Alas, there’s no magic signal to tell us when this market could savagely correct. The latest note of caution comes from famed US investor, Jeremy Grantham. He believes we are seeing a ‘melt-up’ in the stock market – the final stages of a great bubble near to bursting.
Bank of America Merrill Lynch notes that since 1930 the U.S. stock market has fallen by at least 5 per cent three times a year on average. Prior to the recent market ructions, the market hadn’t experienced such a drawdown since June 2016. The investment bank also notes that 70 per cent of fund managers view the global economy as “late-cycle,” the highest level since January 2008 and expect, on average, an S&P 500 peak of 3,100, which is 16 per cent higher than its level at the time of writing.
With that in mind it’s worth examining the most recent thoughts of legendary value investor Jeremy Grantham.
Born in 1938, the 79-year old founder of GMO, Jeremy Grantham, has become an investing icon by presciently identifying speculative bubbles and avoiding crashes. He famously identified bubble conditions in Japanese equities and real estate in the late eighties and steered his clients clear of tech stocks during the DotCom boom of 1999/2000. Famed for studying almost three dozen bubbles and every bust, in September 2007, a month prior to the market peak that preceded the Global Financial Crisis, Grantham noted, profit margins would fall, the housing market would break, and the risk-premium all over the world would widen, “each with severe consequences”. In GMO’s April 2010 quarterly letter Grantham concluded “Every single has broken all the way back to the trend that existed prior to the bubble forming.” There were no exceptions.
Institutional Investor recently reported that in late January, Grantham heard a colleague recount sharing a bus ride from New Hampshire to Boston with a young woman who wanted to sell her house to invest in stocks. The woman wasn’t satisfied with her $300,000 house crawling up a few percentage points in value when stocks had risen by double digits annually since 2009. Suffice to say Grantham’s alarm bells, signalling the euphoria seen before a market crash, began ringing loudly.
In an October 20, 2017 blogpost we wrote;
“…since October 2016, the S&P500 has displayed only one-way traffic. The index rises interminably, and volatility continues to decline, and that’s despite fake news at Facebook, the incineration of cash at Tesla, Russian intercession in US elections, Chinese debt issues, the threat of nuclear attack or even missiles flying over Japan. Every day the market just keeps going up.
On 23 October 2017, Bloomberg reported; “Earnings-day blowups, leverage warnings in China, Apple’s worst rout since August. Oh, and a sixth straight week of gains for the S&P 500…No matter what happens lately, stocks just keep rising, with record closes piling up in U.S. benchmarks at a rate that is starting to defy precedent. The Nasdaq 100 Index has finished at all-time highs 62 different times this year, on par with the most ever in 1999, while the S&P 500 and Dow Jones Industrial Average are closing in on history, too.”
To Grantham, the ‘bus lady’ story combined with euphoric conditions, is evidence of a “melt-up” in the stock market – the final stages of a great bubble near to bursting. Grantham explained to Institutional Investor that “data can flash warning signals that a bull market is heading for a steep fall, but it’s the “touchy-feely” — the traces of euphoria in ordinary situations — that is particularly telling”, and reflecting his January 3 letter warning of a melt-up in stocks, “Be prepared for the fact that the market can break your heart on the upside.”
Grantham also offered advice to other value-based equity managers, like Montgomery:
“The psychology of a bubble can be incredibly painful for asset managers with careers at stake, according to Grantham. In normal times it’s reasonable to believe clients are concerned about how well a manager can handle a downturn. “But in a bubble, forget it,” he says. “Clients care much, much more about underperforming all their friends on the golf course.”
“While everyone is bragging about their gains, sitting on a pile of cash can cost asset managers their clients, so many managers stay invested. “They’re leaping around with great energy, comparing notes,” says Grantham. “They simply can’t stand that one or two of their rivals are playing the game and making a lot of money and making them look bad.”
And of course when it comes to professionally managing money, “If you do what everyone else is doing, even if you all run off the cliff at the same time, you typically don’t get fired,” Grantham notes.
At Montgomery, however, we know our clients care more about losing 30 per cent, 40 per cent or 50 per cent than they care about trying to squeeze out an extra few percentage points of gain in a bubble.
Eventually stocks plummet. And the economy was fine when internet companies and the NASDAQ began to disintegrate in 2000. There was no particular announcement that triggered the sell off – a warning for those looking for catalysts.
We noted in that January 3, 2018 newsletter, Grantham warned value investors that during a melt-up – where prices not only rise but rise at an accelerating rate, “prudent preparation for a downturn will take a psychological toll and make you feel awful, because the average client is going to lose patience”.
Elsewhere, Ken Fisher, the billionaire founder and co-chief investment officer of Fisher Investments, likewise expects U.S. stocks to rise this year. According to Institutional Investor, Fisher notes, “Bear markets always begin gently and quietly,” Fisher says in a phone interview. “A short, sharp break off of all-time highs is never how bear markets begin” adding they tend to fall by 2 to 3 percent a month over their entire duration, with most of the decline coming in the last 40 percent. Bear markets begin by “lulling in greater fools with peaceful, minor declines”, says Fisher. “Nobody gets lulled by what just happened.”
Fisher hasn’t seen broad euphoria suggesting “that big, bad terrible thing, so it’s higher prices ahead.” He would also expect a major pickup in initial public offerings before a potential collapse.
On the subject of IPOs we, however, see a conga line of tech companies about to list. Tech IPOs saw a 85 per cent increase from 2017, with the number of deals worth more than $40 million hitting 100 for the year. The total proceeds from these transactions amounted to $25 billion globally. 2018 is shaping up to be a meaningful one for IPOs in the tech industry. Smartsheet filed to list, just days after fellow enterprise software startup Pivotal made the same move and after Dropbox debuted. Zuora filed for an IPO, Zscaler completed its IPO, and DocuSign reportedly filed its public offering paperwork. The music streaming site Spotify doesn’t make a dollar of profit after ten years in business and listed with aUS$28 billion valuation. Finally, it has been reported that Chinese online companies Bilibili and iQiyi, the streaming video division of online giant Baidu, are getting ready to IPO.
We believe that the recent increase in volatility is but a shot across the bow – an amber and flashing warning light of what is to come. But as long as 1) inflation remains low, 2) profit margins remain wide (remember the $1.5 trillion tax cut package passed in December slashed the corporate rate to 21 per cent from 35 per cent), and 3) GDP is also not expected to go backwards, stocks will probably remain supported.
Benoit Mandlebrot observed that volatility tends to cluster and the clusters appear after longer periods of relatively benign conditions. Given the hyper-long period without even a 1 per cent daily decline, it makes sense that we should see volatility return. Given that it also clusters, it is just as likely that we could now see higher prices before we see lower prices, perhaps in 2019.
The fact that there are still plenty of bears around suggests we haven’t seen the peak yet. As Fisher notes, “The reality is, when you really get to a stock market peak, people don’t want to believe any of that.” But trying to time the exact moment is silly – you’d have to be dancing very close to the door to believe you could get out when the stage the band is playing on blows up. I don’t think we are able to move that quickly. Our models tell us it is wise to have some cash. And we have more cash than most.
Grantham notes that, as a value investor, we are likely to be testing the patience of some clients, but given we only want clients who are patient, we are more than comfortable being tested by the market.