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Conclusion: “Bracing Yourself for a Possible Near-Term Melt-Up (A Very Personal View),” by Jeremy Grantham

You can find Grantham’s full piece here.  Following are selected bullet points from his piece:

• The Fed’s role in recent bubbles — taking a different tack, we should look at the policy of what I call the Greenspan-Bernanke-Yellen Fed. This policy of pushing down generally on rates – lower highs and lower lows – over 25 years, accompanied by a lot of moral hazard, has very probably helped push asset prices higher. All three Chairmen at some time have specifically taken credit for helping the economy by generating a wealth effect from a higher market. Over the years, we have come to believe that moral hazard is more important in raising asset price levels than the interest rate level and availability of credit, although they may also help. The moral hazard – the asymmetric promise to help if times get tough but to leave you alone when times are rolling – had become increasingly well-understood, particularly during Greenspan’s first 15 years. It seems likely that such a policy as the Greenspan Put might culminate periodically in investment bubbles of the type it did indeed generate in the 2000 TMT bubble and the 2006 housing bubble. And the likelihood of bubbles forming no doubt increased because all three Fed bosses outspokenly denied that such bubbles were occurring even as they passed through 2-sigma levels (geek language for extreme rare events).
• Greenspan poetically argued in 1999 that the internet was driving away the dark clouds of ignorance and was issuing in a new era of permanently higher productivity. Think how encouraging this was to the bulls as the market in 1998 went past the 21x peak of 1929 and climbed remorselessly (and at an accelerating rate!) to 35x. Even more statistically remarkable was Bernanke’s dismissal of a clear 3-sigma U.S. housing market – a one in a thousand event normally – as “merely a reflection of a strong U.S. economy,” and that “U.S. housing prices had never declined!” That was accurate enough, but what it really meant – and was interpreted as meaning – was that U.S. housing prices would not decline in the future. But, of course, the U.S. housing market had never been tested by a 3-sigma bubble before!
• And the rest is history.

SB here: The point is don’t take extra comfort in the Fed.

Jeremy’s conclusion and favorite advice:

• Anyone around in 1999 and early 2000 has had a classic primer in these signs. We know we’re not there yet, but we can perhaps see some early movement: increasing vindictiveness to the bears for costing investors money; the crazy Bitcoins of the world (this is a true, crazy mini-bubble of its own I expect – it has certainly passed my “nephew test” of his obsessing about buying or not); and Amazon and the other handful of current heroes – here and globally – taking over more of the press coverage and a growing percentage of total market gains (Amazon +13%, the day before I started to write this, and Tencent doubling this year to a $500 billion market cap).
• The increasingly optimistic tone of press and TV coverage is also important. A mere six months ago, new market highs were hardly mentioned and learned bears were featured everywhere. Now, the newspaper and TV coverage is considerably more interested in market events. (This last comment reminds me of some advice for contrarians: There is usually a phase or two in each cycle where most investors expect a market gain or loss and it actually happens. The mass of investors usually ends up wrong in the end, but not all the time, for Heaven’s sake!)
• Other items worth mentioning are IPO windows and new record highs for corporate deals. We can have a satisfactory melt-up without them, but still one or the other is likely and both together are quite possible. I believe their presence would make a spectacular bust that much more likely.
• Finally, my favorite advice once again: Keep an eye on what the TVs at lunchtime eateries are showing. When most have talking heads yammering about Amazon, Tencent, and Bitcoin and not Patriot replays – just as late 1999 featured the latest in Pets.com – we are probably down to the last few months. Good luck. We’ll all need some.

SB again: I’d like to see my Philadelphia Eagles turn the tide on the Patriots, but our star quarterback is out for the season and while my kids are more optimistic than me, my fingers are crossed.  Best to luck to your favorite team.

Finally, Jeremy’s summary… what he calls his guesses (his personal view).

• A melt-up or end-phase of a bubble within the next 6 months to 2 years is likely, i.e., over 50%. (Emphasis in original.)
• If there is a melt-up, then the odds of a subsequent bubble break or melt-down are very, very high, i.e., over 90%. (Emphasis in original.)
• If there is a market decline following a melt-up, it is quite likely to be a decline of some 50%. (Emphasis in original.)

He suggests everyone own as much Emerging Market equity exposure as your career or business risk can tolerate.

And for individual investors willing to speculate.  (Emphasis mine.)

• Consider a small hedge of some high-momentum stocks primarily in the U.S. and possibly including a few of the obvious candidates in China. In previous great bubbles we have ended with sensational gains, both in speed and extent, from a decreasing number of favorites. This is the best possible hedge against the underperformance you will suffer if invested in a sensible relative-value portfolio in the event of a melt-up.
• [I]f we have the accelerating rally that has typified previous blow-off phases, you should be ready to reduce equity exposure, ideally by a lot if you can stand it, when either the psychological signs become extreme, or when, after further considerable gain, the market convincingly stumbles. If you can’t cope with this thought and can’t develop and execute an exit strategy, then sit tight and ignore all this advice, except for an overweighting of Emerging. I certainly recognize that leaping out of declining markets is a completely unrealistic idea for large, illiquid institutions and nerve-wracking enough for even the toughest-minded individuals. In this sense you can treat this paper as an academic exercise… the musings of an old student of the market, who thinks he sees the signs of an impending melt-up that will be painful for value investors.
• Is it better to be warned and suffer than be surprised and suffer? At least when warned, you can brace yourselves.

Consider ourselves forewarned.  Thanks Jeremy… appreciate your work!

Next, a quick look at the extreme market valuations and the probable low to negative forward returns they forecast.

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Valuations and Probable 7-, 10- and 12-year Returns

Following are a few valuation charts:

Here is a scatter graph with the market valuation on the vertical axis (log scale) and inflation on the horizontal axis.  It includes some key highlights: 1) the extreme overvaluation and irrational period of the tech bubble, 2) the valuations since the start of last recession, 3) the average P/E10 and 4) where we are today.

Source

In the months following the Great Financial Crisis, we have essentially been in “uncharted” territory. Never in history have we had 20+ P/E10 ratios with yields below 2.5%. The latest monthly average of daily closes on the 10-year yield is at 2.40%, which is above its all-time monthly average low of 1.50% in July 2016.

What can we conclude?  Despite the end of QE, many analysts assume that Fed intervention through its Zero Interest Rate Policy (ZIRP), will keep yields in the basement for a prolonged period, thus continuing to promote a risk-on skew to investment strategies despite weak fundamentals.

On the other hand, we could see a negative market reaction to a growing sense that Fed intervention may have its downside, resulting in an aberrant bond market and increased inflation/deflation risk.

Source

One of my favorites, “Median P/E.”

Here’s how you read the chart:

• Median P/E is the P/E in the middle out of all the stocks that make up the S&P 500 Index. I like it because it tends to take out the accounting games that may go on.
• Simply see it as a number for now (see the “We are HERE” annotation in red. Currently higher than all times prior except the late 1990 tech bubble).
• The orange box at the bottom measures “Median Fair Value, “ “Overvalued” and “Undervalued.” Today the S&P 500 Index is above 2,700.  At December month end, the S&P was at 2,673.61.
• From the December 31, 2017 close to the median fair value (over the last 53.8 years) of 17 indicates the market is 33.4% overvalued.
• At today’s extreme high Median P/E, it is 12.9% higher than where history suggests “Overvalued” to be. Finally, bargains would be found at a 1 standard deviation move below fair value or 54% lower than where the market sat at year end.

Next is GMO’s most recent 7-year Real Equity Market Return Forecasts:

Here is how to read the chart:

• Take two aspirin and drink them down with your favorite beverage.
• The red arrow points to where they calculate returns to be for the S&P 500 Index, after inflation, over the coming seven years.
• In English, your $1 million dollars in 2018 will drop to approximately $658,198 by the year 2025.

Here is the math on that $1 million:

That’s not a recipe for baby boomer retirement success, which leads to my consistent point.  Absent anything else, put a 200-day moving average stop-loss on everything you own.  Not perfect, we may “melt-up” but you want to be in a position to take advantage of the opportunity the next great correction creates.

Finally, following is the 10-year subsequent return stats based on “Median P/E” and Dr. John Hussman’s 12-Year Return Analysis (not to be ignored).

Hussman’s 12-year Equity Market Return Forecast

Here’s how you read the chart:

• Take two more aspirin.
• The chart below shows his preferred valuation measure, which he introduced several years ago (nonfinancial market capitalization to corporate gross value-added, including estimated foreign revenues).
• The Market Cap/GVA is shown on an inverted log scale in blue. The red line shows S&P 500 average nominal total returns over the subsequent 12-year period.
• Simply, note the high degree of correlation. Meaning, how closely the subsequent 12-year return tracked the valuation measure.
• Current starting condition is the small green arrow pointing to coming negative compounded 12-year return forecast.

Source: Survival Tactics for a Hypervalued Market

May we get a beautiful “melt-up,” stay balanced, aware and successfully manage downside risk properly.  If you are willing to jump all in on that rocket ship, judge your risk tolerance appropriately and diversify to several disciplined risk managed processes.

A 2018 top as Jeremy showed in his chart.  No idea.  Stay risk minded, tactical and nimble.

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Trade Signals — New Record Set for the S&P 500 Index