It is a sensible expectation that reasonable long-term value investors will endure pain in a bubble. It is almost a rule. The pain will be psychological and will come from looking like an old fuddy-duddy, looking as if you have lost your way in the new golden era where some important things, which you have obviously missed, are different this time. For professionals, this psychological pain will also come from a loss of client respect, which always hurts, and loss of peer group respect, which can be irritating.
In truth, there is nothing much that we can do about this problem. Value investors must, as always, invest exclusively on long-term values and long-term risks. We must always build our portfolios from the best possible mix of these two characteristics. Therefore, there is simply no alternative to standing our ground and taking it on the chin when crazy markets get even crazier. Our only consolation will be in knowing that we will win in the end whereas if we start jumping around on other non-value considerations, who really knows what might happen?
On the other hand, it is perhaps useful to be familiar with the various aspects of bubbles that may arrive to trouble us. It is in this spirit that this quarterly letter is written: to better prepare prudent investors for the probable future pain so that they can more easily process it now and be less likely to do something foolish.
What is a bubble? Seventeen years ago in 1997, when GMO was already fighting what was to become the biggest equity bubble in US history, we realised that we needed to define bubbles. By mid-1997, the price earnings ratio on the S&P 500 was drawing level to the peaks of 1929 and 1965 — around 21 times earnings — and we had the difficult task of trying to persuade institutional investors that times were pretty dangerous. We wanted to prove that most bubbles had ended badly. In 1997, the data we had seemed to show that all bubbles, major bubbles anyway, had ended very badly: all 28 major bubbles we identified had eventually retreated all the way back to the original trend that had existed prior to each bubble, a very tough standard indeed.
Having plenty of trained quants back then, it was no time before it was suggested that a two-standard-deviation (or 2-sigma) event might be a useful boundary definition for a bubble. In a normally distributed world, a 2-sigma event would occur every 44 years.
GMO has spent a lot of time during the last 17 years making a considerable review of minor bubbles as well as the 28 major ones that we covered originally in 1997. One thing was clear from the 330 examples we had studied: 2-sigma events in our real world have tended to occur not every 44 years, but about every 31 years. This was quite a bit closer to the 44 years of a random world than we originally would have guessed, given that the world is fat-tailed but, frankly, it is convenient: once every 31 years, which would be a longish career in investing, feels like it perfectly fits the title of ‘bubble’.
The boom-bust story
Statistical representation of the six most important asset bubbles in recent years
In my opinion, time has been kind to this definition in the intervening 17 years. A 2-sigma event now seems to me to be perfectly reasonable even if I have to admit it is completely arbitrary. Having a useful and practical definition of a bubble is important for I have come to believe that the forming and bursting of the great investment bubbles are by far the most important things that happen in investing. So, how do the great events of the past score on this 2-sigma definition? The six most important asset bubbles in modern times (in my opinion) are shown in The boom-bust story and as you can see, each of them qualifies on the 2-sigma definition, although the 1965-72 peak, known in the trade then as the ‘Nifty-Fifty’ event, did so by a modest margin. This event fell short in providing the usual good examples of extreme investment craziness. Perhaps, though, the very definition of the Nifty-Fifty as ‘one-decision stocks’ may have qualified it, with one extremely crazy theme substituting for many smaller ones, for one-decision stocks were so named because you only had to make one decision: buy. These stocks were generally believed to be so superior that, once bought, they would be held for life. (Most, like Coca-Cola and Merck, stood the test of time, but unfortunately several then-unchallengeable examples like Eastman Kodak and Polaroid went the way of all flesh, or all film.)
On a boil
The most volatile market is the first four years of a US presidency
There is one very important event that influenced our lives, financial and otherwise: 2008. The US housing market leaped past 2-sigma all the way to 3.5-sigma (a 1 in 5,000-year event!). The US equity market, though, was overshadowed by the then recent record bubble of 2000, although it still made it to a 2-sigma event on some definitions. But what was unique about 2008 was the near universality of its asset class overpricing: every equity market, almost all real estate markets (Japan and Germany abstained), and, of course, a full-fledged bubble in oil and many other commodities. The GMO Quarterly of April 2007 (It’s Everywhere, in Everything: The First Truly Global Bubble) started out: “From Indian antiquities to Chinese modern art; from land in Panama to Mayfair; from forestry, infrastructure, and the junkiest bonds to mundane blue chips; it’s bubble time”. But it took until last month for the penny to drop about how to make the point statistically. Using just the 40 countries for whom we have the best long-term equity data, we asked how many of these markets have been over one standard deviation at any given time together and found that in 2008, a higher percentage of the 40 equity markets were over that hurdle (a 1-sigma is the kind of event that occurs about once every six years in a random world) than ever before in our data, which starts in 1925. Interestingly, 1929 came the closest. I must say I had not expected that at all. I have been carrying the quite false impression for almost 50 years that 1929 was overwhelmingly a US market event, although I knew the crash was more universal. However, 2008 in contrast is unique in other ways too in 1929, the housing market was more or less normal and the commodity markets were curiously very depressed.
So 2008, particularly if you can imagine adding real estate and commodities, was indeed a true global asset bubble, being the most extreme collective outlier in not just 30 years, but in at least the 88 years of our data and probably forever, given the much lower correlations of earlier times.
Thus, all the earlier major bubbles passed our 2-sigma test with flying colors. So now, to get to the nub, what about today? Well, statistically, we are far off the pace still on both of the two most reliable indicators of value: Tobin’s Q (price to replacement cost) and Shiller P/E (current price to the last 10 years of inflation-adjusted earnings). Both were only about a 1.4-sigma event at the end of March. (This is admittedly because the hurdle has been increased by the recent remarkable Greenspan bubbles of 2000 and a generally overpriced last 16 years.) To get to 2-sigma in our current congenitally overstimulated world would take a move in the S&P 500 to 2,250. And you can guess the next question we should be looking at: how likely is such a level this time? And this, in turn, brings me once again to take a look at the driving force behind the recent clutch of bubbles: the Greenspan Put, perhaps better described these days as the “Greenspan-Bernanke-Yellen Put”, because they have all three rowed the same boat so happily and enthusiastically for so many years.
The Greenspan Put
The power of the Fed to move equity markets in particular is best demonstrated by the Presidential Cycle. On a boil shows the average of the four years since 1964 for the S&P 500 and the quarter of the market cap that is the most volatile. Admittedly, you’ve seen it before, but it is remarkable. And in case you think this is only a US effect, take a look at The presidential effect, which shows the effect on overseas markets. Again you have seen this before, but really — the UK market moves more on the Fed cycle than we do. Never underestimate the influence of the Fed, even in faraway Japan.
The presidential effect
The Fed manages to unsettle equity markets as far away as Japan
Yet, my colleague Nick Nanda and I could never really find the murder weapon. Interest rates and measures of money supply did move in the expected way, but by such tiny amounts it seemed preposterous that such modest moves could affect anything. So what does cause this extraordinary stock market effect? The data and logic strongly suggest that it is moral hazard. Enough professionals hear and understand the subtext of the Fed’s message: if you speculate in year one and two and something goes wrong, you are on your own. But in years three and four, and especially three, we at the Fed will do whatever we can to bail you out in a crisis. And long before Greenspan — that ultimate Pied Piper who appeared to lead not the rats but perhaps the pigs — astute market players heard the message. So, how much more they must have listened as the piping got louder and louder and the promises were more and more often delivered on in the Greenspan era? Thus, the bond market was resuscitated after it stumbled in 1994 and then the Asian crisis and the LTCM crisis, the latter of which might well have brought down one or two Goldman Sachses if the market had been left to its own devices. By then Greenspan was already spelling out what the Put really amounted to, clearly and unashamedly: he would not interfere with bubbles but he would try to reduce the pain of bubbles breaking — to protect speculators who had rolled the dice too enthusiastically and lost. This promise was to be repeated more and more clearly until Bernanke was even bragging of his influence on pushing up asset prices. But Greenspan, back in the LTCM days, was just getting warmed up. He threw lots of money at the Y2K scare, just in case and, most critically, as the great Tech Bubble broke, he led the cavalry to the rescue and stopped the US market from even hitting its trend line. Previous equity bubbles, despite being smaller than 2000, had each crossed below trend and stayed there for years at end. This time, in 2002, the market merely reached a low that was still 10% over trend before doubling once again. By now aggressive and astute investors were openly discussing the remarkable gift — to speculators — of the Fed’s asymmetric promises.
Not surprisingly, many of these speculators became increasingly willing to roll the dice more and more often each time. And the tour de force was still waiting: the bailout of the great housing and commodity-induced economic collapse, aka The Global Financial Crisis, and its twin, The Great Bailout. Despite the painful and unexpectedly slow economic recovery that followed, investors have still been rewarded with a 150% rally in the five years off the low. Surely most investors must be believers in the Fed Put by now?
To be sure, purist value managers may try to block out the siren call because they don’t wish to be tempted and some may hear it and do nothing because the gains are never certain and the lack of prudence is painfully obvious in the end. Yet long-term value managers are outnumbered by momentum managers — always were and probably always will be — and momentum managers have no such qualms. Why this time, then, would they not play the game with even more enthusiasm, or at least enough to drive the market to its 2-sigma level of 2,250 and perhaps a fair bit beyond that? And although nothing is certain in the market, this is exactly what I believe will happen.
The Other Side
Out there in the wilds of the internet along with our free quarterly letter, which always feels like a long painful delivery, there is an equally free letter from John Hussman, who turns out to have the same work ethic as Alexey Stakhanov, that hero of the Soviet Union known for his routine production over quota. Hussman produces a well-researched letter each week. And the data is comprehensive enough that I admit it worries me.
Clearly, he and the others may be right. They indicate an overpricing for the US markets that could range from about 75% overpriced to 125% by the end of March. All of the measures have a history of being predictive — in fact, much more so than, for instance, Yellen’s reprehensible choice of current price as a multiple of next year’s estimated earnings.
Conclusion and Summary
The bull market may come to an end any time; indeed, as I write it may already have happened. It could be derailed by disappointing global growth, profits sagging as deficits are cut, a Russian miscalculation or, perhaps most dangerous and likely, an extreme Chinese slowdown. But I believe it probably (i.e., over 50%) will not end for at least a year or two and probably not before it reaches a level in excess of 2,250 on the S&P 500.
Prudent long-term value investors will of course treat all of the above as attempted entertainment (although I believe all statistically accurate) and be prepared once again to prove their discipline and manhoods (peoplehoods) by taking it on the chin. I am not saying that this time is different (attention Edward Chancellor). I am sure it will end badly. But given this regime of the Federal Reserve and given the levels of excess at other market peaks, I think it would be different to end this bull market just yet.
Abridged extract from GMO’s first quarter letter of 2014