Commentary on Political Economy

Monday 11 January 2021


Grantham's Warning Makes Vigilant Bulls of Us All

Stocks should be OK, provided the Fed keeps rates low and investors don’t go too crazy. There isn’t much margin for error.

Watch those bond yields closely.
Watch those bond yields closely. Photographer: ANDREW HARRER/Bloomberg

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Jeremy and His Bubble

So. Is it a bubble or isn’t it? Last week, the veteran bubble aficionado Jeremy Grantham, founder of the GMO fund management group in Boston, opined that U.S. stock markets are now into the final stages of a speculative bubble, worthy of comparison with the dot-com bubble, the Great Crash of 1929, and the South Sea Bubble.

Many believe that Grantham has grown too cautious in his later career, but few fail to take him seriously. His warning, which I covered last week, has thus prompted many responses. I will now try to summarize the most interesting points made in debate. But at the outset, it’s as well to make clear that I’m only looking at the risk of the market collapsing under its own weight having come to the end of a speculative cycle. There is also good reason to be worried about the exogenous risk that the latest wave of Covid-19 will inflict a fresh recession this year. That isn’t currently priced in, and on balance it shouldn’t be, but as this chart from Oxford Economics shows, the deterioration in the last few days has increased that risk somewhat. This is how the Covid-19 situation has shifted over the last two weeks as the new variant has started to spread :

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On the assumption that the pandemic doesn’t render the debate moot, the arguments that we are in a bubble boil down to two. The first is that valuations are dangerously dependent on the persistence of historically low bond yields. The second is that market behavior has reached the “crazy” stage in which there is no interest in fundamental valuations, and investors are instead merely calculating that they can sell for a higher price to a greater fool.

Are there signs that the bond market is going to get less accommodating? Yes there are, although it remains very lenient for now. Late on Monday, in a matter of great excitement for bond nerds, the 2s-10s yield curve (the spread of 10-year over 2-year Treasury bond yields) rose above 100 basis points for the first time since May 2017. Oddly enough, it is now exactly as steep as it was on the day Donald Trump was elected president in 2016. The bond market is plainly shifting toward reflation, which could mess up the positive scenario:

The 2-10yr Treasury curve is its steepest since May 2017

For evidence that behavior is indeed moving to the “barking mad” end of the dial, as we would expect in a bubble, look only at the extraordinary ructions in bitcoin so far this year:

So far this year: a 44.1% rally, a 27.4% fall and another 17% rally

For another indicator that investors are getting silly, consider the median age of companies at the point they move to an IP0. This is getting younger and younger, as shown in this chart from BCA Research Inc. using data from Jay Ritter of the University of Florida's Warrington College of Business, suggesting investors are growing ever more credulous:

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While excessive valuation isn’t an indicator that a bubble is about to burst, it is a necessary condition. And Jason DeSena Trennert of Strategas Research Partners offers an alarming indicator that indicators are indeed growing historically extreme. The ratio of the S&P 500’s total market cap to U.S. GDP, a rule of thumb made popular by Warren Buffett, is a well-known indicator, and it suggests that the stock market is more expensive than it was even at the top in 2000. But about 40% of S&P 500 companies’ earnings come from outside the U.S., so Trennert ran the same numbers comparing S&P market cap to global GDP. The world’s GDP has grown far more than that of the U.S. over the last 20 years — but remarkably, this indicator now shows the U.S. stock market as expensive as it was in 2000. You really don’t need ultra-sophisticated models to show that the market is untenably expensive:

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Trennert also provides this handy comparison with valuations at previous bull market peaks. On a trailing price-earnings basis, the market is more expensive than at any previous peak — although the prospective P/E was slightly higher at the top in 2000. When we look at the equity risk premium, the gap between expected returns on stocks and bonds, however, the market appears spectacularly cheap. This can be fixed either by a rise in share prices, or a fall in bond prices (and rise in their yields):

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Will bond yields rise sharply from here? There is a sense that the risks have risen since last week’s Senate elections in Georgia gave Democrats control of the Senate. This should make it easier for them to carry out a reflationary economic agenda. However, their margin is so narrow that they cannot do anything radical — and indeed stocks briefly dipped on Friday last week after reports (later retracted) that Joe Manchin, the Democratic senator for West Virginia, would vote against distributing individual $2,000 checks for Covid relief. And while the Democrats’ hopes to reverse some of the corporation taxes enacted by the Trump administration three years ago have provoked talk of “socialism” among some analysts, the following BCA Research chart shows clearly that higher or lower taxes have little or no relationship to higher or lower growth:

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So the advent of unified Democratic government should change economic forecasts a bit, but shouldn’t  transform them. The Federal Reserve will be under unchanged leadership, and wants to keep rates low. This assessment by Doug Peta, BCA Research’s investment strategist, seems fair:

Net-net, we expect that the outcome of the Georgia run-offs will lead to slightly higher interest rates, a steeper yield curve, increased consumption and fewer defaults, a welcome mélange for credit performance and the equities that were left behind as investors flocked to COVID winners.

That brings us back to the crucial question:  Are investors over-complacent about continuing low bond yields? There is some anecdotal evidence of this. Surveys reveal startling unanimity that rates will stay low for years to come, even from investors who have confidence that the global economy will reflate. 

But the most intriguing evidence to catch my eye that the chance of higher rates isn’t being taken seriously is in the following chart. It is a sensitivity analysis from Goldman Sachs Group Inc., which has a positive target for the stock market this year. It acknowledges that this would be sensitive to rising inflation expectations and to rising 10-year real yields. Therefore, it shows the model’s outcomes for a range real yields, and a range of inflation forecasts:

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This is all very useful research, and confirms that the S&P can be expected to fall this year if inflation expectations don’t rise much (suggesting that hopes for reflation aren’t going well) while real yields rise to minus 0.3%.

What intrigues me is that the highest real yield that Goldman tested was minus 0.3%. For reference, this is how the 10-year real yield has moved over the last decade. I have marked the 0.3% level:

What is the chance that the 10-year real yield tops -0.3% this year?

Negative real yields are historically very unusual. They have been below minus 0.3% for less than two years out of the last 20. The only precedent for yields this low came in 2012-13, after the Fed announced that it was resorting to indefinite quantitative easing bond purchases. Negative yields ended suddenly and dramatically as soon as the Fed started to talk about tapering off that support, in what became known as the Taper Tantrum. A repeat of that incident, in some form, is exactly what many now worry about.

To be clear, I think real yields are unlikely to exceed minus 0.3% this year. But the fact that a large investment bank seems not to have considered such a possibility when conducting a sensitivity analysis does rather suggest that there may be some complacency at work. 

That in turn leads to an uncomfortable conclusion that Grantham may well be right. Plenty of people have addressed his concerns, but as far as I can see nobody has tried to say that they are downright wrong. He plainly has a point. The only questions are how far the crazy behavior has advanced, and how decent the chances are that the bond market keeps stocks afloat. Peta of BCA describes himself as “vigilantly bullish” and came up with this conclusion — which suggested to me more “anxious bullishness” than “vigilant bullishness”:

We respect Jeremy Grantham’s experience and formidable accomplishments and listen closely to any insights he’s willing to share. We acknowledge that there are many signs of froth across financial markets and that the [Charles] Kindleberger red line of purchasing assets without regard to their intrinsic merit could be crossed in the not-too-distant future. We echo the sentiment that central bankers are not omnipotent and that easy monetary policy is not a magical elixir. We do, however, assert that the combination of extremely easy monetary policy and a new round of fiscal aid offers equities and spread product a supportive backdrop that should be expected to hold throughout the year provided that markets don’t get over their skis by bidding up asset prices too far. 

In other words, we should be OK, providing the Fed keeps rates low, and providing stock market investors don’t get too carried away. There isn’t much margin for error. It’s a case for ultra-vigilant bullishness.

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