The Stock Market’s Speculative Frenzy
(Not intended to be investment advice)
A few weeks ago, I posted a link to legendary value investor Jeremy Grantham’s article about the current market environment. Mr. Grantham’s article is so great and courageous that it deserves a second and more in depth post.
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. — Jeremy Grantham
The previous quotation sums up the current situation perfectly. In many parts of the market, valuations have not just decoupled from underlying business fundamentals, valuations have completely blasted off and away from them (to the moon!).
It’s become very much a speculator’s market. A conservative estimate of a what an informed buyer might pay for a business no longer matters — market participants believe en masse that there are and will be no shortage of greater fools to eventually buy their shares.
Bearishness Is Hard
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. — Jeremy Grantham
The Bitcoin craze and the GameStop craze are both examples of this. Watching everyone around you make bank is excruciatingly painful. Much of investing is emotional. It’s about buying when you (and everyone else) don’t want to buy and taking profits and hedging when everyone else is exuberant.
Valuation is a terrible near-term market timing indicator (because expensive things usually get more expensive for a time before the enthusiasm suddenly peters out). But it’s a great predictor of long-term (7–10 year) returns.
Besides the DotCom bubble, perhaps the most epic bubble of all time, valuations as measured by the Shiller PE Ratio (the S&P 500’s price divided by its 10 year average earnings) have never been higher.
My definition of a market bubble is when we look down and there’s no floor below us for miles. The floor of course is based on the prices that an astute and informed buyer would pay for these companies (a function of the underlying earnings power of these companies).
If the floor is far below us, then when the exuberance wanes and greater fools become scarce, prices will free fall. At which time there will be no support — selling will beget panic and even more selling. The prices of many stocks will have to fall 30%-50% before they even begin to look cheap enough to entice bargain hunters to step in.
This obviously doesn’t mean that prices will fall tomorrow, or next month, or even next year:
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. — Jeremy Grantham
It just means that when stock prices finally do stumble, there will be no fundamentals (cash, earnings, assets) around to catch them.
A Higher Base For Valuations?
It’s worth noting that one thing that might be different going forward (famous last words) is the steady state valuation of the stock market as a whole. If you look back at the Shiller PE Ratio, as expensive as it looks now, it definitely appears that the long-term average valuation of the market is higher post-1990 than it was pre-1990.
I could write a whole series of post hypothesizing why this is (I just might). But I would guess two things — the obvious one is low interest rates and easy monetary policy basically indefinitely. The other is that many of today’s biggest companies (Google, Apple, Microsoft, Amazon, etc.) are virtual monopolies with little competition besides each other and massive earnings.
But that doesn’t mean that valuations don’t matter. Even if the “true” average is higher, we are certainly miles above the average right now. At the same time, economic uncertainty abounds.
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. — Jeremy Grantham
The Cult Of Equities
The most impressive features are the intensity and enthusiasm of bulls, the breadth of coverage of stocks and the market, and, above all, the rising hostility toward bears. In 1929, to be a bear was to risk physical attack and guarantee character assassination. For us, 1999 was the only experience we have had of clients reacting as if we were deliberately and maliciously depriving them of gains. In comparison, 2008 was nothing. But in the last few months the hostile tone has been rapidly ratcheting up. — Jeremy Grantham
There are many current market participants that believe that stocks only go up. And you can’t blame them for feeling that way — markets have been steadily marching up through thick and thin regardless of what’s going on in the real economy. But it’s when this belief becomes pervasive and bears are beaten and ridiculed into submission that it gets dangerous to be heavily invested in equities and other risky assets. A variety of opinions leads to efficient markets; bubbles, on the other hand, are characterized by herding mentality and an increasing lack of dissenting opinions.
The great bull markets typically turn down when the market conditions are very favorable, just subtly less favorable than they were yesterday. And that is why they are always missed. — Jeremy Grantham
No one knows when things will finally turn. But if there were clear and obvious signs, investing would be easy. As Mr. Grantham observes, the turn is impossible to predict in real-time. It’s like the straw that broke the camels back — the last straw that finally crashes the market doesn’t do so because it’s special. It just represents the final unextraordinary event in a years long sequence of froth and foolhardiness. Rather it is this massive compounding accumulation of recklessness that will ultimately crash the market.
As investors, it’s important that we stop believing that we can identify the straw in advance and safely eject at the last second before the crash. Instead, we should realize that speculative frenzy and blind faith in the Fed has pushed valuations to an unsustainable level. Take some profits on the stocks you own — nobody ever went broke from taking profits.