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Epic Stock Market Bubble in a World Gone Mad

Stock Market Bubble
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EDITOR NOTE:  There are a number of important lessons you can take from this piece. One of them that seems critical to me--something that investors often overlook--is that fact that despite there being no safe investments, there are safer ways to invest. It’s a matter of eliminating stupid decisions from the mix--something the author below points out more than once. And with the S&P 500 index hovering at critical highs, and with the pandemic continuing to ravage economies across the globe, it's hard to come up with a ‘smart’ reason to jump in now, especially with a huge position. No matter how you look at it, the market is in a bubble. Bubbles can continue much longer than expected, but eventually, all bubbles burst.

Right now happens to be an attractive time to do something stupid.  What’s more, everyone’s doing it.  Maybe you are too.

Stock valuations and corporate earnings growth no longer appear to matter.  Why not buy an S&P 500 index fund and let it ride?  Or, better yet, why not buy shares of Nvidia?

The semiconductor company’s up more than 170 percent over the last 9-months.  Perhaps it’ll double again from here.

Of course, there’s nothing like an epic stock market bubble that warms the hearts and softens the minds of men to ideas that would otherwise be impossible.  One idea du jour, for example, is that low interest rates justify high valuations.  Another is that the Fed can permanently inflate stocks using its seemingly unlimited supply of credit.

These ideas, and many others, are nearing their expiration date.  As they turn from ripe to rot, investors that are counting on there always being a greater fool will discover what happens when you overpay for a stream of future cash flows.  In short, future returns stink.

Making any investment requires a combination of analysis, judgement, risk/reward expectations, time horizon, and personal finance considerations.  Providence and luck are also important factors.  You can do everything right, at least on surface.  Yet still suffer unfortunate losses.

This is especially so when it comes to stock market investing.  You may buy precisely the right stock at precisely the wrong time.  Something previously unknown may surface, and the bottom drops out.

Asset diversification and position sizing are critical to managing these risks.  An S&P 500 index fund, at the moment, won’t cut it.

Fear and Greed

At critical stages in the stock market – like now – your long-term success comes down to what you don’t do, as opposed to what you do.  Above all, you want to avoid doing something stupid.  Something that will set you back a decade – or more – on your goal of accumulating long-term investment wealth.

Currently, the stock market is at a critical stage.  After peaking at 3,386 on February 19, the S&P 500 abruptly loss over 33 percent, reaching an interim bottom of 2,237 on March 23.  Since then, as of yesterday’s (December 17) close at 3,722 (a new all-time closing high), the S&P 500 is up over 66 percent.  In addition to the S&P 500, yesterday the Dow Jones Industrial Average (DJIA) and the Nasdaq also attained record closing highs.

It certainly is enticing to want to buy stocks at the moment.  But remember, investing psychology goes contrary to other purchases.  While most people can quickly discern a bargain price for a pair of jeans or a flat screen TV, with stocks, they have the uncanny ability to buy high and sell low.  Fear and greed emotions seem to always get the best of them.

Perhaps, as the economy opens back up, growth will come roaring back.  Maybe the new coronavirus vaccine will soon make this all a really bad dream.  With these prospects, wouldn’t now be a great time to buy stocks?

This rosy scenario appears to be what many investors are banking on.  They continue to push stocks higher with every positive report of a vaccine rollout or a new stimulus bill from Congress.

Who knows?  Maybe they’re right.

Still, we have some reservations.  This is an extremely dangerous stock market.  There are plenty of unknowns with respect to the economy and markets.

How much economic damage did the lockdowns do?  How long will it take for the economy to recover?  What are the implications for the massive deficit spending and monetary stimulus measures that have been undertaken?  When will this bubble finally pop?

Grantham’s ‘Real McCoy’ Bubble in a World Gone Mad

On June 17, billionaire investor and co-founder of the Boston-based money manager GMO, Jeremy Grantham, sounded the alarm.  During a CNBC interview with Wilfred Frost, Grantham warned that the U.S. stock market’s rebound amid the coronavirus pandemic is a bubble that will end up hurting many investors.

“My confidence is rising quite rapidly that this is, in fact, becoming the fourth ‘real McCoy’ bubble of my investment career.  The great bubbles can go on a long time and inflict a lot of pain, but at least I think we know now that we’re in one.”

In the months since Grantham’s warning the stock market bubble has continued to inflate to new highs.  This move has gone against GMO, which had cut its fund’s stock exposure to 25 percent.

On November 24, Bloomberg reported that GMO’s flagship Benchmark-Free Allocation Fund trailed the S&P 500 by 14 percent year-to-date.  On top of that, investors have pulled $2.2 billion from the fund in the last 10 months.

Still, we’re certain Grantham will be proven correct in good time.  And investors that stuck with him will be rewarded for their patience.  Here’s why?

Grantham has accurately predicted several bubbles over his lengthy career.  He correctly predicted the Japanese Nikkei stock market bubble in the late 1980s, the dot com bubble in 2000, and the housing bubble in the mid-2000s.

Grantham’s philosophy is very practical.  His focus is centered on his commonly used phrase ‘reversion to the mean.’  This is an observation that all asset classes and markets will revert to mean historical levels from highs and lows.

Reversion to the mean, as an investment philosophy, is the recognition that financial asset prices in relation to their underlying value will get out of whack from time to time.  The greed and euphoria of a bull market will overshoot into a dangerous bubble.  Similarly, during a fear driven bear market and mass liquidation, financial asset prices fall to a deep discount to their underlying value.

Of course, the time to buy is when prices are low.  So, too, the time to sell is when prices are high.  While reversion to the mean may be an accurate forecaster of the long-term price movement of a financial asset, it is a terrible indicator for market timing.

Bubbles often inflate much further and grow much more extreme than a rational observer would expect.  In a world gone mad, the deviation can grow wider and more extreme before the reversion occurs.  Nonetheless, Grantham’s analysis and the alarms that it sounds should be taken serious.

The fact that the stock market has continued to rise – including yesterdays’ record closing highs for the S&P 500, DJIA, and Nasdaq – since Grantham called this a ‘real McCoy bubble’ does not disprove his assertion.  Rather, it validates it.

Originally posted on Economic Prism

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