When GMO’s Jeremy Grantham says that he is “still a believer that the Fed will engineer a fully-fledged bubble” what can one say but, yes: it did so a few years back.
Recall that back in May, Grantham so far accurately predicted that on the back of central bank liquidity, the overstretched market will stretch even further “at least enough to drive the market to its 2-sigma level of 2,250 and perhaps a fair bit beyond… And although nothing is certain in the market, this is exactly what I believe will happen.”
In fact, his prediction so far has been spot on in terms of not only magnitude but also timing, accurately calling for the recent swoon and subsequent rebound. Notably, he also offered his forecast for when the bubble would burst which he timed as follows: “then around the election or soon after, the market bubble will burst, as bubbles always do, and will revert to its trend value, around half of its peak or worse, depending on what new ammunition the Fed can dig up.”
So here is how the legendary investor predicts the upcoming timing of events in the near future, with a focus on the presidential cycle:
The Presidential Cycle
Regular readers know the score: +2.5% a month for the seven months from October 1 to April 30, in year three on average since 1932 (a total of +17%). This is now the 21st cycle. The odds of drawing 20 random 7-month returns this strong are just over 1 in 200 according to our 10 million trials. But 17 of the actual 20 historical experiences were up and the worst of the 3 downs was only -6.4%, so the odds of this consistency plus the high return would be much smaller. The remaining 5 months of the Presidential year have a good but not remarkable record, over .75% per month, but the killer here is that the remaining 36 months since 1932 averaged a measly +0.2% a month!
With the 7 months having returned over 10 times the average of the 36-month desert, it may seem like a nobrainer investment for those seven of us not intimidated by the obvious simplicity of the idea, but be advised that going into this particular cycle there appear to be more negatives than normal. (Though many of the previous 20 occurrences may well have seemed that way to investors at the time. Who knows?) The negatives this time include the ending of the Fed’s bond purchase program. There is also talk of a rate increase early next year, given the recent recovery of the U.S. economy reflected in the improved employment report of early October (5.9% unemployed) and positive adjustments to the previous month’s employment numbers. Other negatives include the potential for escalation of several minor but intractable wars and the recent Ebola outbreak.
Some would mention the very substantial overpricing of the U.S. market at the top of the list but, surprisingly, overpricing has had no material effect on third-year returns or the particularly sweet seven-month subset: an average of 17% for seven months becomes 19% if cheap and 15% if expensive. Big deal. Value, however, is very important for the other three years in which the cheapest 25% have produced a respectable return of +12%, and the other three quartiles are absolutely not worth having, all three together averaging almost exactly nil! More disturbing to me than the obvious overvaluation is the large and growing number of other negatives – technical and psychological – put together by Hussman and other market experts. Nevertheless, despite my nervousness I am still a believer that the Fed will engineer a fully-fledged bubble (S&P 500 over 2250) before a very serious decline.
One can add the BOJ and ECB to the list now too, even if netting out the impact of Jim Bullard’s verbal interventions.
So what is Grantham’s advice to a prudent investor, by which don’t mean your typical Virtu algo:
As always, the prudent investor (unlike the political year three) should definitely recognize overvaluation, factor in regression to the mean, and calculate the longer-term returns that result from this process. More easily, such prudent investors can use our seven-year numbers, which have a decent long-term record measured when we have viewed markets as overpriced, as we believe they are today, and a better record measured in the periods after bubbles break. The other necessary ingredients to the investment mix are suitable measures of risk, and when these are added to estimated returns we believe efficient portfolios can be produced. On our data, with U.S. large cap equities offering negative returns (-1.5%) except for high quality stocks (+2.2%), with foreign developed and emerging equities overpriced (+3.7%), and with bonds and cash also very unattractive, investors have to twist and turn to find even a semi-respectable portfolio. It is a particularly tough process today with nowhere to hide and no very good investments compared to, say, the time around the 2000 bubble when there were several. My colleagues Ben Inker and James Montier have written in some detail about the problems of investing in these difficult times.2 Designed to help your thinking about this topic, Exhibit 1 shows an example of a portfolio that might be used in a world that excludes private equity and venture capital, and for a client who can do without a benchmark and can settle for owning a (hopefully) sensible long-term efficient portfolio. Efficient, that is, in terms of trying to minimize risk per unit of estimated returns. As always, and particularly in this type of overpriced environment, there are no guarantees of success even if every GMO recommendation were to be implemented for, regrettably, we too are often imperfect.
His conclusion:
My personal fond hope and expectation is still for a market that runs deep into bubble territory (which starts, as mentioned earlier, at 2250 on the S&P 500 on our data) before crashing as it always does. Hopefully by then, but depending on what the rest of the world’s equities do, our holdings of global equities will be down to 20% or less. Usually the bubble excitement – which seems inevitably to be led by U.S. markets – starts about now, entering the sweet spot of the Presidential Cycle’s year three, but occasionally, as you have probably discovered the hard way already, history can be a snare and not a help.
The only problem is that once the bubble bursts, nobody will be able to put the Humpty Dumpty (or CYNK as some call it) market together again. Which is why the central banks will do everything in their power to avoid even a 10% correction. We are now in all in territory, and the next market crash will be the last: something the all-in central-planners know well, which is why the market’s emergency preparedness system now gets a daily test run: if and when the crash begins, the stock exchanges will simply “break” as investors suddenly find they have been volunteered for the last bail-in.
Source: GMO
via Zero Hedge http://ift.tt/1EZHNGc Tyler Durden