Grantham (The entire piece from his quarterly wirte-up)
It's Everywhere, In Everything: The First Truly Global Bubble (Observations following a 6-week Round-the-World Trip)
by Jeremy Grantham
From Indian antiquities to modern Chinese art; from land in Panama to Mayfair; from forestry, infrastructure, and the junkiest bonds to mundane blue chips; it's bubble time!
The necessary conditions for a bubble to form are quite simple and number only two. First, the fundamental economic conditions must look at least excellent – and near perfect is better. Second, liquidity must be generous in quantity and price: it must be easy and cheap to leverage. If these two conditions have ever been present without causing a bubble it has escaped our attention. Conversely, only one of the conditions without the other may cause an ordinary bull market but this is often not the case. For example, good or even excellent fundamentals with tightening credit often result in a falling market.
That these two conditions have been met now hardly needs statistical support, so widely accepted have they become. Never before have all emerging countries outperformed the U.S. in GDP growth over a 12-month period until now, and this when the U.S. has been doing well. Not a single country anywhere – emerging or developed – out of 42 listed by The Economist grew its GDP by less than Switzerland's 2.2%! Amazingly uniform strength, and yet another sign of how globalized and correlated fundamentals have become, as well as the financial markets that reflect them.
Bubbles, of course, are based on human behavior, and the mechanism is surprisingly simple: perfect conditions create very strong "animal spirits," reflected statistically in a low risk premium. Widely available cheap credit offers investors the opportunity to act on their optimism. Sustained strong fundamentals and sustained easy credit go one better; they allow for continued reinforcement: the more leverage you take, the better you do; the better you do, the more leverage you take.
A critical part of a bubble is the reinforcement you get for your very optimistic view from those around you. And of course, as often mentioned, this is helped along by the finance industry, broadly defined, that makes more money when optimism and activity are high. Hence they have every incentive to support rising markets as they do. But geography and culture can weaken the chain. The South Sea bubble was infl uenced by earlier speculation in France, but was distant and alien to the rest of the world. The great Japanese land and stock bubble was utterly persuasive to everyone in Japan, but completely unpersuasive to almost all of our clients. Seen through our eyes 10,000 miles away, it seemed obviously overdone and dangerous, didn't it? Even the 2000 bubble was really confined to TMT in the developed countries.
But this time, everyone, everywhere is reinforcing one another. Wherever you travel you will hear it confirmed that "they don't make any more land," and that "with these growth rates and low interest rates, equity markets must keep rising," and "private equity will continue to drive the markets." To say the least, there has never ever been anything like the uniformity of this reinforcement.
The results seem quite predictable and consistent. All three major asset classes – real estate, stocks, and bonds – measure expensive compared with their histories and compared with replacement cost where it can be calculated. The risk premium has reached a historic low everywhere: last quarter we showed that by using our 7-year forecasts to create efficient portfolios for high, medium, and low risk levels, the return for taking risk had dropped precipitously from September 2002 until May of last year. To be precise, the gap between our low and high risk portfolios on our 7-year forecast in September 2002 was 6.4% points and by May last year it was a paltry 0.8%. But in Australia last month it was pointed out that we had missed the point, that all these portfolios included our expected alpha, which not surprisingly is higher for the risky portfolios (small cap and emerging) than it is for low risk portfolios (cash and TIPS). So Exhibit 1 reproduces the three points in time, using just the asset class forecast. As of May last year we now show – drum roll – the first negative sloping risk return line we have ever seen. Just think about it: if we are correct, the process of moving all asset prices smoothly to fair value over 7 years (which is how we do our 7-year forecasts) will have resulted in a world where investors are paying for the privilege of taking risk! If you believed this data you should, of course, put all your money in cash. In the real world, unfortunately, even if you believed it with every fi ber in your body, you could only have a little cash on the margin because the career risk or business risk of moving more would be unsupportable.
So to recap and extend:
1. Global fundamental economic conditions are nearly perfect and have been for some time.
2. Availability of global credit is generous and cheap and has been for some time.
3. Animal spirits and optimism are therefore high and feed on themselves through reinforcing results and through being universally shared.
4. All global assets reflect this and are overpriced and show, probably for the fi rst time, a negative return to risk taking.
5. The correlation in global economic fundamentals is at a new high, refl ected in the steadily increasing correlation in asset price movements.
6. Global credit is more extended and more complicated than ever before so that no one is sure where all the increased risk has ended up.
7. Every bubble has always burst.
8. The bursting of the bubble will be across all countries and all assets, with the probable exception of high grade bonds. Risk premiums in particular will widen. Since no similar global event has occurred before, the stresses to the system are likely to be unexpected. All of this is likely to depress confidence and lower economic activity.
9. Naturally the Fed and Fed equivalents overseas will move to contain the economic damage as the Fed did last time after the 2000 break. But the heart of the last bubble, the NASDAQ and internet stocks, still declined by almost 80% and 90%, respectively. (The heart of the bubble this time is probably private equity. In 10 years, it may well be described as the private equity bubble just as 2000 is thought of as the internet bubble. You heard it here first!)
10. What is wrong with this logic? Something I hope.
11. Of course the tricky bit, as always, is timing. Most bubbles, like internet stocks and Japanese land, go through an exponential phase before breaking, usually short in time but dramatic in extent. My colleagues suggest that this global bubble has not yet had this phase and perhaps they are right. (A surge in money fl owing into private equity might cause just such a hyperbolic phase.) In which case, pessimists or conservatives will take considerably more pain. Again?!
This Time It's Different
Yes, each bull market reflects its near perfection in a different way, with most accompanied by claims of a golden new era. Today the apparently infinite and cheap supply of Chinese labor, a truly colossal U.S. trade deficit, and the sheer uniformity of easy money and strong economics certainly give this one plenty of differences.
But under the surface capitalism eventually grinds pretty fine. The return to capital and the cost of capital sooner or later get into line. Competition bids down returns. Confidence to spend capital finally recovers. Profit margins, at long last, become normal or even drop below normal. The workings of competitive capitalism are, in the end, an irresistible force and that is why everything always trends to normal and every very different bubble has always burst. And hey, if it happened in a smooth and regular way, how boring our business would be.
What Is the Catalyst for a Break?
Everywhere I went on my trip this was the question that followed my gloomy talk. But there usually is no catalyst that can be observed. We haven't agreed yet on a catalyst for 1929, 1987, or 2000, or even the South Sea bubble for that matter. On pondering the reason for the lack of a catalyst I offer a thought experiment (or tortured analogy). A market in equilibrium can be likened to a ping-pong ball sitting on a pool of water. You may have seen the fun fair trick of having ping-pong balls sitting atop jets of water that rise and fall with the power of the jets. The force of the jet can be likened to economic and financial conditions. The more nearly perfect the fundamentals and the more generous the liquidity, the higher the water jet raises the ball. At maximum force the ball is as high as it gets – a bull market peak. Then the jet is turned down a little, so it still represents a nearly perfect set of conditions but just the very slightest bit less perfect than it was – the jet is slightly lower and the ball falls. If bear markets start in nearly perfect conditions, far above average but just a little worse than the day before, what chance do historians have of finding the trigger? It is lost in a second derivative nuance. And, by the time conditions are merely well above average, the most leveraged and aggressive investors have registered the series of declines and are beginning to take evasive action. From here intelligent career and business risk management creates the normal herding or momentum, but in a seamless way as slight reductions in real conditions blend in with gamesmanship. Given all the uncertainties and the fact that conditions do not weaken linearly but in uneven and unpredictable steps, is it any surprise that we always miss market tops?
Having said all this, what are the special vulnerabilities this time that might work over a period of time to reduce the near perfection of today's market conditions? The first is easy: rising inflation. It constrains the Fed's support to any weakening economy, and the U.S. economy is indeed weakening. It directly lowers the traditional bond markets. Stocks may be real assets, but behaviorally it destabilizes stock investors and causes P/Es to fall. In the short term it tends to depress profit margins as corporations relearn how to pass through any cost increases. It wreaks havoc with housing and commercial real estate by lowering the possible leverage and therefore lowering prices. And perhaps most significantly this cycle, it lowers the feasible leverage in private equity deals and places many deals that can be done today out of reach, which in turn has dire effects on the current stock market.
The second possible catalyst is our old friend: profit margins. They are currently far above average globally and they will, of course, come down. A slowing U.S. economy and fewer pleasant global surprises will put pressure on profit margins. Possibly continued house price declines will slow the growth of credit, and consumption will grow less fast. There are leads and lags, and large retroactive changes to the profit margin data, so this factor is not so certain a death knell to the bubble as is inflation, but a couple of years of margin declines should do the job just fine.
The First Quarter's Stress Test
In late February we had a spot of trouble in the subprime market. ("Subprime ..." – it already begins to sound familiar. Haven't we always talked about it?) And a Chinese red herring arbitrarily jumped in with a 9% market decline in one day, for no related reason. The combined effect was to create an echo of last May, where the carry trade pulls back for a few days and lets us see where the vulnerabilities are. There is a tendency to say, "Whoopee! We always bounce back! We're armor plated!" This seems like a bad idea. There is probably lots of information in these minor shocks, which may prove useful for a major shock. Last May's lesson, I believe, was not that emerging markets could bounce back, but that they could decline by 25% in three weeks in the face of the best year fundamentally in emerging's entire history. What might the decline have been on bad news? A 50% decline in 3 weeks? It just let us know the potential pain in really bad risk-liquidity events. I suggest taking a close look at one's entire portfolio on each of these shocks and checking for leaks in the boat – unexpected effects.
In May of last year emerging was a big holding for us, but there was no real concern because we believed that in an extended decline the extra value in emerging would materialize as it did in 2002. And if the market recovered, emerging would storm back. This time we took unexpected pain in our fixed income investments, which in many of our asset allocation accounts had risen to 50%. We knew that in general our fixed income portfolios tend to prosper as risk premiums narrow, whereas our equity accounts have a hard time, and vice versa. It was just a question of degree. In asset allocation, in our desire to have more of fixed income's enviable alpha, we had probably reached for a bit too much of it to be compatible with the normal risk avoiding preference of our asset allocation portfolios. On examination it really came down to having accumulated, in the different portfolios, too much currency exposure, which in turn can get in the way of carry trade events. So after long consideration of alternatives, we reduced the currency alpha exposure. It may be an over-reaction, and you can never know for certain at the time (and indeed risk taking in general continued to prosper in the first quarter), but I don't think so.
I urge our clients to take a detailed look at all their portfolios' responses to these two jolts, for sometime sooner or later the shots will not be across the bows.