Billionaire’s ‘epic bubble’ call may be wrong

Billionaire’s ‘epic bubble’ call may be wrong

Jeremy Grantham is the legendary former Chief Strategist of fund manager GMO. In his 82 years there’s very little he hasn’t seen in financial markets, and he rightly earned his legend status by calling the last three great stock market bubbles: the Japanese equities bubble of the late 1980s,  the US dotcom bubble at the end of the 1990s and the 2008 GFC.

So it’s understandable people took notice when he greeted the new year with a frightening declaration:

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 behaviour, 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.

Consider the counter factual

It sounds absurdly presumptuous to take the other side against such a storied investor, but I believe Grantham’s arguments warrant some context, and smart investors should always consider the counter factual.

First, Grantham has warned of an imminent US stock market collapse literally every year since the GFC and always for the same reasons: over extended valuations and the market’s reliance on central bank support. Grantham made a career out of identifying stock market bubbles, but even he conceded in an interview with Barron’s in 2015 that “for bubble historians…it is tempting to see them too often.”

Second, Grantham points to the S&P 500’s PE being in the top few per cent of its historical range while the economy is in the worst few.

With respect to the PE ratio, there have been spectacular changes in the macro, or big picture, settings for stock markets that have dramatically affected valuations. For example, inflation and interest rates have undergone the greatest ever reversal over the past 40 years. After interest rates peaked at close to 20 per cent under Fed President Volcker in the early 1980s, they have drifted lower and lower ever since, to the point where now we are becoming accustomed to negative government bond yields. Likewise, inflation is persistently below central bank targets.

I’ve argued before that it makes perfect sense those low yields have a profound influence on how shares are valued, especially for companies that offer higher levels of growth than the broader market. Whether it be through basing a discounted cash flow valuation on lower risk-free rates (bond yields) or the return premium offered by stocks over bonds, lower yields drive higher share prices.

Inflation’s effect on valuation

Given we’ve never seen a mix of yields and inflation like we’re seeing now, using historical references as your only valuation anchor makes no sense. A more convincing concern is the potential return of inflation because that will fundamentally change the valuation landscape, but there is no one who can give you a definitive answer as to what drives inflation. You need only look at the Fed’s ‘dot plot’, which started back in 2012 and records where each of its 12 board members and seven presidents think inflation and interest rates are headed. Despite having the best information available, and apparently being the best qualified in the US, they’ve never been close to right.

Another thing that has driven valuations on the US market up is that so-called ‘growth’ stocks, which are those companies whose earnings are growing faster than the index and therefore usually trade on higher PE ratios, have increased from 15 per cent of the overall index in the 1970s to now 77 per cent. By contrast, ‘value’ stocks, which rely more on general levels of economic growth and trade on lower PEs, account for commensurately less of the index.

In terms of the economy being terrible, recent economic data suggests otherwise. Like Australia, the US government injected about 13 per cent of GDP in brand new money in the form of COVID support, money that has to go somewhere. Sure, GDP fell 31 per cent in the March quarter of 2020, but it rocketed up 33 per cent in the June quarter. Business confidence is close to its equal highest in the last 25 years, unemployment is not far off its average for the post GFC/pre-COVID period, house prices are at an all-time high and there has been a record number of US companies upgrading earnings guidance in the first quarter. And the new Biden administration is preparing to spend another $1.9 trillion.

Lessons to be learned

By his own admission, Grantham’s past calls have typically been early. Getting out of Japanese and US stocks two years before the market peak cost his firm’s investors about 60 per cent each time. That offers a couple of salutary lessons. First, timing market tops is really challenging, especially if you rely on valuations to do it. And second, even if you’re worried about a market looking toppy, you don’t have to sell out of it entirely. You can simply reduce your holding gradually as it rises and switch your money into an asset class or market that doesn’t look as stretched, such as Australian, European or emerging markets shares.

There are undoubtedly pockets of the US market that look extreme right now, especially the speculative end of retail investors, but even that doesn’t apply to the whole market. When billionaires make bearish calls it’s hard to overcome our innate human bias that prioritises self-preservation and sees pessimists as smarter, but for your portfolio’s sake, it can pay to look for context.

The 2020 recession, why this time is different.

The 2020 recession, why this time is different.

There are number of things that make the global economic recession of 2020 different to any other we’ve seen, and while you’d never wish to go through an experience like it, there are definitely some silver linings.

The government forced the economy into recession

This was the first time in living memory that governments deliberately threw economies into recession. If you close down all but a few sectors and tell workers to stay home, obviously economic activity is going to crash.

Previous recessions have been attributable to the business cycle: typically there is a speculative build up which causes an imbalance that eventually tips over, and the worst recessions are those fueled by debt.

The standout example of this is, of course, the GFC. Building activity reached frenziewd levels in the US because buyers were able to access debt way too easily. The adjustment process was long and painful because credit, which is the lifeblood of a modern economy, all but seized up.

This time there were no baddies

When a recession is caused by excess building in some part of the economy, there is normally going to be a culprit you can point to. It might be banks, or it might be investors, but there’s a group that cops the blame and derision for crashing the economy.

That’s when the philosophy of ‘moral hazard’ argues if the culprits just get bailed out there’s no lessons learned to stop the same thing from happening again. Politicians and the media will often argue the responsible group should somehow be punished, perhaps with tighter regulations or even criminal charges.

This time (ignoring arguments about how COVID started and who or what is responsible), there is no real culprit to punish.

No holds barred support program

Because the government was responsible for switching off the economy and there was no concern about moral hazard, both they and central banks were able to throw the proverbial kitchen sink at supporting the economy.

Central bankers learned valuable lessons from the GFC that they had to make sure credit could continue to flow. The range of measures undertaken was unlike anything we’d seen before, and while things were ugly for a short time, markets were once again reminded how powerful central banks can be.

Remarkably, US financial markets have clearly recovered strongly despite the Federal Reserve barely tapping a range of the programs they announced – see chart 1 below.

 

Chart 1: US financial markets have recovered despite many of the Fed’s announced measures barely being utilized
Chart 1

The Bazooka

By far the most important support measures were from governments. One after another, governments wre throwing massive amounts of newly created money into their economies. Programs like JobKeeper in Australia and its equivalents overseas were critical in supporting families that otherwise would have been in dire financial circumstances.

The critical part is that it was newly created money, which governments can do directly, but central banks can’t. The central bank programs can help create new money by encouraging people to borrow (loans also create money) but that was going to be tough when the media was full of stories about the global economy crashing.

This is the opposite to what happened after the GFC, where, especially in Europe, governments preached from the gospel of austerity. Spending cutbacks sucked money out of economies and saw them slow to a grinding crawl.

Economies are on fire

Some of the data showing how sharply economies are bouncing back is remarkable. Here in Australia, we’re seeing restaurant bookings up to 50-80% compared with the same time last year, new car sales leaped 12% from last year and Commonwealth Bank credit card sales were up 11%. They are huge numbers and it’s not just because lockdown restrictions were eased.

The Australian government’s COVID support programs amounted to 13% of GDP. It’s hard to overstate how massive that is. In the wake of the GFC, the Chinese government ‘rescued’ much of the developed world by announcing a spending package equivalent to 12% GDP (clearly the absolute amounts are hugely different, it’s the proportion that’s significant). The early withdrawal of superannuation adds anotehr 2% to that. The household savings ratio hit almost 20% in the June quarter, only a fraction less than the highest it’s been in the past 60 years.

That’s an awful lot of pent-up spending power.

The silver lining

Ever since the end of the GFC, central banks have pleaded with governments to raise fiscal spending to help increase economic growth. But most governments, including Australia’s, were obsessive about balancing budgets and instead were more intent on reducing spending (the obvious exception to that was $1.2 trillion Trump tax cuts, which helps explain why the US economy was doing so much better than most others).

It’s taken the unique circumstances of the pandemic to show the power of fiscal spending to drive economic activity: low income families suddenly had enough money to go to the dentist and get the car fixed, and the money they spent doing that got spent again and again.

If governments take the lessons on board, it’s possible it could be the first step toward abandoning the flawed dictums of neoliberalism and addressing the massive wealth inequalities that lie at the heart of so many other problems we face. That would be a great silver lining.

Want to take advantage of the expected economic growth?

Call Steward Wealth today on (03) 9975 7070 to learn how.

What are the prospects of a post-COVID boom?

What are the prospects of a post-COVID boom?

This article appeared in the Australian Financial Review.

After news of a promising COVID vaccine hit financial markets on 9 November, those sectors that had been shunned like last week’s fish dinner while economies were at risk of ongoing lockdowns suddenly became flavour of the month.

Investors pounced on the stocks that should benefit from people returning to ‘normal’, which saw sectors like energy, banks, retail property trusts, hospitality and travel shoot up. At the same time, the companies that had starred during lockdown, that benefited from people shopping, working and exercising from home, surrendered some of their astonishing gains.

This has left smart investors facing the usual challenging questions: has the market already priced in the return to normal? Should you be erring on the side of caution and selling into these strong markets?

We continue to advise clients to remain fully invested in the allocation to growth stocks their risk profile allows.

Strong outlook for the economy

There are several indicators pointing to the possibility of a strong economic environment in the year ahead. First, the Australian government injected stimulus equivalent to 13% of GDP in the form of JobKeeper, JobSeeker and other direct payments. The $34 billion worth of early super withdrawals added another 2.5% to that.

A lot of that stimulus has already been spent, which was the whole idea, but much of it has been saved, with Australia’s household savings ratio hitting 19.8% in the June quarter, almost eight times higher than a year ago and only 0.5% below its peak of the last 60 years. That’s a serious amount of spending power.

And spending is exactly what it looks like Australian consumers are doing after confidence levels jumped to 10-year highs. The Commonwealth Bank reports its credit card data showed spending in the week to 13 November was up 11% compared to last year. Restaurants in New South Wales enjoyed seated dining numbers 55% higher than a year ago, while Queensland was a whopping 79% and even shellshocked Victoria was up 54%.

Retailers will be eyeing off that pool of savings in anticipation of a bumper Christmas and companies in general should expect a lot of that money to work its way around the economy for a while yet.

The US is in a similar position, with a 13% stimulus package pushing the personal savings rate to almost double what it was at the start of the year. Although a fresh stimulus package has been trapped in a political standoff for the time being, it is expected the new Biden administration will make it a priority. Meanwhile, record low interest rates have ignited the housing market, with home values at record highs, homeowners’ equity at record levels and monthly new home starts challenging their all-time highs.

If the new vaccines are as effective as they appear, the Chinese economy has shown how quickly things can bounce back. China’s manufacturing and services sectors have rebounded strongly, pushing annualised GDP growth to 5% and retail sales are almost 5% higher than a year ago.

What about the markets?

Whoever would have thought the US share market would already be at a record high the day a COVID vaccine was announced? Let alone that it would hit that high amidst COVID cases being reported at record rates across the globe. And that strength is being seen in stock markets around the world, with 52-week highs in China, Europe, the emerging markets and even Japan is at 30-year highs.

2020 has been a great reminder that share markets do not necessarily follow economies, so it’s entirely possible we will see an economic rebound and poor markets. And there are plenty of sceptics ready to point to elevated valuations as a warning signal.

So how do those valuations stack up? Australia’s ‘forward PE (price to earnings) ratio’, so based on earnings forecasts for next year, is at 19 times compared to a 32-year average of 14, and the MSCI World Index is at 21 times compared to 16.

On the face of it, that makes shares look pretty expensive. However, I’ve argued for a long time that low inflation supports higher PE ratios. 30 years ago, Australia’s inflation rate wasn’t far off 10% and it’s been trending downwards ever since. So, with inflation currently below 1%, it makes perfect sense that the PE ratio would be higher. In fact, comparing today’s PE ratio to any period as far back as 40 years ago, when inflation peaked at close to 18%, is like comparing the proverbial apples and oranges.

Further, high growth companies such as the tech sector have defied any gravitational pull of lower PE ratios. I’ve argued before that it makes little sense to value a software company whose earnings can grow exponentially without requiring any further capital outlay the same way you’d value a company whose earnings can only grow in proportion to how much they spend on building new factories.

Bond yields have also been steadily declining and, likewise, it’s well established that falling bond yields underwrite higher equity valuations. The typical way to value a share is by working out what a company’s future cash flows are worth today by applying a ‘discount rate’, which is normally based on the 10-year bond yield. The closer bond yields get to zero, the more valuable are those future cash flows in today’s money.

With interest rates at levels designed to punish savers and prospects of a vaccine unleashing a post-COVID spending spree, it’s little wonder global equities just saw the biggest week of inflows ever. Now is not the time to be sitting on cash.

Want some help with your investments?

To discuss how we can help call Steward Wealth today on (03) 9975 7070.

The Post-Pandemic Boom

The Post-Pandemic Boom

    2021 is shaping up to be a year of strong economic growth, and, right now, the indicators are looking good for financial markets as well.

Australia

    • The government response to the COVID shutdowns  was swift and big. In total, the federal government is spending $272 billion, equivalent to 14% of GDP, and the states $122 billion. All that newly created money has to go nowhere.
    • Early on, households saved a lot of the extra cash. The June quarter savings rate hit 19.8%, 8x higher than the year before and only 0.5% below the 60-year peak set in 1974. The Commonwealth Bank estimates households will have about $100 billion of savings, or 5% of GDP, that has been accrued between the start of COVID and December.
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      • To that you can add $34 billion of super withdrawals so far, with Treasury estimating an eventual total of $44 billion.
      • After a record plunge to 76 in April, consumer confidence has now had 11 consecutive weekly gains to 108.
      • It now appears Australians are spending those gains. Commonwealth Bank reported credit card spending jumped 11% year on year in mid-November. Restaurants in New South Wales enjoyed seated dining numbers 55% higher than a year ago, while Queensland was a whopping 79% and even shellshocked Victoria was up 54%
      • Retailers have seen record spending in the Black Friday sales, prompting Gerry Harvey to say, “This is like the greatest boom I’ve ever seen in my lifetime”.

US

      • The US fiscal package injected 13% of GDP and pushed the personal savings rate to almost double what it was at the start of the year.
      • Low interest rates have ignited the US housing market, where prices are now 10% above the pre-GFC levels. Homeowners’ equity is at a record high and the increase in the pending sales index is parabolic.
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      • More than 80% of stocks in the S&P 500 are trading above their 200-day moving average, a sign of positive market breadth that has only been seen twice in the past 20 years.
      • We are seeing 52-week highs in share markets across the world, from China, to Japan, to Europe, to Australia.
      • Global equities have seen a record inflow post the COVID vaccine announcements.
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While the indicators are stacking up well, there are, of course, no guarantees that markets will play ball and they sure do have a way of wrong-footing us. However, it’s noteworthy that nothing in the economy was ‘broken’ going into the pandemic downturn; there was no particular sector on the cusp of being crushed by excessive debt and while valuations were not cheap, they were certainly defensible.

Now is not the time to be sitting on lots of cash.