precipitous decline phases. But basically the 1929 peak didn’t really bottom
until 1945. The 1972 peak didn’t bottom until 1982. And, incidentally, in those
ten years, the S&P was down close to 40% in real terms." (emphasis added)
That call turned to spot on (I have the the full text, but if anyone has a link, it would be appreciated).
For those of you who did not follow up the reference in the linkfest, here’s a quick overview:
1. Global fundamental economic conditions are nearly perfect and have been for some time.
2. Availability of global credit is generous and cheap and has been for some time.
3. Animal spirits and optimism are therefore high and feed on
themselves through reinforcing results and through being universally
shared.4. All global assets reflect this and are overpriced and show, probably for the first time, a negative return to risk taking.
5. The correlation in global economic fundamentals is at a new
high, reflected in the steadily increasing correlation in asset price
movements.6. Global credit is more extended and more complicated than ever
before so that no one is sure where all the increased risk has ended up.7. Every bubble has always burst.
8. The bursting of the bubble will be across all countries and all
assets, with the probable exception of high grade bonds. Risk premiums
in particular will widen.9. Naturally the Fed and Fed equivalents overseas will move to
contain the economic damage as the Fed did last time after the 2000
break. But the heart of thelast bubble, the NASDAQ and internet stocks, still declined by almost 80% and 90%, respectively.10. What is wrong with this logic? Something I hope.
11. Of course the tricky bit, as always, is timing. Most bubbles,
like internet stocks and Japanese land, go through an exponential phase
before breaking, usually short in time but dramatic in extent. My
colleagues suggest that this global bubble has not yet had this phase
and perhaps they are right.
The bottom line remains that U.S. stocks are hardly the bargain they are made out to be; Rather, trading them has become a combination of liquidity driven momentum based investing.
Grantham is the best asset allocator in the world. Paying attention to his 7 year forecasts is definitely worthwhile.
OT, I had to post the news that David Lereah has moved on from shilling for the NAR
WESTLAKE VILLAGE, Calif.–(BUSINESS WIRE)–Move, Inc. (NASDAQ:MOVE – News), the media leader for the when, where and how to move, announced today that Dr. David Lereah has joined the company as an executive vice president for Move, Inc. and serve as chairman and partner with Allan Dalton, who will be the president and CEO, of a new business entity which will launch in the third quarter of 2007 and which is expected to be transformational for both consumers and real estate professionals.
Lereah is the nation’s leading real estate economist . For seven years, he has served as senior vice president and chief economist of the NATIONAL ASSOCIATION OF REALTORS® (NAR) as the Association’s spokesman on the U.S. economy, the housing and real estate markets as well as other economic and policy issues affecting the industry in the U.S. and abroad. He also directed the Association’s Research Division, the Regulatory and Industry Relations Division, the Real Estate Services Group and Strategic Planning Activities for the Association.
“David Lereah has established himself as the ultimate expert for the real estate industry,” said Allan Dalton. “Having David partner with me on this new venture will ensure that consumers and the industry will benefit from his unparalleled knowledge of financial issues and the real estate marketplace.”
It seems to me the big $100 billion plus money managers are trying to eek out another few percentage points with the belief they have the fastest trigger finger and that they can spot the exact top before their peers. A sort of a prisoner’s dilemma.
I can think of at least four $100 billion managers who have said in recent interviews that the biggest risk is a continued melt-up, because when the inevitable correction does come, the damage will be even worse.
i thot Malkiel’s piece in WSJ this morning made much the same point as Grantham. but like 1999-2000, this is no time for greybeards. just time to buy buy buy. i dont believe there has ever been such a time as today: Bernanke and Fed and all other central banks underwriting asset inflation and absolutely refusing to look into derivatives, leverage.
https://www.gmo.com/America/Research/
The meltup will likely continue as long as there is so much liquidity. Although impossible to predict but blatantly obvious in hindsight, the $64,000 question is, What removes the liquidity from the market? There are tons of possibilities, but few are obvious right now (and if they are obvious, they will not happen).
Barry, any thoughts?
How does Graham’s prediction of asset over-valuation compare to the current Price Earnings ratio of the market, which is approximately 16 (looking at the entire market, e.g. the Wilshire 5000).
Do we expect earnings to lower as other assets–e.g. housing–deflate? We’ve been hearing about asset inflation and bubbles for a while now, and certainly in 1999 the PEs of stocks screamed bubble. But now? I’m not sure. I think housing is going to hit earnings more broadly than the housing industry, but that is also balanced against the global market that companies find themselves in, and earnings seem to be strong because of it.
The PEs right now are not screaming asset inflation. Are they? I could be wrong. Does he expect PEs to drop below 10?
I posted this on an earlier thread, but it seems like there’s enough discussion of liquidity on this board to merit a discussion of a possible credit crunch if liquidity is removed.
In particular I’ve read an interesting paper that studies the 1966-67 credit crunch, but I’d love to hear thoughts from this board. Any takers?
(PDF):
http://research.stlouisfed.org/publications/review/69/09/Historical_Sep1969.pdf
(TinyURL link to PDF):
http://tinyurl.com/327zlp
-TexasHippie
Here is the video link:
Worldwide Market Bubble
is mr. Grantham putting most of assets in cash or high grade bonds right now? just curious.
Liquidity is stealthly being withdrawn. China has increased interest rates, increased reserve requirements and allowed it’s currency to modestly appreciate. India is tightening. ECB is tightening. BOJ started tightening, but is now in pause mode. New Zealand raised rates again last week and is now up to 7.75%.
I read somehwere that central banks around the world have collectively raised rates over 200 times in the past couple of years. So much for “don’t fight the fed [central banks]”.
Even so, I don’t think the liquidity gravy train ends until Japan has a competitive interest rate. As long as financial intermediaries believe the Yen will remain pressured, it’s just too tempting for them to borrow in Japan at a barely positive interest rate and lend virtually anywhere else in the world for a positive carry.
Texas Hippie – I haven’t read the piece yet, but in general I’d be cautious in drawing conclusions about the current situation from monetary conditions in 1966. Among other things, money was limited by gold flows in 1966. Now it’s apparently limited only by the supply of paper and helicopter rental time.
Loved the quotes about the scintillatingly brilliant Dr. Lereah.
Is it possible that his bailing on the NAR is bottom ticking residential real estate? LOL :))
Is it China and Japan who have recently been the largest buyers of US Treasuries? If so are they simply shifting global liquidity to dollars by sinking their own liquidity into our debt? Compared with politics, foreign currency valuation and trade deficits, will global liquidity play a factor in continuing foreign interest in purchasing US debt?
Thanks Estragon. But regarding: “Now it’s apparently limited only by the supply of paper and helicopter rental time.”…
What about the risk of hyperinflation? It seems to me that the more we print, the worse trouble we’ll be in if oil becomes Euro-denominated or foreign banks dump our treasuries, etc. Low dollar valuations are nice for exports, but it seems like we have such a weakened position in manufacturing that the only things left to export are products we have a solid hold on in the market such as software and services.
Ironically a scared gold-bug can’t even trust his commodities with this latest report. Personal commodities have been jacked up by gold demand in India from a rising middle class, and industrial commodities such as copper are driven by growth in emerging markets; neither of which will last if China & India do a face-plant on the mean-reversion concrete.
With the exception of the PBoC, I don’t think central banks are really pumping out liquidity anymore – the liquidity is coming from a continued leveraging of the financial system – low risk premiums on all risky assets, extensive use of funding trades, etc. It’s a positive feedback loop on the way up, and a negative feedback loop on the way down. Bubbles do usually end with a final growth blowout before they blow up, but in this case maybe the blowout is seen in the sheer pervasiveness of this bubble worldwide, through all financial markets? How often in the past have all risky asset classes traded with simultaneously low risk spreads, and seemingly traded with a correlation of 1? I’d say never is a good answer.
There are really only two things that reduce this type of liquidity: 1) a divergence between the Fed target rate and bond yields so the Fed must subtract money to protect the rate, or 2) a collapse.
Unfortunatley, the latter is probably more likely. I fear the Fed will chase the short term bond yields down, creating even more of a bubble, making the collapse worse than it should be.
Pretty pessimistic, but unless sanity makes an unlikely appearance the glass is neither half-full nor half-empty, but instead simply overflowing with bubbles with little H20 in its base.
T.R. Elliott:
Be careful not to place too much weight on PE ratios that use only previous 12 months’ earnings (forward looking PE is even worse). Current profit margins are at historic highs, and are not likely to persist indefinitely. Ben Graham suggests using Price / 7-Year Moving Average of Real Earnings to smooth out sudden increases or decreases in earnings (as we have expereinced in the last two or so years). Robert Shiller has also demonstrated that future stock market performance is correleated to current measures Price / 10-Year Moving Average of Real Earnings.
Currently, the Price / 7-Year Moving Average of Real Earnings for the S&P 500 is 22+. Ben Graham suggested that 15-20 is a reasonable range for equities.
Winston – it sounds like Grantham is on board with your latter point, as a rate drop could spurn the exponential run-up before dropping. On timing then, how soon after a Fed rate drop should we expect a mean-reversion in equities?
Interestingly I saw a recent article studying bullish attitudes of market-timing “experts.” A choice quote: “The public has yet to embrace this bull market, and in essence, there is ample cash on the sidelines.”
http://www.marketwatch.com/news/story/top-performing-market-timing-newsletters/story.aspx?guid=%7BF6A128AA%2DBAB0%2D464F%2DA054%2D8B36E55CFF8B%7D
(TinyURL) – http://tinyurl.com/2qn38e
Seems like an exponential phase could be driven/worsened by smart-money egging on this sidelined dumb-money in order to sucker in new bag-holders before the drop. If that happens, goodbye wealth effect!
The Fed will only reduce rates if the economy tanks. The market is the economy. Therefore, there is no way the Fed will reduce rates until the market has already dropped. I firmly believe that. Therefore, do not expect that a rate cut leads to some exponential run-up before the bottom falls out.
Adam,
I don’t know if the stock market is the economy, but I have said for some time that there will be no Fed cut until the market has dropped and not rebounded. Then they will cut to try to get it bubbling agian. When thet doesn’t work, the trap door will open.
What if the (housing) market is the economy? Surely not according to Luskin, but it is definitely a concern for the Fed. What if the housing market drops without a rebound?
I sincerely doubt the Fed’s only goal in lowering rates would be a push for Dow 36,000.
JG is a quality money manager. I remember reading one of his newlestters, I’ve printed it out somewhere, probably from last year, where he just humbly, but straightforwardly talked about their underperformance. He’s an honest voice, like our host and several others.
Barry,
You mentioned the Forbes debate between Grantham and Blodget back in 2000. Here’s the link:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/darkside/articles/blodget.html
Incidentally, Grantham’s latest commentary concerning a bubble-like atmosphere in a broad spectrum of assets/asset markets is very reminiscent of comments made by Marc Faber earlier in the year. See:
http://financetrends.blogspot.com/2007/01/marc-faber-warns-of-asset-market.html
Hmm, part of the link seems to be chopped off.
Once again:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/darkside/articles/blodget.html
“there will be no Fed cut until the market has dropped”
One thing the Fed has learned – or should have learned – from recent experience is that once you start letting liquidity build you cannot control where it will go. It might go to a bubble in tech or a bubble in mortgage debt or to hedge funds that do things you don’t even know about. The Fed has one control and it is labeled ‘on’ and ‘off’.
A choice quote: “The public has yet to embrace this bull market, and in essence, there is ample cash on the sidelines.”
There’s no such thing as “cash on the sidelines”. Every transaction has a buyer and a seller. The amount of cash “entering” the market is exactly equal to the amount that is “exiting” the market, for every transaction. If you buy my 100 shares of XYZZ for $10 each, your cash goes to me, not to “the market”.
Obviously.
Small Investor Chronicles™
Adam: Thanks for the response. I do agree that profit margins are high and stocks, going forward, are likely pricey.
Alex – good point to clarify, but the quote specifically refers to the public’s cash. As in: the public exited the market and has cash on the sidelines. The anticipation then is that the public can be goaded into coming back in, allowing the funds to exit at just the right time.
People with a preference for liquidity are on the sidelines, Alex. Corporations are sitting on billions because they don’t know where to invest it. If a rising market can diminish the liquidity preference, then prices will rise.
Oops, that’s tautological.
Prices will rise further into irrational exuberance.
As far as liquidity and rate cuts, the Fed is not so much in the driver’s seat as most assume. I wish I knew how to cut and paste charts, but I don’t, so I’ll have to use Adam Hamilton’s entire piece at: http://www.zealllc.com/2001/revolt.htm
First part is pretty mundane description of how the bond market operates – however, the second half has a chart from 2001 that shows that Greenspan’s ratecuts were actually chasing the drop of the 3-month T-bill, not the other way around. What would be the reason? The huge divergence between the Fed target rate and the bond yield, meaning the Fed would have had to drain huge amounts to protect its target rate. Instead, Greenspan chased the T-bill rate, lowering the Fed’s target to compare with the bond yield. The flight of money into bonds led the way, and knowing that the huge drains to keep the target rate intact would cause a credit crisis, the Fed simply followed suit by lowering rates. The killer was not necessarily the drop, but leaving them too low for far too long afterwards.
According to Richard Daughty, AKA The Mogamno Guru at The Daily Reckoning, Turbo’s comment is correct insofar as the U.S. is concerned – there has not been a great deal added to the U.S. liquidity by Fed action. Quote: “Total Fed Credit was finally up a little bit last week – but only $1.8 billion. And considering the staggering loads of existing debt that everyone is currently saddled with, this ain’t diddly-squat. TFC still, as they say, ‘ain’t going nowhere fast.’
Now, there may be a lot of reasons why TFC is down below where it started the year, but not one of them is a good one.”
Also, a number of central banks globally have raised rates while the BoC institued an 11% limit on bank reserves. It seems between the lines there is considerable concern about inflation (liquidity risk), at least worldwide.
Texashippie: No one can know the future but in my own mind I am seeing a set of circumstances that could lead to serious drop in the 9-18 month range – much sooner if an unknown catalyst explodes.
But what do I know – I am no expert, financial guru, economist, or fund manager.
Just a simple investor with an opinion.
I was going to say “what Turbo said” but Winston beat me to it and said it better.
Regardless, in brief, I do not believe central banks are in control and that includes credit (money) creation. They may have some limited ability to spoil the party before it turns into a complete orgy and the house is torn apart: We shall see.
JMO; FWIW
wally,
yes, and i continue to wonder why, given the de facto ending of reserve requirements from the early-mid 1990s, the rise of non-bank banks, the expansion of government sponsored enterprises, a more fully globalized finanancial sector, etc etc, that – other than for psychological reasons – there remains the notion that central banks are in control of the credit creation process.
‘fine tuning’ during an era of ‘nuclear credit fision’ must be at least somewhat frustrating, even if the ‘tuners’ still believe their old songs.
In other words, the implication is that there are eager buyers on the sidelines. Well, that’s fickle and may change anytime. If true at all.
All in all, this sounds like the typical bubble argument to me – stocks will go up because there are people out there who will want to buy them. If this is not a tautology, I don’t know what is!
Mogambo not mogamno, i believe is the correct spelling.
“Mogambo not mogamno, i believe is the correct spelling.”
My typing skills match my bank account – both on the low end. My apologies to the Mogambo Guru.
I’m wondering at what point those higher interest rates start taking away more power of control from the CBs. 5, 6 and 7% interest rates compounded yearly are probably looking pretty good to people who just went through dealing with the risk of a shaky stock market and then a shaky housing market. As more people shift to cash in order to collect high risk free rates more money will again flood the system.
I’m sure many seniors are happy their low interest rate suffering is over
“Cash on the sidelines” is one of those catchy concepts that seem meaningful and spark the public’s imagination but on closer inspection are devoid of any real meaning.
Back in July of ’06, Barry pointed us to the following article by Jim Hussman, which explains this very well.
http://www.hussman.net/wmc/wmc060710.htm
The upshot is basically what others above have said. The statement “there is cash on the sidelines” is a deceptive one because it sounds as though it is providing you with new, useful information, when in fact it is always true, so you don’t learn anything from hearing it (except maybe that the person who told you wants you to think the market can go higher but can’t offer you a real reason for it).
Try:
http://www.investorsinsight.com/otb_va_print.aspx?EditionID=512
About halfway down the page is where Grantham starts.
Turns out Hussman recently brought up the “cash on the sidelines” issue again:
http://www.hussman.net/wmc/wmc070312.htm
This entire global bubble thesis has been talked about for a while by Faber.
I normally like Grantham, but don’t find anything original about this.
Have a lot of family in Lat Am and make trips yearly. Brazilian and Argentine farmland and nice residential condoes in BA and Rio are still extremely cheap. They are nowehere near bubbles. They are cheap on an historical basis and relative to almost every major world city.
Mortgage markets are just being developed, or re-introduced since the 02 collapse in Arg.
Additionally was in Eastern Europe in September. Helped bring to my attention that residential real estate in Germany hasn’t gone up in over a deade until this year.
Berlin has cheaper commercial real estate than Prague and Warsaw and is a bargain relative to rest of EU. Last I saw somewhere around $33/ sq foot to lease.
Vienna and Singapore also are quite reasonable spots.
Japanese art has also not participated in the global boom. Residential just ticked up there for the first time since 1993.
There are for sure cheap assets left, one simply has to be open minded and willing to get on a plane and look for oneself.
The entire world is not in a bubble if you do some digging.