The cause of the next financial crisis might surprise you

I’ve been reading the latest quarterly update from probably my favourite analyst, guru, whatever you want to call him – Jeremy Grantham of GMO.

In his latest piece, he gives a mea culpa for failing to recognise the commodities bubble before it popped. (Grantham is an expert on bubbles, which makes this an unusual occurrence.)

He also looks at why US stocks are expensive – but not quite ready to pop.

But that’s not the most interesting part. There’s another burgeoning bubble that’s got him feeling a little more twitchy.

And it might surprise you…

The end of the commodities bubble

GMO’s Jeremy Grantham begins his most recent update with a bit of soul-searching. Back in 2011, he took a look at the soaring price of commodities.

While prices were way out of line with their historic averages – usually something that signals a bubble – Grantham looked at China’s staggering growth rates, and the growing global population, and decided that soaring resources prices were a genuine warning that we were “facing peak everything”, as he puts it.

As it turns out, it wasn’t different this time. Indeed, 2011 was pretty much when commodities peaked.

Grantham’s analysis of where he went wrong is worth reading in full. It’s a good, worked example of how to fess up to your mistakes as an investor and work out lessons for next time. (Just Google “Grantham GMO” and get the quarterly letter from the website).

But the takeaway for now is that while commodity prices have fallen hard amid sliding Chinese demand, and are unlikely to enjoy “a quick or dramatic recovery”, mining stocks – given their “current very low prices… will probably outperform based on historical parallels following similar major crashes”.

That makes me feel more comfortable about sticking with mining stocks, despite the recent volatility – Grantham has an impressive instinct for the markets, barring the resources bubble mis-step. At the start of the year, when everyone else was panicking, he reckoned that this wasn’t “the big one” – assets aren’t quite overvalued enough and there isn’t quite enough exuberance in the air as yet.

Of course, Grantham isn’t saying that everything’s hunky dory. He just expects everything to get a bit more bubbly before it blows. “We are unlikely, given the beliefs and practices of the US Fed, to end this cycle without a bubble in the US equity market.” By his calculations, that would take the S&P 500 to at least 2,300, and he doesn’t expect to see a top “before the election”, at least.

But that’s not the bubble that he’s most concerned about.

The next bubble could be in the most dangerous asset of all – again

What’s really interesting is that Grantham reckons US house prices might be at risk of moving back into bubble territory. In fact, they’re pretty much already there.

Grantham defines a bubble as any asset that moves to two standard deviations above its long-term average (in other words, it rises a long way above its historical trend).

As of the end of last month, the ratio of the median US house price compared to the median family income was one and a half standard deviations away from its long-term average (going back to 1976).

That’s pretty striking. You have to remember that US house prices (nationwide, rather than specific areas) have been pretty stable over the long run. It’s nothing like the UK from that point of view – US house prices have simply tracked inflation, whereas UK house prices have gone up a lot more rapidly than inflation.

But the days of easy money and the rush to find assets that might pay an income seems to have changed that somewhat. According to Grantham’s data, the only other time that the price/income ratio in the US has risen above even one standard deviation was during the 2000 to 2006 bubble era.

Admittedly, prices then rose to more than three standard deviations above the mean. But as Grantham points out, that merely makes this “a classic echo bubble – ie driven partly by the feeling that the substantially higher prices in 2006… somehow justify today’s”.

In short, “in 12 to 24 months, US house prices – much more dangerous than inflated stock prices in my opinion – might beat the US equity market in the race to cause the next financial crisis”.

Given how much more significant property loans are on banks’ balance sheets, compared to shale-oil producer debt, that’s a worrying prospect. The idea that President Trump or Clinton might shortly find themselves facing the choice of whether to bail out the banks yet again, at a time when voters are still smarting from 2008, is unpleasant.

Trump might get to find out if printing even more money to buy US debt (at a discount, or otherwise) really is a feasible economic policy. And the rest of us will have to live with the consequences.

  • SCIdirector

    The reason we are headed for yet another property market driven crash is that there have been no systemic changes made to the system of regulations and tax policies that doom our society to boom-to-bust cycles. One need look no deeper than to the intense land speculation that soon reignited after the 2008 crash. The Federal Reserve started the process by lowering rates of interest to levels that allowed land (and property) owners to increase asking prices, absorbing much of the affordability associated with the low rates of interest. Some property owners burdened by predatory mortgage loan terms were able to secure “conventional” financing and significantly reduce their mortgage debt. For mortgage loan investors, these refinancings reduced the number of foreclosures and foreclosure-related losses. Once this pent-up demand was met, the property market ran into the problem that household incomes were stagnant or declining for millions of households. Low households savings made it impossible to meet more stringent down payment requirements. The way land markets work is right before us to see and understand. Any measures taken to stimulate demand will be capitalized into higher land prices. Speculators add fuel to the fire, especially when able to acquire credit for their speculation rather than utilize their own cash. A clear indication that the land markets are stressing a regional market is revealed when appraisal data shows the median land-to-total value ratios above 25-30 percent and increasing at a rate greater than the rate of increase of median household income. This is where we are now.

    • Tony Smith

      That explanation, is too simplistic it is more complex than that. Your are dealing with Macro and Micro Economics on a scale unimaginable; that in itself need some in depth measures and thoughts, so as to make the necessary adjustment; to the present economic model. Furthermore, that which is used to regulate the economy at present, Money and Fiscal policies are not enough, when you are dealing with Quantitative Easing; worse economic stagnation. Believe me, there is a lot more to this, than meets the eyes. Adam Smith, perhaps this would give you a hit.

      • SCIdirector

        I would describe the complexity as externalities. The extenalities have some effect on the depth and duration of cyclical downturns but not on the existence of the cycle. I am not alone on these issues. A growing number of economists have closely examined the statistics and reached similar conclusions. Read what Joseph Stiglitz has been writing on the subject. There is also Mason Gaffney and Fred Foldvary to name a few others.

  • dfl3tch3r

    I don’t know much about economics but I think I know that US debt is way too high both government and personal debt….It’s un-manageable surely? Regardless of all the Macro and Micro tinkering…Do we really need to know what’s gonna trigger the next crash? All we need to know is that it is coming…Followed by QE3……..America Stop spending on not just houses but on everything…..Or is that too simplistic lol