Legendary money manager Jeremy Grantham believes the bear market rally that started in late June is signaling the final stage of a so-cailled “super bubble.” If the GMO founder is correct, the ending won’t be pretty.
“Only a few market events in an investor’s career really matter, and among the most important of all are super bubbles,” Grantham wrote yesterday in a letter to clients. “These super bubbles are events unlike any others: While there are only a few in history for investors to study, they have clear features in common.”
Jeremy Grantham (Bloomberg).
Grantham describes ordinary bubbles “2 sigma deviations from trend” and they typically account for 85% of all bubbles. Consequently, they can be painful but are fairly frequently and rarely cause long-term damage. In contrast, “superbubbles reach 2.5 sigma or greater,” and some like the one that ushered in the Great Depression scarred a generation.
In his view, there have only been three “true U.S. superbubbles.” They occurred in 1929, 2000 and 2021.
Grantham awards “honorary” membership to the 1972 "Nifty Fifty" bubble. Although it was “only” in 2 sigma event when measured by standard deviation, stocks subsequently tumbled 62%, the worst drop since 1929.
Grantham was a young money manager in 1972 and the collapse of the Nifty Fifty stocks clearly left an indelible impression on him. “In some ways, it lacked the crazy speculation of the others but caused, for the only time ever, the highest quality segment [that dominates the S&P 500] to go to a 50% premium versus the rest of the market and to be called “one-decision stocks,” Grantham writes, “because once bought they would be held forever, because they were so good—a belief system bought into by the entire banking establishment that still managed all the money back then.”
In the current 21st century global economy, Grantham sees shortages of labor, commodities and raw materials coming to the fore in the face of inflated stock price multiples. If corporate profit margins start shrinking from record levels while equity price-to-earnings multiples compress, the twin forces could exert a powerful depressing influence on stocks and global wealth.
If Grantham is right, what investors may have seen playing out between early July and last Friday’s Federal Reserve meeting at Jackson Hole was a classic suckers’ rally. “One of those features is the bear market rally after the initial derating stage of the decline but before the economy has clearly begun to deteriorate, as it always has when superbubbles burst,” he writes. “This in all three previous cases recovered over half the market’s initial losses, luring unwary investors back just in time for the market to turn down again, only more viciously, and the economy to weaken. This summer’s rally has so far perfectly fit the pattern.”
Grantham divides the current predicament of the economy and markets into two different threats—the near-term problems and the more intractable longer-term ones. The immediate issues center on inflation and supply-chain issues.
“The food/energy/fertilizer problems, exacerbated by the war in Ukraine, are even worse in the emerging world (especially Africa) than the European energy problems we have heard about,” he writes. “Russia and Belarus account for 40% of global exports of potash, a key fertilizer, driving wheat/corn/soybean prices to records earlier this year. Increased food and energy prices are causing acute trade imbalances and civil disorder in the most vulnerable countries, as seen for example in the extremely rapid virtual collapse of the Sri Lankan economy. The energy shock is now all but guaranteed to tip Europe into recession; while the U.S. market has a long history of ignoring foreign problems and interactions, global growth is assuredly coming down.”
Then there is China, which has driven most of global growth “for the last 30 years.” That nation’s inability to manage the Covid-19 pandemic is colliding with a property bubble, he writes.
China is not alone in having serious problems in the real market. “This real estate weakness is mirrored around the world, with U.S. homebuilding for example now declining rapidly to well below average levels, as perhaps it should given the record unaffordability of new mortgages,” Grantham writes.
Aging demographics top the list of long-term threats. “Workers are beginning to be in short supply and will stay that way for the indefinite future in China and the developed world, where no single country is producing babies at replacement rate,” he argues. “Together with rapid ageing, this will be a drag on growth and a push on inflation. Resources: Many metals, especially those required for decarbonizing, are in an unavoidable squeeze, lacking sufficient reserves—which currently are a mere 5% to 20% of what is needed—and capex is woefully low. It simply does not compute, and it makes clear that our existence in any faintly satisfactory condition will depend on our sustained success with replacement, recycling, and new technologies.”
Many of the long-term issues like climate change and food supply that Grantham has been warning about for several decades are rapidly becoming short-term problems, he writes. He urged investors to prepare for “an epic finale.”
This time could be different because Grantham believes we could be confronting what he has called a “trifecta” of bubbles. The current super bubble, he writes, features the most dangerous mix of these factors in modern times: All three major asset classes—housing, stocks, and bonds—were critically historically overvalued at the end of last year. Now we are seeing an inflation surge and rate shock as in the early 1970s as well,” he writes. “And to make matters worse, we have a commodity and energy surge (as painfully seen in 1972 and in 2007) and these commodity shocks have always cast a long growth-suppressing shadow.”
The recent bear market rally “has so far played out exactly in line with its three historical precedents, the bear market rallies that marked the middle phase of deflating super bubbles,” he says.
The next leg for Grantham's model is "likely to be driven by falling margins. Our best guess is that the level of explained P/E will fall toward 15x, compared to the current level of explained P/E of just under 20x, while the actual P/E just rose from 30x to 34x in mid-August in what was probably a bear market rally. (Of course, if the model is indeed driven by falling margins in the near future, then the E will fall as well as the P/E.)," he writes.
Ultimately, Grantham admits he doesn’t know how this will end. “Each cycle is different, and each government response is unpredictable. But these few epic events seem to act according to their very own rules, in their own play, which has apparently just paused between the third and final act. If history repeats, the play will once again be a tragedy. We must hope this time for a minor one,” he concludes.
In a footnote, he adds that “2000 was minor, 1972 major, and 1929, of course, horrific."