Jeremy Grantham’s Bullish Two-Year Outlook – Barron’s 11-19-13

Salient to Investors:

Jeremy Grantham at BMO writes:

The Greenspan-Bernanke policy of excessive stimulus, now administered by Yellen, will continue, and that the path of least resistance, for the market is up.

It would take a severe economic shock to outweigh the effect of the Fed’s relentless pumping of the market as seen by its continued advance despite almost universal disappointment in economic growth.

US stocks, especially the non-blue chips, will rise 20% to 30% in the next 2 years, with the rest of the world including emerging market equities outperforming in at least a partial catch-up. Then we will see the third market bust since 1999.

US stocks are badly overpriced with the prospect of negative real returns over 7 years. The sharp and unexpected uptick in parts of the US IPO market indicates we are in the slow build-up to a badly overpriced market and bubble conditions.

Most foreign markets are overpriced but less so.

There are few signs of a traditional bubble in equities – US individuals are not yet consistent buyers of mutual funds. There are no wonderful and influential theories as to why the P/E structure should be much higher today as there were in Japan in 1989 or Greenspan’s theory of the internet driving away the dark clouds of ignorance and ushering in an era of permanently higher P/Es in 2000, though today’s unprecedented margins, usually the most dependably mean reverting of all financial series, are apparently now normal.

Prudent investors almost invariably must forego the fun at the top end of markets so should now be reducing their equity bets and their risk level in general.

Yellen also thought the housing bubble merely reflected a strong economy and has happily gone along with the failed Fed policy of hoping for a different outcome despite repeating exactly the same thing. The consequences threaten to be just as bad again within 2 or 3 years. Greenspan had had no serious job prior to becoming Fed chairman, and a proven record of almost laughable failure as an economic prognosticator to the stock market in the 1970s.

The crash of 2008 is overwhelmingly seen as a financial event, but commodity price rises and the only US-wide housing bubble in history are understated in their contribution. The general bias in our economic thinking exaggerates the significance of the financial, paper world at the expense of the more mundane, but more important, real world.

We had the largest ever price rise in oil and other commodities, despite the absence of inflation in wages and consumer prices, hurting demand. Oil prices rose due to the rapidly rising long-term cost of finding and delivering oil and short-term shortages. The housing bubble was GMO’s warning signal.

We are almost back to normal in home ownership, perhaps within a year of full readjustment of the excesses.

The wealth effect from housing is greater than from the stock market and more dangerous, because home ownership involves over 30% more of the general public and those additionally impacted had typically far less liquidity to deal with a crisis than did stockholders.

Economic growth is slowing down globally, most obviously in Europe, and has a 25% chance of overwhelm even the Fed in the next 2 years. The general lack of global fiscal stimulus and almost precipitous decline in the US Federal deficit do not help.

Economist Kenneth Boulding believed economics had lost its way in a maze of econometric formulas, which placed elegance over accuracy.

The theory of rational expectations does not fit the real world and resulted in 5-7 decades of economic mainstream work being largely thrown away.

Efficient Market Hypothesis is the most laughable of all assumption-based theories, which tells us that investment bubbles have not occurred and could never occur, despite at least 4 of the great investment bubbles in all of investment history in the last 25 years – Japanese stocks in 1989, the Japanese land bubble in 1991, US stocks in 2000, and the first truly global bubble in 2007 in global stocks, fine arts and collectibles, and almost all of the real-estate markets. Brainwashed by the EMH, Bernanke and Yellen could not, or would not, even recognize the risk.

During the 1970s and 1980s, EMH helped reduce the number of quantitatively talented individuals entering the money management business.

The S&P 500 is within ±19% of its trend two-thirds of the time. Volatility is 19 times more than justified by underlying fundamentals, caused primarily by individual investors driven by behavioral factors that result in herding – non-experts simply feel more comfortable in a herd, and being wrong on your own is the cardinal crime for an investment manager so managing career risk results in very destructive herding and a great deal of extrapolation.

Extrapolation dominates the workings of the market. Keynes said extrapolation is a convention we adopt even though we know from personal experience that it is not applicable in the real world. For example, in 1982, 30-year bonds peaked at a 16% yield as inflation touched 13% so to extrapolate a full 13% inflation is as foolish as extrapolating currently very low inflation for 30 years. The same is true for extrapolating profit margins.

Economist Hyman Minsky said periodic financial crises were well-nigh inevitable because a form of extrapolation would occur with stability generating more risk-taking and on into a spiral until something inevitably would go wrong.

Despite high UK housing prices, the UK government is encouraging more leveraged mortgages, guaranteeing new mortgages over 5% that will further push prices up so that new buyers can only afford houses at low mortgage rates.

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