Legendary Boston-based Jeremy Grantham (of GMO) has published his quarterly letter. You can read the whole thing here.
Grantham says he doesn’t know what’s going to happen with the market (too bad all forecasters don’t start with that admission!). What Grantham thinks probably will happen, however, is this:
The economy will recover more slowly than people want, and that will prompt “Helicopter Ben” Bernanke to keep rates too low for too long. This, in turn, will make stocks go to the moon.
And that would be good news for stock investors. For a while. Except that stocks are already overvalued, so when the effect of the Bernanke crack-hit wears off, there will be nothing left to support them. And down they will come.
Grantham thinks there’s about a 50% chance of that happening–continued boom and then bust. There’s also about an equal chance of two other scenarios:
- Some event (e.g., China crash) breaks the animal spirits and the market breaks down NOW. This will have one positive benefit, which is that it will stave off a future crash that will be much worse (21% chance).
- Economy has a strong and sustained recovery, interest rates rise, market falls modestly (30% chance)
Now, it’s worth noting (because if we don’t, one of you will) that, last quarter, Grantham was predicting a crash to happen about now and that he continues to stick to his “fair value” estimate of 875 on the S&P. As he and others would be quick to note, valuation tells you almost nothing about what the market will do next. And it appears that even Jeremy has been surprised by the strength of the rebound.
Here’s Jeremy:
If the economic recovery is slow and if unemployment drops slowly, then Bernanke will certainly keep rates very low, as he has promised in as clear a way as language permits. In that case, stocks and general speculation will very probably rise from levels that are already overpriced. And if they do, Bernanke will definitely not be concerned and has told us as much.
There were some teasing comments from Bernanke at the lows last spring to the effect that the Fed might take the embedded risk of asset class bubbles more seriously, as many foreign central bankers have begun to, and very sensibly so. But that hope has now been utterly squashed, and Bernanke has returned to the original Greenspan line: let the bubbles look after themselves.
Even if we were to re-enter bubble territory in a way that would be obvious to anyone who can tell the difference between 15 P/E and, say, 28 P/E (35 of us at last count), he still will do nothing. For he is now once again genuinely unconcerned with bubbles and even doubts their existence, as proven conclusively by his comments during this last one, the 100-year U.S. housing bubble, the breaking of which landed us in the rich and deep manure of 2009: “The U.S. housing market has never declined,” etc., etc. No believer in the existence of bubbles could ever say such things.
If we get lucky and have a strong, broad, and sustained economic recovery, interest rates will probably rise before we reach real bubble territory. As rates rise, the market will almost certainly settle down, and we will only have to deal with a substantially overpriced U.S. market and moderately overpriced global equities and risk premiums.
If, however, the economy only limps along, which seems more likely to me, then we run a very real danger of a third dangerous bubble in stocks and in risk-taking in general. For in that event, Bernanke will definitely keep rates low quarter after quarter and speculation will surely respond. Again? Yes, I’m afraid so. In that environment, Bernanke will do nothing to let the air out gently. His lack of anti-
bubble action is pretty much guaranteed.
The end of such events is always hard to predict, but usually bubbles break for almost any reason when they are big enough. Of course, the larger the asset bubble, the bigger the shock to the economic and fi nancial system. Now, Greenspan was lucky enough to inherit Volcker’s good work, and that gave him a base from which he could launch or blow a huge equity bubble; he also had the advantage that the country’s balance sheet was in excellent shape. Even Bernanke inherited a reasonably solid position from which to fund a second bailout. But a third time? It is hard to work out where the resources would come from to resuscitate the economy if a real shock were to be delivered by another collapse of a major asset class.
The key problems here are the Fed’s refusal to see the risks embedded in asset class bubbles and the willingness of both the Administration and Congress to tolerate this dangerous policy. Heck, they recently reappointed him! Yes, the Congressional natives were restless, but in waiting for a third crisis to kick him out, they may be too late to avoid the major-league suffering caused by his blind spot.
Should unemployment linger at high levels, which I think is likely, and I get these things right better than half the time (I believe about 52%), then we had better hope that something lucky turns up to break the speculative spirit.
This is perverse, but so is Bernanke.
What could go wrong, preferably in the next few months? Some combination of the following: an unexpected second leg down in house prices and a continued rise in the level of defaults, leading to a crisis at Fannie, etc.; a wash-out in commercial real estate and private equity caused by refunding problems (along the lines of Goldman’s and Morgan Stanley’s recent real estate fund wipe-outs) that result in a chainof major defaults in properties like Stuyvesant Town; a crisis in the euro where Portugal or Spain or Greece, or all three, default and strange things start to happen; a rapid rise in commodity prices, despite the anemic growth of the developed world, which, with the same caveats, I also think is quite likely; competitive devaluations leading to a serious trade war; or my colleague Edward Chancellor’s favorite, two or three wheels falling off of the Chinese economy, which today acts as the main prop to global growth. Okay, enough.
We all know that there is plenty that could go wrong. Some combinations would be enough to break the market but still leave the economy limping along. This would be far better than having the market rise through the fall of next year by, say, another 30% to 40%, along with risk trades similarly flourishing and then all breaking. The possibilities of this happening seem nerve-wrackingly high. The developed world’s financial and economic structure, already none too impressive, would simply buckle at the knees.
And, briefly, let me give you my reasons why this rally running through next fall is not at all out of the question.
In October we enter the third year of the Presidential Cycle, the year every Fed except, of course, Volcker’s, helped the incumbent administrations get re-elected. Since 1932, there has never been a serious decline in Year 3. Never! Even the unexpected Korean War caused only a 2% decline. Even when Greenspan ran amok and over-stimulated the first two years instead of cooling the system down – which he did twice, having not suffered enough the fi rst time – he stimulated Year 3 as well. The result was that we entered Year 3 in October 1998 and Year 3 in October 2006 with horribly overpriced markets, and still the market went up, and by a lot. The overpricing in October 1998, by the way, was so bad that our 10-year forecast was down to -1.1%; in October 2006, by a nerve-wracking coincidence, our 7-year forecast was -1.0%.
If the market is 1320 by this coming October (up 10% from today), our 7-year forecast will again be -1.0%. (Please hum the Jaws theme here.) Do not think for a second that a very stimulated market will go down in Year 3 just because it’s overpriced … even badly overpriced.
So far it has had 19 tries to go down since 1932 and has never pulled it off. We can, of course, hope that this time will be exceptional. Even in the best of times, though, overpricing is only a mild downward pull. Its virtue is that it never quits. Eventually it wears the market back down to fair value.
So what do I think will happen? That’s easy: I don’t know. We have been spoiled in the last 10 years with many near certainties – mainly that real bubbles would break – but this is definitely not one of them. Not yet anyway. (However, I am still willing to play guessing games despite the fact that “I don’t know.” So here, as Exhibit 1, is my probability tree.)
The general conclusion is that the line of least resistance is a market move in the next 18 months or so back to the old highs, say, 1500 to 1600 on the S&P, accompanied by an equivalent gain in most risk measures, followed once again by a very dangerous break. If that happens, rates will still be low and thus diffi cult to use as a jump starter, the financial system will still be fragile, and the piggybank will be more or less empty. It is remarkably silly for the Fed to allow, even encourage, this flight path. It is also remarkably silly for investors to be so carefree, given their recent experiences. Fortunately, there are several less likely outcomes that collectively, I hope, are equally probable.
We are definitely playing with fire and need some luck. The best kind of luck would be that Bernanke gets bitten by a Volcker bug.
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