Asset allocation
A bubble is a category 4 hurricane
With a strong stock market over the last ten years I have been anxiously watching to see if a stock market bubble developed. My basic asset allocation strategy has been to stay 100% invested in stocks unless I decided the stock market was in a true bubble. In that case my strategy calls for a switch to short term bonds.
I have read with great interest, over the years, opinions about bubbles written by Jeremy Grantham. He is smart and experienced and I share a lot of his views about how the stock market works.
In the last few years he has become convinced we are in a true stock market bubble. He even calls it a superbubble. With some trepidation I have to say I disagree with him. That’s what I want to explore in this post.
50% drawdowns
Before we get to bubbles, there is a bit of stock market wisdom we need to refer to. Ben Graham tells us: “In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.” (Graham, The Intelligent Investor, fourth revised edition. 1973) p101.
The stock market experiences great volatility. Even big drops are not necessarily caused by bubbles. As I recall, the S&P 500 dropped some 43% in 2008 in the bear market brought on by the Great Financial Crisis of 2008. That drop was not caused by a stock market bubble. It was caused by a financial crisis.
What distinguishes drops following bubbles is that it can takes years for the stock market to regain ground lost. Following the market top of the dot com bubble it took some 14 years for the S&P 500 to decisively make new highs. Whereas, following the market top before the Great Financial Crisis it took 7 years for the market to make new highs. The same can be seen in all true bubbles. I agree with Grantham that in the last 100 years there have been only three true North American stock bubbles, what he calls superbubbles; 1929, 1972 and 2000. The gold bubble of the 1970s when the price of gold rose by 2,276% in ten years and the Japanese stock market bubble of the 1990s followed the same pattern. It took decades for prices to recover.
Grantham’s bubble call
His August 31, 2022 report is titled: ENTERING THE SUPERBUBBLE’S FINAL ACT. He writes: “We’ve been in…. a true superbubble, for a little while now. And the first thing to remember here is that these superbubbles, as well as ordinary 2 sigma bubbles, have always – in developed equity markets – broken back to trend. The higher they go, therefore, the further they have to fall.”
His current call is expressed as follows:
“My theory is that the breaking of these superbubbles takes multiple stages. First, the bubble forms; second, a setback occurs, as it just did in the first half of this year, when some wrinkle in the economic or political environment causes investors to realize that perfection will, after all, not last forever, and valuations take a half-step back. Then there is what we have just seen – the bear market rally. Fourth and finally, fundamentals deteriorate and the market declines to a low.” (Emphasis added)
He is basically telling us to expect Armageddon. For his report see here.
Grantham’s bubble thesis explained
We can go back and look at what Jeremy Grantham has written before. He seems to have become concerned we were in a bubble back in 2017. His report titled Bracing Yourself for a Possible Near-Term Melt-Up was dated January 3, 2018. He wrote:
“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.” (Emphasis added) To access this report see here
Euphoria indicated by price acceleration
Grantham continues: “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.” (Emphasis added)
The following chart Exhibit 4 in Grantham’s January 2018 report purports to show what would have been necessary to identify an ‘acceleration of price’ on a chart. It suggests the S&P 500 would have to steepen its slope substantially over the slope of the previous eight years. We can see this depicted in red and orange.
The problem with this chart is that the y axis is arithmetic not log. It is thus completely misleading as a way of identifying price acceleration. The space between 1000 and 1500 is the same as the space between 3,500 and 4,000. The problem with using an arithmetic y axis is that prices will appear to accelerate even if the rate of change is stable.
Look at the chart below that I made using Metastock. It shows the S&P 500 from 2013 to the present with a log y scale. The space between 1500 and 2000 is significantly larger than the space between 3,500 and 4,000. You can see the period in late 2017 ringed in red. There is an increasing slope to the S&P 500 in that period that certainly shows a price acceleration.
My point very simply is that while price acceleration is a useful indicator, you have to use a chart with a log y axis or you could be seriously mislead. You need to see a trend of increasing steepness on a semi log chart. I explain this clearly in earlier posts: Use of charts and statistics to identify bubbles and Chart distortions that drive me crazy
We will come back to this chart in a moment.
Concentration and the outperformance of quality
Grantham’s 2018 report uses the Nifty Fifty bubble of the late 1960s and early 1970s to illustrate two other indicators of bubbles. He says “as the market soars, attention is increasingly focused on those with the largest earnings and stock price gains, and interest in the B players falls away.” This is concentration.
Next he refers to the “the outperformance of quality and low beta stocks…” In the 1960s the quality stocks were the nifty fifty. In the 2010s they were the FAANGS.
Two standard deviations
In his 2018 report Grantham tells us about a further indicator: “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.”
To look at this indicator we need a chart with a linear regression line accompanied by a channel showing two standard deviations from the regression line.
Let’s go back to the chart below which shows the S&P 500 for the period 2013 to the present, i.e. for nine years. A linear regression with a channel set at two standard deviations is shown. In late 2017 the S&P 500 remained well within the two standard deviation channel. This was the main reason I felt that late 2017 was not a true bubble. I prepared the chart using Metastock.
We can see on this chart a bit of price acceleration in 2017 ringed in red. The price line trends increasingly steeply for a while. It indicates a bit of growing euphoria.
Two standard deviations and the dot com bubble
Now let’s look at a chart of the S&P 500 from 1988 to the present in order to see and understand the dot com bubble. This is shown below. The main thing to draw from this chart is that the dot com bubble shows what happens when the stock market goes well outside two standard deviations
The other thing is that the blue boxes represent the physical size of drawdowns of 50%, 10% and 20%. These boxes can be used anywhere on the chart because of the log y scale. We can see the 20% drawdown that started in January of 2022. If we wanted to see what a 50% drawdown from January of 2022 would look like we can simply place the 50% rectangle in place of the 20% rectangle.
As an aside we can see that the two standard deviation channel on the earlier chart from 2013 to present shows the January 2022 high some distance from the upper channel. The longer term chart from 1988 to present shows the January 2022 high right on the upper channel. These channels are sensitive to the period of data presented.
High prices
An essential condition of bubbles is high prices. As we’ve seen above, high prices alone will not do it. To understand where Grantham is coming from we need to look at his firm’s view of price levels.
In October of 2021 GMO’s Asset Allocation Team published a note titled: GROWTH BUBBLE: Making Money on Companies That Make No Money . For the report see here.
Their view that there was a growth bubble in the stock market was based on their assessment that “more than half of U.S. Growth stocks have negative earnings, yet Growth stocks have dramatically outperformed in the past few years.”
There is no mention in this note of the other indicators of bubbles such as extremes of euphoria, or prices outside the two standard deviation channel or of price acceleration. I wrote a post about this note and offered the view that the growth companies mentioned tended to be companies making investments in intangibles of lasting value where the investment is written off against earnings but doesn’t show on balance sheets. I suggested that reported earnings and price earnings ratios needed to be revisited in light of that change. I also felt that GMO was in error in using trailing twelve months earnings that had been impacted by the 2020 Covid recession. My post on this: My thoughts about GMO’s ‘GROWTH BUBBLE’
Conclusion
As I noted at the beginning of this post, Ben Graham tells us to be ready to see our portfolios go down in price regularly. This does not depend on the bursting of a bubble. Stocks can simply get overpriced and go through a correction. It’s entirely possible the market could go down by 30% from here for whatever reason.
I do not, however, think we are in the last stage of the bursting of a bubble or superbubble as Grantham would call it. I didn’t see the stock market as unduly overpriced last January at the market top. I saw no inordinate euphoria in the market last January. I didn’t see a price acceleration in the year or two leading up to last January. I didn’t see particular concentration or a special outperformance of quality. And those indicators are little different today.
So why does it make a difference whether there is a bubble or not. A bull market and its denouement are like a summer storm. A bubble is a category 4 hurricane. It requires special thought and handling. The bursting of a true bubble could take investors decades to pick up the pieces. If I thought we were in the bursting of a true bubble I would sell all my stocks and go to short term bonds.
What I see right now is the potential unwinding of a bull market. On that basis I see no need to change my 100% stocks asset allocation.
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I’ve written other posts about bubbles and what you should do about them. See:
What you need to know about bubbles
My thoughts on asset allocation
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If you would like to read further about bubbles, they are dealt with in the Motherlode in Chapter 29. Bubbles, crises, panics and crashes
That Chapter continues with these Sections:
29.01 What to do about bubbles?
29.02 The subject of bubbles has been studied
29.03 Globalization and bubbles
29.04 Bubbles have always been with us
29.06 Warning signs of a bubble
29.10 CAPE as an indicator of bubbles
29.11 Use of charts as a warning of bubbles
29.12 New era talk – this time is different
29.13 Barbers giving stock market advice
29.14 Corporate predatory behavior
29.16 No bell goes off to warn the investor of an impending crash
29.17 Picking the time to go to cash
29.19 Selling by others during a panic
29.21 No return to the dark ages
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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