See full: https://www.gmo.com/europe/research-library/waiting-for-the-last-dance/
The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.
These great bubbles are where fortunes are made and lost – and where investors truly prove their mettle. For positioning a portfolio to avoid the worst pain of a major bubble breaking is likely the most difficult part. Every career incentive in the industry and every fault of individual human psychology will work toward sucking investors in.
But this bubble will burst in due time, no matter how hard the Fed tries to support it, with consequent damaging effects on the economy and on portfolios. Make no mistake – for the majority of investors today, this could very well be the most important event of your investing lives. Speaking as an old student and historian of markets, it is intellectually exciting and terrifying at the same time. It is a privilege to ride through a market like this one more time.
Most of the time, perhaps three-quarters of the time, major asset classes are reasonably priced relative to one another. The correct response is to make modest bets on those assets that measure as being cheaper and hope that the measurements are correct. With reasonable skill at evaluating assets the valuation-based allocator can expect to survive these phases intact with some small outperformance. “Small” because the opportunities themselves are small. If you wanted to be unfriendly you could say that asset allocation in this phase is unlikely to be very important. It would certainly help in these periods if the manager could also add value in the implementation, from the effective selection of countries, sectors, industries, and individual securities as well as major asset classes.
The real trouble with asset allocation, though, is in the remaining times when asset prices move far away from fair value. This is not so bad in bear markets because important bear markets tend to be short and brutal. The initial response of clients is usually to be shocked into inaction during which phase the manager has time to reposition both portfolio and arguments to retain the business. The real problem is in major bull markets that last for years. Long, slow-burning bull markets can spend many years above fair value and even two, three, or four years far above. These events can easily outlast the patience of most clients. And when price rises are very rapid, typically toward the end of a bull market, impatience is followed by anxiety and envy. As I like to say, there is nothing more supremely irritating than watching your neighbors get rich.
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I am long retired from the job of portfolio management but I am happy to give my opinion here: it is highly probable that we are in a major bubble event in the U.S. market, of the type we typically have every several decades and last had in the late 1990s. It will very probably end badly, although nothing is certain. I will also tell you my definition of success for a bear market call. It is simply that sooner or later there will come a time when an investor is pleased to have been out of the market. That is to say, he will have saved money by being out, and also have reduced risk or volatility on the round trip. This definition of success absolutely does not include precise timing. (Predicting when a bubble breaks is not about valuation. All prior bubble markets have been extremely overvalued, as is this one. Overvaluation is a necessary but not sufficient condition for their bursting.) Calling the week, month, or quarter of the top is all but impossible.
I came fairly close to calling one bull market peak in 2008 and nailed a bear market low in early 2009 when I wrote “Reinvesting When Terrified.” That’s far more luck than I could hope for even over a 50-year career. Far more typically, I was three years too early in the Japan bubble. We at GMO got entirely out of Japan in 1987, when it was over 40% of the EAFE benchmark and selling at over 40x earnings, against a previous all-time high of 25x. It seemed prudent to exit at the time, but for three years we underperformed painfully as the Japanese market went to 65x earnings on its way to becoming over 60% of the benchmark! But we also stayed completely out for three years after the top and ultimately made good money on the round trip.
Similarly, in late 1997, as the S&P 500 passed its previous 1929 peak of 21x earnings, we rapidly sold down our discretionary U.S. equity positions then watched in horror as the market went to 35x on rising earnings. We lost half our Asset Allocation book of business but in the ensuing decline we much more than made up our losses.
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The strangest feature of this bull market is how unlike every previous great bubble it is in one respect. Previous bubbles have combined accommodative monetary conditions with economic conditions that are perceived at the time, rightly or wrongly, as near perfect, which perfection is extrapolated into the indefinite future. The state of economic excellence of any previous bubble of course did not last long, but if it could have lasted, then the market would justifiably have sold at a huge multiple of book. But today’s wounded economy is totally different: only partly recovered, possibly facing a double-dip, probably facing a slowdown, and certainly facing a very high degree of uncertainty. Yet the market is much higher today than it was last fall when the economy looked fine and unemployment was at a historic low. Today the P/E ratio of the market is in the top few percent of the historical range and the economy is in the worst few percent. This is completely without precedent and may even be a better measure of speculative intensity than any SPAC.
This time, more than in any previous bubble, investors are relying on accommodative monetary conditions and zero real rates extrapolated indefinitely. This has in theory a similar effect to assuming peak economic performance forever: it can be used to justify much lower yields on all assets and therefore correspondingly higher asset prices. But neither perfect economic conditions nor perfect financial conditions can last forever, and there’s the rub.
All bubbles end with near universal acceptance that the current one will not end yet…because. Because in 1929 the economy had clicked into “a permanently high plateau”; because Greenspan’s Fed in 2000 was predicting an enduring improvement in productivity and was pledging its loyalty (or moral hazard) to the stock market; because Bernanke believed in 2006 that “U.S. house prices merely reflect a strong U.S. economy” as he perpetuated the moral hazard: if you win you’re on your own, but if you lose you can count on our support. Yellen, and now Powell, maintained this approach. All three of Powell’s predecessors claimed that the asset prices they helped inflate in turn aided the economy through the wealth effect. Which effect we all admit is real. But all three avoided claiming credit for the ensuing market breaks that inevitably followed: the equity bust of 2000 and the housing bust of 2008, each replete with the accompanying anti-wealth effect that came when we least needed it, exaggerating the already guaranteed weakness in the economy. This game surely is the ultimate deal with the devil.
Now once again the high prices this time will hold because…interest rates will be kept around nil forever, in the ultimate statement of moral hazard – the asymmetrical market risk we have come to know and depend on. The mantra of late 2020 was that engineered low rates can prevent a decline in asset prices. Forever! But of course, it was a fallacy in 2000 and it is a fallacy now. In the end, moral hazard did not stop the Tech bubble decline, with the NASDAQ falling 82%. Yes, 82%! Nor, in 2008, did it stop U.S. housing prices declining all the way back to trend and below – which in turn guaranteed first, a shocking loss of over eight trillion dollars of perceived value in housing; second, an ensuing weakness in the economy; and third, a broad rise in risk premia and a broad decline in global asset prices (see Exhibit 1). All the promises were in the end worth nothing, except for one; the Fed did what it could to pick up the pieces and help the markets get into stride for the next round of enhanced prices and ensuing decline. And here we are again, waiting for the last dance and, eventually, for the music to stop.
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