October 27, 2023
By Steve Blumenthal
“We shall not cease from exploration, and the end of all our exploring will be to arrive where we started and know the place for the first time. “
– T.S. Elliot
In a conversation with a client this week, he shared the above quote by T.S. Eliot. I loved it. Being alive! Exploring… learning. After much journeying, we arrive at the place where it first began, but now, with the wisdom we gained through all of our experiences.
Talk to a young person with little experience but a wealth of book knowledge, and you’re likely to hear a regurgitation book-learned advice. Talk to someone with lots of life experience, arriving back to the place where they started, and you’re likely to hear true wisdom that could help you when you need it most.
Eliot’s quote is really quite powerful. As I reflected on it, my mind took me to the markets—and in particular, to a recent research piece about stock market superbubbles written by the wise, old sage Jeremy Grantham that I’d tucked away to share with you.
Grantham, a longtime investor and founder of GMO LLC, has written a few pieces about superbubbles in recent years—the first, “Waiting for the Last Dance,” came in January 2021. I’ve referenced them in the past On My Radar missives. I particularly liked “Let The Wild Rumpus Begin,” which he wrote in January 2022, signaling that the last dance was done.
In his most recent piece, titled “Entering The Superbubble’s Final Act,” Grantham writes, “Only a few market events in an investor’s career really matter, and among the most important of all are superbubbles. These superbubbles are events unlike any others: while there are only a few in history for investors to study, they have clear features in common.” He goes on:
“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. 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.”
We remember again part of T.S. Eliot’s quote: “…the end of all our exploring will be to arrive where we started and know the place for the first time.” How fitting.
2.5 Sigma Events
In finance, the concept of sigma, or standard deviation, is used to measure the volatility or risk associated with an investment or financial instruments like stocks, bonds, or currencies. Sigma helps investors and financial professionals assess the potential ups and downs they may see in the value of their investments.
A “2.5 sigma event” in finance signifies an event that is extremely rare and falls far outside the expected or normal range of outcomes. In terms of the markets, think of extreme overvaluation and speculation (greed) or extreme undervaluation and risk aversion (fear). A 2.5 sigma event is a crucial concept used for assessing and managing risk in financial markets and making investment decisions in a world where unexpected and rare events can have a significant impact on financial assets.
Grantham makes the following point:
“In the U.S., the three near-perfect markets with crazy investor behavior and 2.5+ sigma overvaluation have always been followed by big market declines of 50%. The papers said nothing about fundamentals except to expect some deterioration. Now, here we are, having experienced the first leg down of the bubble bursting and a substantial bear market rally, and we find the fundamentals are far worse than expected.”
He adds:
“Most of the time (85% or thereabouts) markets behave quite normally. In these periods, investors (managers, clients, and individuals) are happy enough, but alas these periods do not truly matter. It is only the other 15% of the time that matters, when investors get carried away and become irrational.
“This 15% is very different from ordinary bull and bear markets. Averaging ordinary bull and bear markets with this handful of outliers dilutes the data and produces misleading signals. My strong suggestion is to treat the superbubbles – 2.5 to 3 sigma events – as special, collectively unique occasions. It is as if there is a phase change in investor behavior. After a long economic upswing and a long bull market, when the financial and economic systems look nearly perfect, especially with low inflation and high profit margins, as does the friendliness of the authorities, especially toward cheap leverage, there gets to be a flashpoint, like that summer evening when every last flying ant takes off simultaneously. This effect luckily creates measurable events in the market. So you can see the explosion of confidence and speculation and crazy wishful thinking regardless of value however you wish to define it. And outcomes from this unique group of superbubbles (just three in modern times in the U.S. before this current one) are indeed special.”
We old dogs are nodding “yes.” The young guys are saying, “I’m not so sure.”
Grab that coffee and read on. If you opened On My Radar in your email, click on the blue On My Radar button below to read the full piece on the website. Grantham goes on to write about The Stages of a Superbubble, summarizes the Near-term Problems and the Long-term Problems, and advises to Prepare for an Epic Finale. The “Last Dance” is done, the “Wild Rumpus” is ongoing, and we are nearing “The Final Act.” Buckle up. More defense than offense.
Here are the sections in this week’s On My Radar:
- Entering The Superbubble’s Final Act
- Random Tweets
- Personal Note: No O’Reilly’s Sandwich
- Trade Signals: Weekly Update, October 26, 2023
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
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Excerpt: “Entering the Superbubble’s Final Act,” by Jeremy Grantham
Only a few market events in an investor’s career really matter, and among the most important of all are superbubbles. These superbubbles are events unlike any others: while there are only a few in history for investors to study, they have clear features in common.
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. 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.
The U.S. stock market remains very expensive and an increase in inflation like the one this year has always hurt multiples, although more slowly than normal this time. But now the fundamentals have also started to deteriorate enormously and surprisingly: between COVID in China, war in Europe, food and energy crises, record fiscal tightening, and more, the outlook is far grimmer than could have been foreseen in January. Longer term, a broad and permanent food and resource shortage is threatening, all made worse by accelerating climate damage.
The current superbubble features an unprecedentedly dangerous mix of cross-asset overvaluation (with bonds, housing, and stocks all critically overpriced and now rapidly losing momentum), commodity shock, and Fed hawkishness. Each cycle is different and unique – but every historical parallel suggests that the worst is yet to come.
Click on Jeremy’s photo to link to the full post or click AdvisorPerspectives website.
- The Times that Really Matter for Investors,
- The Stages of a Superbubble, and
- Advises to Prepare for an Epic Finale.
Not a recommendation to buy or sell any securities. Opinions expressed may change at any time.
Random Tweets
The Federal Deficit
From Bloomberg on Treasuries
Down 10% from July 31 Peak
Jim Grant
Follow me on X (formerly Twitter) @SBlumenthalCMG
Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to change.
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Personal Note: No O’Reilly’s Sandwich
I have to admit to an error I made in last week’s On My Radar. I shared a fun story with you about my then-upcoming golf trip to Old Sandwich Golf Club in Massachusetts and the legend of Howard O’Reilly’s famous sandwich. Specifically, I told the story about a caddy named Emma who’d found the lost recipe of this storied sandwich in the club’s old storage shed. The sandwiches were said to be so delectable that they had the power to improve a golfer’s game… Or so I thought after asking ChatGPT to tell me about the history of the place. Upon arrival at the club, I learned the legend was not true. My host, Ben, informed me that not only was there no special sandwich, the club had only been founded in 2004, not 1892 as ChatGPT had said. So much for trying to be clever.
Ben did assure me, though, that the weather was in the mid-50s, and the company wonderful and the course were spectacular. ChatGPT may have disappointed me, but Ben and the course most certainly did not.
Team Update
My outstanding wife Susan’s high school boy’s team had an outstanding 2-1 win against a powerful Germantown Academy team on Tuesday. They played excellent soccer, and after scoring only two goals in the previous five games, it was nice to win. I’m hoping for another well-played game with a well-earned win today. In fact, I’m rushing to hit the send button because the Malvern Prep vs. Haverford game is starting soon. I want to be there to see a big smile on Coach Sue’s and the boys’ faces. And mine, too.
And yes, I know. Ugh. It was a painful loss for my Nittany Lions against the Buckeyes, and sadly, my Philadelphia Phillies’ bats went cold at the wrong time. I’m now rooting for the Texas Rangers in the World Series. (Joe A. and John M., this is your year!) For non–baseball fans, in the World Series, the first team to win four games of seven wins the series. I’m hoping it goes to game seven this year. That would be exciting.
I do love the fun and comradery that sports provide. And I hope your favorite teams are doing well.
Wishing you and yours the very best!
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Trade Signals: Weekly Update, October 26, 2023
“Extreme patience combined with extreme decisiveness. You may call that our investment process. Yes, it’s that simple.”
– Charlie Munger
Notable this week:
“We’d be better off here.” Keep the following top of mind.
- The green arrows point to “Median Fair Value,” analyzing 59.6 years of data. I think Median Fair Value is a reasonable target in terms of providing a reasonable stock market return (using the S&P 500 Index as a proxy for U.S. stocks).
- The orange line plots the month-end Median PE going back to 1964. You can see that the current Median PE is 23.8 (9-30-2023). I’ll update this chart when we get the October month-end data.
Bottom line: Valuations remain in the “Overvalued” zone.
Here is what GMO is estimating in terms of real returns over the coming 7-years. I think this is a reasonable expectation.
When the market corrects to the “Fair Value” zone as represented in the Median PE valuation chart above, the 7-year return estimates will shift up making the broad stock market an attractive asset class again.
The Match That Lights the Fuse
The yield on the 10-year Treasury note is the most important indicator to watch. It is at 4.95% at the time of this Trade Signals post. The pressure in the system is extreme.
This is the match that lights (or already lit) the fuse.
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