Jeremy Grantham of GMO Investments (the G in GMO stands for Gratham), a very well regarded and long standing investment manager (the firm runs over $140 billion, much of it in equities). He is skilled in the black art of modelling and at the peak of the dot com bubble, correctly called how far the S&P 500 and Nasdaq would decline.
Mind you, it’s also not in the business interest of managers of serious institutional money to sound alarms about the market. So Grantham’s across the board bearish view is eye-opening. He’s not the first to sound this sort of alarm (Nouriel Roubini and Jim Rogers are generally on the same page), but he is more statistically driven than other bearish types and less inclined to theatrics.
His first quarter letter to shareholders declared everything to be overvalued, save managed timber, high quality US stocks, and bonds. He sees an ugly, protracted decline across asset classes. But he also expects there to be one last explosive run up before the fall begins. In other words, bears who are early will look like morons for a bit.
The only point on which I differ with Grantham is the likely catalysts. He cited inflation and/or a decline in corporate profits. If you believe Robert Shiller (and I don’t) you don’t need a catalyst. But my view is similar to David Merkel’s of Seeking Alpha:
[T]he next major blow-up will happen as a result of a neophyte developing large country central bank overshooting on their tightening of monetary policy. China is my lead candidate, but India could do it as well.
In other words, the effort to address global imbalances, meaning the tsunami of foreign buying of dollars that allow us to continue our profligate consumption, will finally start to unwind. Foreign central bankers are already showing signs of dollar fatigue. If they tighten monetary policy in their countries to strengthen their currencies (which would help lower our trade deficit and hence the need for foreign capital), it will lower liquidity and produce deleveraging, which if done suddenly, could feed on itself. And even if it is done surgically, investors will come to realize that the party’s over.
The Street.com excerpts Grantham’s letter:
While euphoria sweeps stock markets here and worldwide, there are at least a few voices of dissent.
One, unsurprisingly, is legendary value investor Jeremy Grantham — the man Dick Cheney, plus a lot of other rich people, trusts with his money. Grantham, chairman of Boston firm Grantham Mayo Van Otterloo, has been a voice of caution for years. But he has upped his concerns in his latest letter to shareholders. Grantham says we are now seeing the first worldwide bubble in history covering all asset classes.
Everything is in bubble territory, he says.
“From Indian antiquities to modern Chinese art,” he wrote in a letter to clients this week following a six-week world tour, “from land in Panama to Mayfair; from forestry, infrastructure and the junkiest bonds to mundane blue chips; it’s bubble time!”
“Everyone, everywhere is reinforcing one another,” he wrote. “Wherever you travel you will hear it confirmed that ‘they don’t make any more land,’ and that ‘with these growth rates and low interest rates, equity markets must keep rising,’ and ‘private equity will continue to drive the markets.’ “
As Grantham points out, a bubble needs two things: excellent fundamentals and easy money.
“The mechanism is surprisingly simple,” he wrote. “Perfect conditions create very strong ‘animal spirits,’ reflected statistically in a low risk premium. Widely available cheap credit offers investors the opportunity to act on their optimism.”
And it becomes self-sustaining. “The more leverage you take, the better you do; the better you do, the more leverage you take. A critical part of a bubble is the reinforcement you get for your very optimistic view from those around you.”
It’s something to think about the next time you hear someone tell you that the stock market will keep rising simply because the world economy is doing so well. That would make sense only if we were paying a constant price for each unit of world GDP, instead of higher and higher prices for one slice of that GDP — equity.
Grantham concludes that every asset class is expensive today compared with historic averages and compared with the cost of replacing it….
“The bursting of [this] bubble will be across all countries and all assets, with the probable exception of high-grade bonds,” Grantham warned. “Since no similar global event has occurred before, the stresses to the system are likely to be unexpected. All of this is likely to depress confidence and lower economic activity.”
Grantham sees two big potential catalysts that might turn this bull market into a bear: a surge in inflation, leading to higher interest rates, and a squeeze on profit margins, which are currently running way above long-term averages.
As for timing, he concedes that’s impossible to predict. But here’s the kicker: Even Grantham thinks you probably need to be bullish right now. The reason? Most bubbles, he notes, go through a short but dramatic “exponential phase” just before they burst. Like Japan in 1989 or the Internet in early 2000.
“My colleagues,” wrote Grantham, “suggest that this global bubble has not yet had this phase and perhaps they are right. … In which case, pessimists or conservatives will take considerably more pain.”
Barry Ritholtz provides an easy-to-scan summary of key points:
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.