Toil and Trouble

Here’s the Executive Summary of Jeremy Grantham’s analysis of present trading trends at GMO:

All 2-sigma equity bubbles in developed countries have broken back to trend. But before they did, a handful went on to become superbubbles of 3-sigma or greater: in the U.S. in 1929 and 2000 and in Japan in 1989. There were also superbubbles in housing in the U.S. in 2006 and Japan in 1989. All five of these superbubbles corrected all the way back to trend with much greater and longer pain than average.Today in the U.S. we are in the fourth superbubble of the last hundred years.Previous equity superbubbles had a series of distinct features that individually are rare and collectively are unique to these events. In each case, these shared characteristics have already occurred in this cycle. The checklist for a superbubble running through its phases is now complete and the wild rumpus can begin at any time.

He goes on to explain that we are presently seeing four bubbles concurrently:

  • Real estate
  • Equities
  • Bonds
  • Commodities

It’s an unprecedented situation and, when something is unprecedented, there is no way to know what will happen with any confidence. Here are his “Rules of the Bubble”:

  1. All 2-sigma equity bubbles in developed equity markets have burst – all the way back to trend. The U.S. reached the 2-sigma level in the summer of 2020.
  2. But some of them went to 3-sigma or more before they burst – producing longer and deeper pain. The U.S. reached 3-sigma in late 2021.
  3. Timing is uncertain and when you get to 3-sigma superbubbles, such as we have now, there are few examples. Yet they have all shown certain characteristics before they broke.
  1. A speculative investor frenzy that generated stories for distant decades, which we have had for well over a year;
  2. A penultimate blow-off phase where stock gains accelerate, as we had in 2020;
  3. And the ultimate narrowing phase – unique to these few superbubbles – where a decreasing number of very large blue chips go up as riskier and more speculative stocks underperform or even decline, as they did in 1929 and 2000 and as they have done since February 2021.

If a, b, and c are accounted for, light the blue touchpaper and retire to a safe distance, praying for a paradigm shift.

Nervous yet? If I didn’t live in the world, the “rumpus” might be fun to watch. As it is I do not look forward to it, even the less with inflation as high (or higher) than it is now.

Hat tip: Cullen Roche

3 comments… add one
  • TastyBits Link

    In the Modern Monetary System (MMS), most money is “printed” by adding zeros to balance sheets, and overwhelmingly, those are private sector balance sheets. When zeros are subtracted, money is destroyed.

    Bubbles require credit created through leveraging assets – real or financial. When a bubble bursts, asset prices decrease and credit is destroyed. In the MMS, credit created through leveraging is money, and therefore, destroying credit results in deflation of assets, GDP, and available money.

    As an individual bubble increases, it begins to interact with other bubbles creating super-bubbles, and eventually, these super-bubbles will interact to form ultra-bubbles. Finally, an uber-bubble will be formed, and at some point, the carrying capacity will be exceeded. It will burst.

    The destruction is not simply limited to asset owners, investors, and banks. All economic activity is affected, and few are able to escape unscathed.

    The Great Depression was exacerbated by the Dust Bowl. Farmers production decreased, and they could not repay their loans. The credit & asset values were simultaneously destroyed, and with production decreased, the economic activity required to “fill the hole” was not available.

    With the supply chain problems, global production is reduced, and the credit being created, private and public, cannot be supported. Credit destruction creates deflation. There is less money available, and inevitably, there is a liquidity crisis.

    The liquidity crisis feeds deflation, and deflation breeds distrust of valuations. Since Keynes and MMT are credit based solutions, neither can resolve the problem. Glass-Steagall provided a basis for trust, and as the financial industry recovered, the overall economy was able to begin recovering.

    Nervous yet?

    At this point, there is nothing to do but party like it’s 2008.

  • Since Keynes and MMT are credit based solutions, neither can resolve the problem

    a point I have been making for some time. The problem is that our political leadership has only that arrow in its quiver.

  • Drew Link

    Mean reversion is, of course, his mantra. Valuations do indeed fluctuate, but it would be nice if he went further and attached a mean valuation to fundamentals. Examples would be relative yields affected by the Fed or other factors. Demographics and the associated lifetime spending/saving cycle of the baby boom bulge. And of course government policy that affects the long term growth in earnings.

    Tasty – valuations often are related to credit, but credit is not a prerequisite for a bubble or bust. For example, most of the valuation/capitalization of global equities is not related to margined purchases, although purchase on margin exists. It is much more due to central bank affected fixed income yields and prospects for earnings growth. Real estate, on the other hand, is strongly correlated to prevailing credit conditions because so many people buy to a monthly payment goal, and not a home’s intrinsic value.

    In your own comment you point to an exogenous variable, the weather, as a factor in the Great Depression. There are a whole host of credit risks that determine overall credit quality and amount of extension. But an economy doesn’t therefore opt for all equity financing because of that. To do so would be to have economies a fraction of the size they are.

    IMHO what we have here is nothing more than the irresponsible excesses of politicians, economists and voters who believe in a free lunch. Those voters mostly got started as Democrats – the free lunch was to be used for grand purposes. And politicians and economists (see: Janet Yellen) started licking their chops. As I have commented here a number of times, we will have to take a recession to correct the what was inevitable inflation problem building over the years. (Supply chain issues may substantially clean up over time. But the reduction in the workforce, the loss of productive capacity brought on by covid hysteria, and the inflationary psychology that has been unleashed will be tough to overcome. (As an interesting side note for thought: has the demand for money balances stabilized?) Joe Biden and his advisors are as reckless and irresponsible as they come with their blathering about solving problems with BBB. Its like an alcoholic who wakes up in a fog Monday morning and thinks the answer is to head to the bar.

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