Will this bull market end with a whimper – or a catastrophic bang?

New York stock exchange © Getty Images
US stocks: expensive, but not in a bubble

If you’ve been reading Money Morning for any length of time, you’ll have heard me mention Jeremy Grantham before.

If you haven’t, Grantham heads up US wealth manager GMO. He’s got a great record of spotting and avoiding bubbles, dodging both the tech bubble and the 2008 crash.

But he also made a very high-profile call to get back into the market in March 2009 – pretty much the bottom. A level-headed independent investor, rather than a permabear, in other words.

He’s also a great writer. So I like to keep an eye on what he’s saying.

But his latest take on the overvalued US stockmarket has me wondering if he’s looking in the right direction…

When a bubble is not a bubble

GMO has built a model to try to define what actually constitutes a bubble.

The argument is that when an asset moves to more than two standard deviations above its long-term average, it’s in a bubble. Put simply, two standard deviations means a price is way out of whack with its long-term trend (such a move should only happen once every 44 years).

In the vast majority of the 30-odd specific historic examples of this happening that the GMO team has tracked down, the bubble has burst, and prices have “reverted to the mean” sharpish. In other words, prices have fallen back to their long-term average or below – often dropping by around 50% within three years or less, in the case of equities.

On the US S&P 500 index, the 2,300 level marks the two standard-deviation point. Right now, the S&P is at 2,260 or so. So not far off it. So when’s the bust? This is where Grantham – reluctantly, he says – departs from the script.

In his third quarter review – published in November – he suggests that “the US market today is not a classic bubble, not even close”. It is overvalued, yes, but Grantham reckons it’ll work off that overvaluation gradually over time – the bull market will end, to quote TS Eliot, “not with a bang but a whimper”.

That might sound like a good outcome, but it’s pretty depressing for investors in the US. On the one hand, investors in US stocks can look forward to eking out measly returns for maybe two decades. On the other, bears won’t get their longed-for chance to pile in and buy the market at a bargain price.

So when is a bubble not a bubble? Basically, when the story isn’t sexy enough.

Grantham points out that a bubble is built on something specific: “excellent fundamentals irrationally extrapolated”. A great story, taken to extremes.

Japan was a great story in the 1980s – a fast-growing Asian powerhouse with fresh, efficient ways of doing things. It was worth getting excited about. But people just got too excited, and started to believe impossible things (that a small chunk of central Tokyo had the same value as the entire state of California, for example).

Tech stocks were the same. They really did change the world. It’s just that investors paid too much, too soon for them.

But today, what’s the story and where’s the excitement? “The market lacks both the excellent fundamentals and the euphoria required to unreasonably extrapolate it.”

So what’s different this time (those dangerous little words)? Why is the market overvalued, while the psychology of a bubble doesn’t seem to be present?

It’s mostly Alan Greenspan’s fault

It boils down to central bankers, who Grantham – rightly, I think – largely blames for the market overvaluation. “The US Fed and its growing list of converts… have successfully bullied the entire discount rate structure of assets.”

That’s a bit technical sounding, but it’s not that tricky to grasp. Central banks – led by the Federal Reserve in the US – have been keeping interest rates down since 1995 (just after the last big bond market panic in 1994, which is actually rather pertinent, as we’ll reveal further down).

The central banks cut short-term interest rates. Over time, this gradually spread out to longer-term interest rates (as set by government bond markets). From 1945 to 1995, says GMO, the average yield on the US ten-year Treasury bond, after inflation (“real”), was 1.6%. But now it’s down to 0.1%.

If the yield you can get risk-free drops by 1.5%, then you’re going to be more willing to accept a lower return from other assets too. So, for example, the real yield on high-quality corporate bonds in the US has fallen from an estimated 4.9% to 2% now.

When yields fall, prices rise. And this yield repression has worked its way outward from bonds “rather like a virus” and has now infected “all investable assets”. Hence the surge in share prices, property prices, and all the rest.

This was a deliberate policy, designed to generate a “wealth effect” by making consumers feel richer, and thus boost economic growth. Fed boss Janet Yellen and her predecessors, Ben Bernanke, and Alan Greenspan – the bubble-blower-in-chief himself – “all overtly bragged about their success in driving asset prices, particularly stocks, higher”.

So what happens next? Well, this is where it gets interesting to me. Grantham seems to embrace a version of the “new normal” argument. He struggles to see a world where central bankers give up on controlling interest rates. There are also structural reasons – demographics, for example – to expect a world of slower growth and weaker inflation.

So while real yields might gradually return to something close to their previous average, it could take around 20 years to do so. So you get a slow bear market, with historically very low real returns, dragged out over time, rather than a rapid collapse in prices followed by a rally.

Like the man said, a whimper rather than a bang.

Here comes the twist

It’s an interesting take. But I read another interesting and scary piece yesterday that makes me wonder if the real issue is that Grantham is perhaps paying attention to the wrong bubble.

US academic Paul Schmelzing of Harvard University is currently working at the Bank of England. He’s been looking back at the history of interest rates over 800 years.

In all that time, the current bond bull market has been both one of the longest, and one of the biggest (in terms of how far yields have fallen per year). And we haven’t really seen anything of a comparable magnitude since, oh, 1664.

I don’t know, but that sounds pretty bubbly to me. So how do these sorts of bull markets tend to come to an end?

Schmelzing reckons there are two main risks. First, rising inflation, as seen in the 1967-71 bond bear market. During this period, “US bonds lost 36% in real price terms” at a time when annual CPI “more than tripled… from 1.6%, to 5.9%”. US inflation is higher than 1.6% right now, and with Donald Trump in charge, it’s only expected to rise further.

Secondly, there’s the risk that as bond prices start to fall, you get a self-sustaining sell off as banks in particular, dump government bonds that are shedding value rapidly.

What would all that mean? And bear in mind that this is a presumably level-headed academic, not an attention-seeking journalist, talking here.

“By historical standards, this implies sustained double-digit losses on bond holdings, subpar growth in developed markets, and balance sheet risks for banking systems with a large home bias.”

What are the chances of overvalued stockmarkets surviving a bang like that intact? A 20-year long whimper looks a cheery prospect compared to that sort of bust. (And it’s another good reason to hang on to your gold, even if it’s not doing much at the moment).

So don’t fret too much about Dow 20,000 or what’s going on with equities in general. The bond market is the one to watch in 2017.

  • Cliff Williams

    An interesting article which has been somewhat confirmed by other sources. For example, both Fed 30year, UK 10year, JGB and Euro bonds have made price peaks and reversed within the last 3 months. Technical analysis strongly suggests that a multi-decade reversal has already occurred. see https://www.youtube.com/watch?v=nSAoyklLndQ&index=30&list=PLgwuLiI9Z7Bd_iXbUALyV3E41cbgLn6VE.
    Now 3-4 years ago, Bengt as part of the FS Letter discussed the FED model, which is the general relationship between bond yields and stock divided yields. https://en.wikipedia.org/wiki/Fed_model. For the UK market, he was able to show that the bond market leads the FTSE by about 6 months. So if we are 3 months into the bond market turn, it suggests that we are potentially awfully close to a FTSE top. Lets review again in a few months’ time….