Sunday, May 3, 2015

Are We There Yet?

We know that the markets are overpriced, but does that mean we are on the brink of a crash and burn?  In his Q1 letter from GMO, Jeremy Grantham gives his response to this question. 

He starts with the observation that the Fed is “bound and determined” to create another “full-fledged market bubble”.  It is hard to disagree.  Central banks of the developed world seem are caught on an unending treadmill of easy money.  They have little choice but to continue QE.

He then observes that the 21st century Fed has a record of stimulating until it has created a bubble.  He cites the NASDAQ bubble of 2000, and the housing bubble of 2006.  It is hard to disagree, especially when the Fed has little choice but to repeat this pattern.

In Grantham’s estimation, bubble territory for the S&P 500 is around 2250, compared to around 2108 now.  He expects either a normal bear market soon, or a march to 2250 followed by a bigger disaster.  It seems prudent to forecast at least two scenarios but bold to call a specific top.  Of course, it is just one more analysis for consideration, based on one set of assumptions. 

What Grantham didn’t say is that people are catching on that central bank policies are not working.  After the housing crash, the economy came back, but only in a “new normal” way.  Disaster was averted at the cost of economic vitality.  Real wages are stagnant or falling, debt is climbing again.  Income distribution is more skewed than ever.  The economic fabric of America has been puffed up and hollowed out, and other advanced economies are in little better shape.

We are borrowing from the future to live today, rather than cutting back consumption to invest in the future.  Under these conditions, the markets are valued on policy promises, not on dollars and cents.  People are counting on the Fed to save the markets.

“It’s different this time” is not a sound foundation for investing.

The Fed pumped up the market, but how high can it pump valuations?  Without real growth, the advance just pushes PE multiples higher.  People are catching on.

What we are heading toward is a crisis of confidence.