Waiting longer for the big one

Looking back to last year we could simplify it by saying that the big positive was, as usual, support from the Fed and its allies, as they continued to maintain lower than market rates. You know my view: These lower rates have surprisingly little effect on the economy but a big effect on pushing up asset prices. Historically – well for 25 years anyway – the lack of reasonable values has often not impeded the Fed’s ability to push equity prices higher. Indeed, by any traditional measure we have spent over 80% of the last 25 years overpriced. The big negative in 2015, of course, was China slowing down, especially in areas requiring raw materials. This helped to broadly lower global GDP growth. Loosely speaking, the closer investments were to China – say, miners, countries supplying raw materials, and emerging markets with heavy Chinese trade – then the relatively worse they did. And the closer to the Fed, as the U.S. is, the less badly they did.

The global bear market bias of 2015 was also helped along everywhere by the plunging oil price, which caused layoffs, reductions in capital spending, and, probably more importantly for equities, increased global uncertainties both at the company financial level and the country political level. Right behind that as a negative, particularly in the U.S., was a decline in profit margins. Finally! But the drop was from levels so far above the old trend that even after recent declines they remain handsome.

Looking at the U.S. equity market I think we might agree on how powerful the Fed is in the market equation. It approximately offset these three very large negatives: China, oil, and declining margins, which together caused disappointing global growth. But in addition, it had to neutralize the justifiable nervousness caused by increased terrorism, immigrant problems, Russia’s sharp elbows, and an apparently disheveled Europe. Not bad!

Year ahead

Looking to 2016, we can agree that uncertainties are above average. But I think the global economy and the U.S. in particular will do better than the bears believe it will because they appear to underestimate the slow-burning but huge positive of much-reduced resource prices in the U.S. and the availability of capacity both in labor and machinery. So even though I believe our trend line growth capability is only 1.5%, our spare capacity and lower input prices make 2.5% quite attainable for this year. And growth at this level would make a major market break unlikely. As discussed elsewhere, this situation feels at worst like an ordinary bear market lasting a few months and not like a major collapse. That, I think, will come later after the final ingredients of a major bubble fall into place.

As always, though, prudent investors should ignore historical niceties like these and invest according to GMO’s rather depressing 7-year forecast. The U.S. equity market, although not in bubble territory, is very overpriced (+50% to 60%) and the outlook for fixed income is dismal. At current asset prices no pension fund requirements can be met. Thus, we should welcome a major market break that will leave us with more reasonable investment growth potential for the longer term, but I suspect that we will have to wait patiently for such a major decline. The ability of the market to hurt eager bears some more is probably not exhausted. I still believe that, with the help of the Fed and its allies, the U.S. market will rally once again to become a fully-fledged bubble before it breaks. That is, after all, the logical outcome of a Fed policy that stimulates and overestimates some more until, finally, some strut in the complicated economic structure snaps. Good luck in 2016.

U.S. equity bubble update

On the evaluation front, the market is not quite expensive enough to deserve the bubble title. We at GMO have defined a bubble as a 2-standard-deviation event (2-sigma). We believe that all great investment bubbles reached that level and market events that fell short of 2-sigma did not feel like the real thing. (In our view, 2008 was preceded by an unprecedented U.S. housing bubble – a 3-sigma event.)

Today a 2-sigma U.S. equity market would be at or around 2300 on the S&P, requiring a rally of over 20%; even from the previous record daily high it would have required an 8% rally. The impressive bubble peaks of 1929 and 2008 also featured broad international overpricing of equities, measured at over 1-sigma, and this, too, was completely lacking this time. Emerging market equities were just ordinarily overpriced last year and full of investor concerns totally unlike normal bubble conditions. Europe and other developed markets were more overpriced but nowhere near bubble levels, and were also characterized by extreme nervousness.

On the more touchy-feely level of psychological and technical measures, the U.S. market came closer to bubble status but, still, I think, no cigar. I had pointed out two years ago that nearly all major bubbles are immediately preceded by a period when the safer blue chips outperform the riskier, higher-beta stocks on the upside. At other times this would be considered very unusual. Two years ago there was not a hint of that, but last year was a classically narrow market – i.e., led by a handful of the very largest and, on average, higher-quality companies. So the bears can claim this one, although I think with an asterisk because the market was not really going up last year and outperformance of bigger stocks in a flat market is not particularly remarkable. Also mitigating the bear argument is that this market effect was not caused by defensive buying of blue chips but, I would say, offensive buying into the spectacularly superior earnings of this small group. So, not convincing. I had also written that I did not see much chance that this market would end before records would be set for corporate deals done, encouraged by the extremely low rates and reluctance to invest in new plants and equipment. This test, I must admit, was passed with flying colors, for all deal records were broken in the second half of last year. Much more convincing.

A third less elegant but historically effective test further improves the odds of a bear market this year: the infamous January rule. Applied GMO-style, it goes that the first five trading days predict the balance of the year, especially if the average number is negative. (As does the whole month with about the same – and quite significant – statistical weight.) When the two signals oppose each other, on the other hand, we have had very normal years. Needless to say, the first five days and January were both record-ugly this year. Since 1925, a down five-day and down January have more than doubled the probability of a down market for the remaining 11 months.

So I must admit to feeling nervous for this year’s equity outlook in the U.S. But I am not entirely convinced. Sure, we can have a regular bear market. That is always the case. But the BIG ONE? I doubt it. And here is my admittedly reduced case.

The most important missing ingredient is a fully-fledged blow-off. This should come complete with crazy speculative anecdotes for your grandchildren, massive enthusiasm from individual investors, an overwrought, overcapacity economy, and, at minimum, a 2-sigma S&P 500 at 2300. Lacking all of this, I still believe it is “likely” that we will reach Election Day more or less intact. I will, though, admit to my definition of “likely” being beaten down by the negative factors listed earlier to something just over 50%. The wild card, as usual these days, is China. The market is discounting lower growth. (I believe 4% a year for the next 10 years would be a reasonable target.) But a deep entry into negative GDP numbers might ruin my relatively positive case for global growth.

To rub in how ordinary our present market negatives are compared to the impending doom bubble of 2007 when a crash seemed inevitable – like “watching a slow motion train wreck” – let’s compare today with 2007.

Back then the banks looked very vulnerable. Indeed, I predicted in July 2007, “at least one major bank… will fail.” This time oil debt may hurt, but our moderately strengthened banks will surely withstand this much smaller hit easily. In 2007, resource prices, historically a terrible drag on economies, were at cosmic highs – oil alone was over $150/barrel. Today they are at cosmic and unsustainable lows. So a major, major negative is this time a major positive. The U.S. housing market back then was at a 3-sigma high (never before approached) and represented a potential and realized $6 trillion write-down of perceived wealth. This time the U.S. housing market is merely moderately overpriced. Last time the economy was cranking out 1.25 million extra houses and the whole economy was running flat out. This time we are building at least 300,000 houses below normal levels and there is spare capacity in the broad economy. Clearly, this current situation has no material similarity to that which impressed us as so irresistibly negative in 2007. In short, the economic outlook for the immediate future is less bad than recent commentaries would have you believe. Especially in the U.S.

Yet more on oil

So, this is the situation: The world’s most important resource, oil, which we need for practically everything but especially to drive our cars, is getting really cheap. And this is helping to drag other commodities down with it. Everything is getting cheap. It is like a tax cut for individuals that is being financed by the profits of oil companies and Saudi Arabia. Now, what’s not to like about that? Yet this is a big part of what is spreading terror in the markets. Why?

I have described before the situation that although in the long run there is an apparent balance between winners and losers, the problem is that oil companies and their suppliers take their hits up front as they reduce their exploration and development efforts projecting deep into the future. Oil-dominated countries do the same, in addition to cutting their national budgets and their foreign buying. Under this shock, economic expectations can take a hit.

The shock, I suppose, is how completely Saudi Arabia and OPEC were willing to give up any and all attempts to control price. Through 90% of oil history, if oil producers wanted to outproduce demand they could have. And it would always have buried oil prices. But mostly they restrained their competitive market share instincts in the interest of a more stable price. And very sensibly so. To summarize my previous case, I consider that Saudi Arabia, if it has been driven by commercial as opposed to political reasons, has made perhaps the biggest economic error in the history of oil. If their main motive is political, on the other hand, it better be an extremely important one for they themselves are quite likely to pay a very high political as well as financial price. An oil price change of this magnitude and speed is very destabilizing to economies, politics, and social cohesion. It makes for dangerous times and the market does not like it. The psychological response is understandable.

But excluding some major political upheaval, what are the likely economic consequences from here? The largest hits from the major oil company responses are behind us, although at $30/barrel (and maybe less) there will be some further retrenchment. And now comes the matching response from us, the consumers. Everything we buy has cheaper input costs. The major item of gasoline purchases is a steady jolt of encouragement. Heating bills are also much lower. Could there be a better financial input than this to the group that has been hurting for 30 years – the median wage earner? Not easily. Some of us argued that the impact of high resource prices in 2008 had an underappreciated major negative impact on the economy, and there certainly is a strong statistical relationship between previous upward jots in oil prices and ensuing recessions. (Actually, the number is 100%. Every major previous increase in the price of oil was followed by an economic setback. And why would this not be the case?) We argued that mainstream economists were so obsessed with bank and credit problems that they had no time to worry about resource prices. Typically they almost never do. Market opinion now, though, impressed with the early negatives that it should have expected and because the offsetting stimulus effect is delayed and weakened initially by some understandable increases in savings, is doing the opposite. It is underrating what will very likely become an important economic tailwind for the next several quarters. Reflecting current opinion (January 25), Luke Kawa, a writer for Bloomberg reviewing the oil situation claims, “One of the biggest surprises in economics has been how the world responded to a period of lower energy prices.” Well, the economic world is easily surprised.

A lot of people who worry about resources had felt that several years of much higher resource prices (from 2006 to 2014) were acting to weaken our global economy, slowly but surely, and I was one of them. I feel that this period now is a reprieve, if only temporary, from that pressure. It gives an opportunity for the global economy to regroup and start to grow a bit faster again, at least for a while.

The U.S. economy in particular, with its available labor, tucked away in the current ultra-low labor participation rate, and a moderately low industrial capacity ratio (76.5% – 3.5 points below its 1972- 2014 average), appears to be well-positioned to benefit. And, we are still an important wheel in the global machinery.

This is an excerpt from Jeremy Grantham's 4Q2015 GMO quarterly letter, you can read the full version here

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