Tag Archives: james montier

GMO: Did The Bubble Just Start To Burst?

Do current stock prices reflect a speculative frenzy? It’s a crucial question for anyone trying to preserve and grow their capital, but also a difficult one to answer. Martin Tarlie of Boston asset manager Grantham, Mayo, van Otterloo (GMO) has just published a short paper trying to quantify investor sentiment and whether it has driven prices to the stratosphere.

Many, including GMO’s James Montier, have commented on how strange this run-up in prices has been. Cab drivers aren’t eager to tell passengers about their latest technology stock purchases. Euphoria seems absent. But prices keep rising, making the rally seem cynical to Montier. And that has made it seem like there’s a disconnect between how investors feel and what they are doing – and, therefore, also difficult to call current prices a frenzy.

But Tarlie’s Bubble Model tries to capture both the “quantitative and anecdotal euphoric elements of a bubble.” Central to Tarlie’s thesis is the concept of “mean aversion.” Most of the time when price trends and valuations become extended they snap back or “mean revert” in some span of time. But, more rarely, they remain extended for long periods, and Tarlie calls this “mean aversion.” This happens when speculators dominate markets.

Mean reversion speeds vary over time. But in a few instances mean reversion displays a negative speed, and this is Tarlie’s quantitative measure of euphoria. Between 1881 and today there have been five periods of explosive dynamics or mean aversion – the late 1910s, 1929, the early 1980s, the late 1990s, and 2017-2018. Two of these periods coincide with bubbles – 1929 and the late 1990s, and two others are characterized by low valuation – the late 1910s and the early 1980s. Tarlie notes that in the latter two periods are characterized by an anti-bubble mood that is more “dysphoric” than euphoric.

The fifth period – from 2017 through late 2018 – matches the other four quantitatively, though it lacks a sense of euphoria. Then in the fourth quarter of 2018, the trend reverts. Tarlie finds some substitutes for the cab drivers and shoe shine boys with stock tips of past generations. Instead of the stock market itself, Big Data, Artificial Intelligence, and Bitcoin were where animal spirits found outlets most recently. Moreover, in the last quarter of 2018 there is a “dramatic change from an explosive mean averting phase to a strongly mean reverting” one. The scale and duration of the change in move resembles the market turns in 1929 and 1999.

The five incidents show that extreme changes stem from valuation extremes. In the late 1910s and in the early 1980s, stocks were unusually cheap. In 1929 and in 1999, they were unusually expensive. And when sentiment changes occur at moments of valuations extremes, prices can change rapidly.

The upshot of this analysis for investors now is that even though earnings are still strong, disappointments when expectations and valuations are so high can turn the market downward in a hurry. Changes in sentiment are also difficult to understand, which is why timing bubbles is so difficult. What matters isn’t the level of sentiment, but the degree of change, and that’s hard to predict. The fourth quarter (downward) move in stocks could be a head fake, Tarlie notes, but odds are that this is the beginning of the end of the bubble of 2017-2018. The bubble can always reflate, though, just as it did after Long Term Capital Management blew up in 1998, but Tarlie’s advice is “to continue to own as little U.S. equity as career risk allows.”

Divorced From Reality: Prices & Fundamentals

There are many ways of assessing the value of the stock market. The Shiller PE (price relative to the past decade’s worth of real, average earnings) and Tobin’s Q (the value of companies’ outstanding stock and debt relative to their replacement cost) are likely the two best. That doesn’t mean those metrics are accurate crash indicators, or that one can use them profitably as trading signals. Expensive stocks can stay expensive or get more expensive, and cheap stocks can stay cheap or get cheaper for inconveniently long periods of time.

But those metrics do have a good record of forecasting future long-term (one decade or more) returns. And that’s important for financial planning and wealth management. Difficult though it is sometimes, everyone must plug in an estimated return into a formula for retirement savings. And if an advisor is plugging in a 7% or so return for a balanced portfolio currently, he or she is likely not doing their job well. Stocks will almost certainly return less than their long-term 10% annualized average for the next decade or two given a starting Shiller PE over 30. The long-term average of the metric, after all, is under 17.

Another way of looking at how expensive the market has gotten recently is to look at sales of the S&P 500 constituents and relate it to share price. Companies are always manipulating items on income statements to arrive at a particular earnings number. Recently, record numbers of companies have supported net income numbers with non-GAAP metrics. That can be legitimate sometimes. For example, depreciation on real estate is rarely commensurate with reality. But it can also be nefarious, as Vitaliy Katsenelson recently argued in criticizing Jack Welch’s stewardship of General Electric, which Katsenelson characterized as being more interested in beating quarterly earnings estimates rather than in creating long-term wealth. And that’s why sales metrics can be useful. They are less easily manipulated.

So I created a chart showing sales per share growth and price per share growth of the S&P 500 dating back to the end of 2008. From the beginning of 2009 through the end of 2016, companies in the index grew profits per share by nearly 4% annualized, a perfectly respectable number for a mature economy. But price per share grew by a whopping 14.5% over that time. Over that 8 year period, sales grew less than 50% cumulatively, while share prices tripled.

Anyone invested in stocks should worry about this chart. How do share prices get so divorced from underlying corporate sales? One likely answer is low interest rates. But there must be other reasons because we’ve had low interest rates and low stock prices before – namely in the 1940s. That was after the Great Depression, and stocks were still likely viewed as suspect investments. Today, by contrast, stocks are not viewed with much suspicion, despite the technology bubble peaking in 2000 and the housing bubble in 2008. Investors still believe in stocks as an asset class.

And yet, the decline in rates over the past four decades has been breathtaking, as has Federal Reserve intervention. James Montier of Boston asset manager, Grantham, Mayo, van Otterloo (GMO), has studied stock price movements over the past few decades and found that a significant percentage of upward price movements have occurred on or before Federal Open Market Committee (FOMC) days. Montier estimated that 25% of the market’s return since 1984 has resulted from movements around FOMC days. Moreover, the market has moved higher regardless of what the FOMC decision was.

If this is a stock market bubble – and the data shows unusually high prices relative to sales and earnings – it is a strange one. One doesn’t hear the anecdotal evidence of excitement – i.e., cab driver’s talking about their latest stock purchases, etc…. This is perhaps a kind of dour bubble, where asset ownership at any price seems prudent in an economy that is becoming less and less hospitable to ordinary workers. Or, as Montier wrote in a more recent paper, this may be a “cynical” bubble where investors know that shares are overpriced, but think they can be the first ones out when the inevitable decline begins.