I find myself in an interesting position for an investor from the value school. I recognize on one hand that this is one of the highest-priced markets in US history. On the other hand, as a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market. The data on the high price of the market is clean and factual. We can be as certain as we ever get in stock market analysis that the current price is exceptionally high. In contrast, my judgment on the melt-up is based on a mish-mash of statistical and psychological factors based on previous eras, each one very different, so that much of the information available is not easily comparable. It also leans very heavily on a few US examples. Yet, strangely, I find the less statistical data more compelling in this bubble context than the simple fact of overpricing. Whether you will also, dear reader, remains to be seen. In any case, my task in this note is to present the evidence, both statistical and touchy-feely, as clearly as I can.
So let’s start by looking very hard at all the great bubbles of the past, searching for useful guides to the future. The classic examples are not just characterized by higher-than-average prices. Price alone seems to me now to be by no means a sufficient sign of an impending bubble break. Among other factors, indicators of extremes of euphoria seem much more important than price. Ben Graham, as quoted two quarterly letters ago, said that as far as he could see no bubble had ever broken (by 1963) without being accompanied by signs of real excess such as those found in 1929. Two months ago, Robert Shiller also made the point (in the Sunday New York Times) – as I will do – that not nearly enough signs of euphoria were yet present to make this look like a late-stage bubble. (Although in my opinion they have finally begun to pick up in the last two or three months.) And Robert Shiller was one of a very small group predicting a future market collapse in 1999, and one of a few handfuls with us in 2006 focusing on the future risks from an unprecedented US housing bubble breaking due to vulnerable mortgages. So when he held his fire this time on the issues of a market crash, as I have done, waiting for more evidence, I took considerable comfort. After all, for a major investment bubble to burst it must first form, and this one has been very slow to do that, at least until recently.
While I am attacking the concept of leaning on price alone I should add that I carry a lot of blame for exaggerating the significance of price alone as a bubble measure. After all, I helped pioneer the data-mined result that previous bubbles have been separated from ordinary bull markets by passing through 2 standard deviations on their price series, a level that statistically should occur every 44 years in a random series. It has been a very useful assumption for a broad-based study of global bubbles in a variety of asset classes and it had, of course, a good historical record, because that’s how we picked it. But this time, this statistical measure has been misleading because as the US market hit a 2-sigma level, it had almost none of the other more important bubble indicators of investor euphoria and even craziness. Similarly, early 1998 had none when we reduced our risk levels to a minimum based on price alone. In complete contrast, late 1999 and early 2000 had very many signs of bubbly, completely irrational behavior, just as mid, or even early 1929 had.
Is a late bubble surge beginning?
So let’s look at what is missing in the way of psychological and technical signs of a late-stage bubble and what is beginning to fall into place. On the topic of classic bubbles, I have long shown Exhibits 1 and 2. They recognize the importance of a true psychological event of momentum increasing to a frenzy. That is to say, acceleration of price. The average time of the final bubble phase of the great equity bubbles shown in Exhibit 1 is just under 3.5 years, with the average upcycle of real acceleration just 21 months. And the two smaller equity bubbles had gains of 65% and 58%. They also show an interesting symmetry, don’t you think? Rising and falling at about the same rate, as did the real McCoy – the South Sea Bubble shown in Exhibit 2 – before them. Yes, there is a real danger of being late. And in general, average market declines are considerably faster than average advances. But historically, when dealing with real bubbles, being late has not been materially different in time and pain than being too early, as you can see. Value managers are historically painfully too early over and over again, as I know better than most.
Recently an academic paper titled “Bubbles for Fama”2 concluded that in the US and almost all global markets, the strongest indicator – stronger than pure pricing or value – was indeed price acceleration. (This is perhaps the third time I have agreed with mainstream economists in the last 50 years. I have a firm principle of generously quoting them when they agree with me.) Exhibit 3 shows what the market looks like today. Until very recently it could justifiably be described as clawing its way steadily higher. But just recently, say the last six months, we have been showing a
What of other indicators? I have previously defined a great bubble as being “Excellent Fundamentals Euphorically Extrapolated.” And I have previously concluded that, in general, the fundamentals of recent years were disappointing and that investors, far from being euphoric, had instead been “climbing the wall of worry” as they used to say. But fundamentals are improving. The global economy is in sync for the first time in a dozen years and global profit margins are at a high; in the US, a corporate tax cut is on the way, which in today’s sticky, more monopolistic world, is unlikely to be quickly competed away as theory suggests, but very likely to further fatten the corporate share of the GDP pie and perhaps provide the oomph to keep stock prices rising. modest acceleration, the base camp, perhaps, for a final possible assault on the peak. Exhibit 4 represents our quick effort at showing what level of acceleration it might take to make 2018 (and possibly 2019) look like a classic bubble. A range of 9 to 18 months from today and a price rise to around 3,400 to 3,700 on the S&P 500 would show the same 60% gain over 21 months as the least of the other classic bubble events.
In looking for signs of late bubble behavior, we have to reconcile to the fact that no two bubbles, even the classics, are the same. They share the fact that there are many signs of investor euphoria, sometimes indeed approaching the madness of crowds, but the package of psychological and technical indicators has been different each time. The historian has to emphasize the big picture: In general are investors getting clearly carried away? Are prices accelerating? Is the market narrowing? And, are at least some of the other early warnings from the previous great bubbles falling into place?
The writer is co-founder and chief investment strategist, GMO. This is an excerpt from a January 2018 GMO commentary. You can read the full version here.
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