Saturday, January 6, 2018

Much Talk About Market Sweet Spot But Nothing Different

Currently, we are hearing a great deal about how the market is in a sweet spot while nothing is really all that different on the ground. When it comes down to the economy and how it impacts the average American in middle America little has changed during the last year but what we are seeing is an extension by many investors into very speculative investments. In reality not only are we and nations around the world continuing to run huge deficits central banks are still printing money and keeping interest rates artificially low.

Costly Fires In California - Now A Polar Vortex
Ironically this is occurring at a time when America has been under a costly assault by mother nature. First, it was hurricanes, then fires in California, and now much of the country is suffering record-breaking cold temperatures caused by a freezing polar vortex. All these natural disasters are different, however, what they have in common is the fact they are very costly. The point is just in how breaking a window and replacing it with a new one creates economic growth, such action does not really result in great benefit to the country in general. All growth is not equal and growth does not always result in increased economic strength.

Of course, it is not strange that the argument cheap money only masks a weak economy has gained no traction. The low-interest rate environment put in place by the Federal Reserve, European Central Bank and Bank of Japan and money pouring out of China has driven cash into real estate, commodities and speculative whimsies such as bitcoin and other cryptocurrencies. A Market Watch article last week only added to the enthusiasm by informing us that well-respected investor Jeremy Grantham, who is credited with calling the 2000 and 2008 downturns warned investors on Wednesday to be prepared for the possibility of a near-term “melt-up.”

Debt Has Soared Compared To GDP
The negative part contained in Grantham's note that many seemed to discount were his feeling that "this would likely set the stage for a burst bubble and a stock-market meltdown in the future." Nobody can deny that the positive trading mood that drove global stock markets higher in 2017 and early 2018 continues. Our current "trumped-up" upbeat sentiment is buoyed by several factors such as the recently passed tax package in the U.S., rising commodity prices, robust corporate earnings. Solid economic data and low bond yields have also been cited as contributing factors. Central banks have even joined in making true price discovery impossible. The fact is it is difficult to predict how far a market will overextend before crashing in ruins and during the mania warnings of excess are ignored and naysayers ridiculed. That seems to be a constant indicator of such economic blow-offs.

We are constantly being told workers are not seeing big increases in wages while consumers are spending more, saving less, and taking on more debt. Logically this would lead to the conclusion consumers are reaching the point where they are taped out and with huge heating bills as well as rising gas prices at some point a retrenchment in discretionary spending should occur. This conflicts with the idea all is well and the constant upgrading of stock prices to "strong-buy" that has become the daily fare for analyst across the land. A great example of the strength or rather the insanity that is occurring is reflected in the price of Tesla's stock that dropped a mere one percent on confirmation of their inability to produce their newest car the Model 3.

Returning to the MarketWatch story, Grantham states, “I recognize on one hand that this is one of the highest-priced markets in U.S. history. On the other hand, as a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market,” The well-respected investor did this in a 13-page note where he emphasized this reflected his very personal view. Grantham, a value investor, co-founder and chief investment strategist of Boston-based asset manager GMO compared the present market setup with the run-up to past bubbles, including the 2000 tech boom and the precursor to the 1929 crash.

Grantham emphasizes that bubble calls shouldn’t necessarily rely on price alone. Instead, he puts emphasis on price acceleration, which captures “the importance of a true psychological event of momentum increasing to a frenzy.” Grantham refers to an academic paper published last year that concluded that the strongest indicator of a bubble in the U.S. and almost all global markets was price acceleration. Grantham points out that “just recently, say the last six months, we have been showing a modest acceleration, the base camp, perhaps, for a final possible assault on the peak. He wrote. “A range of nine to 18 months from today and a price rise to around 3,400 to 3,700 on the S&P 500 would show the same 60% gain over 21 months as the least of the other classic bubble events.”  

Other bubble factors cited by Grantham include increasing concentration on certain stock market “winners,” the outperformance of quality and low-beta stocks in a rapidly rising market, “extreme overvaluation” and the role of the Federal Reserve. This all seems more of a reminder of well-entrenched market sayings such as the "trend is your friend" and "don't stand in front of a freight train" based on charts, wave patterns and his gut feelings that we have disconnected from true market value and when we do these trends seem to take on a life of their own. Of course, that does not mean Grantham is not right and even as icons such as Macys and Sears announce closing more stores the markets may ignore such things.

Below is a summary of what Grantham sees might happen.

  • ■ “A melt-up or end-phase of a bubble within the next six months to two years is likely, i.e., over 50%.
  • ■”If there is a melt-up, then the odds of a subsequent bubble break or meltdown are very, very high, i.e., over 90%.
  • ■ “If there is a market decline following a melt-up, it is quite likely to be a decline of some 50%.
  • ■ “If such a decline takes place, I believe the market is very likely (over 2:1) to bounce back up way over the pre-1998 level of 15x, but likely a bit below the average trend of the last 20 years, as the trend slowly works its way back toward the old normal on my ‘Not with a Bang but a Whimper’ flight path.”
So what should investors do? Grantham reiterated his call to own “as much emerging market equity risk as your career or business risk can tolerate” and some EAFE, an acronym for Europe, Australasia and the Far East. The problem with this strategy is that when markets correct these markets will also be heavily impacted and possibly even more than those in America. Like so many other investors who have been wrong for so very long, I continue to feel something is very very wrong with what is unfolding. Over the years we have experienced several bubbles each bigger than the last and it might have raised the bar higher for calling something a bubble. It is important to remember how we got here in the first place. As this is being written a feeling of déjà vu has washed over me, yes in some ways it feels just like 2007, but different!

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