For those of you with a memory longer than a few days, it was Jeremy Grantham of GMO who famously called the bottom in the great GFC equity rout. Whilst I never put anyone on a pedestal, Granthan is one of the few equity strategists that sees the way markets actually work these days. Overnight he issued a big fat sell warning.
In addition to entering Year 3 last October, we also had Bernanke’s QE2 … a kind of underlining of the seemingly eternal promise of a bailout should something go wrong, as if Noah had been sent not just one rainbow, but two! So, even though the market was substantially overpriced by last October 1, I found myself atypically writing that it was likely that the market would race up to the 1400 to 1600 range on the S&P 500 by October 1 … Well, believe it or not, the third year has behaved perfectly for the ﬁrst seven months. At the end of April, the S&P had offered up 21% in total return. And the market at 1360 needs just a 3% rise to reach my lower limit of 1400 in the ﬁve months remaining. All of this has occurred as if everything is normal…
Grantham goes on to outline the four challenges that this rally has powered through, the MENA and Japan shocks, as well as spiking commodity prices and rising interest rates in the developing world. He concludes:
So, we have four factors working against the Fed effect (or 4¼, counting my more lightweight “sell-in-May” factor, which suggests that all of the normal Year 3 exceptional performance may have been delivered already). With these headwinds, I do not feel the same degree of confi dence that I did, which was considerable, that the Fed could carry all before it until October 1 of this year. A third round of quantitative easing would very probably keep the speculative game going. But without a QE3, there seem to be too many unexpected (indeed unexpectable) special factors weighing against risk-taking in these overpriced times. I had recommended taking a little more risk than was justified by value alone in honor of Year 3, QE2, and the Fed in general. Risk now should be more reflective of an investment world that has stocks selling at 40% over fair value (about 920 on the S&P 500) and fixed income, manipulated by the Fed, also badly overpriced.
Although the taking of some “extra” risk by riding the Fed’s coattails has been profitable for six months, I admit to being a bit disappointed: I really felt the market had the Fed’s wind in its sails and would move up deep into the 1400 to 1600 range by October 1, where it would be, once again, over a 2-sigma 1-in-44-year event, or, offi cially, a bubble. (At least in a world where GMO is the offi cial.) At such a level, I was ready to be a real hero and absolutely batten down the hatches, become extremely conservative, and be prepared to tough out any further market advance (which, with my record, would be highly likely!). The market may still get to, say, 1500 before October, but I doubt it, especially without a QE3, although the chance of going up a little more by October 1 is probably still better than even. And whether it will reach 1500 or not, the environment has simply become too risky to justify prudent investors hanging around, hoping to get lucky. So now is not the time to fl oat along with the Fed, but to fi ght it. Investors should take a hard-nosed value approach, which at GMO means having substantial cash reserves around a base of high quality blue chips and emerging market equities, both of which have semi-respectable real imputed returns of over 4% real on our 7-year forecast. The GMO position has also taken a few more percentage points of equity risk off the table.
Firstly let me say that Grantham’s notion of front-running the Fed is, to my mind, all that matters in this market cycle. In fact, I would go further than Mr Grantham. I see rising commodity prices not as a challenge to the rally but the sine qua non of the rally. Via the falling dollar, commodities are the only game in town. Of course there are limits to that game, given that commodities are a fundamental input into the real economy, not to mention human beings themselves.
Like Grantham, I have argued that the rally could get through the end of QE2. There was so much momentum in it, and markets always seem at such times able to manufacture enough liquidity to keep running. Crucially, I thought as well that the $US could remain the world’s whipping boy because everyone would raise rates ahead of the Fed (QE3 or not).
But as I said last week when commodities began to crash, a 2% pop in the $US is not normal. It is a signal that something just broke and a harbinger of weakness to come.
So here’s where I think we are now. The Fed has committed to end QE2 even as US data is weakening. Normally the weakness would be a good thing for this rally because it would signal more Fed easing. But now, it’s too early and the Fed can’t spin on a dime. It will need to see more weakness to turn around.
Second, the EU has backed off on rate rises and that is pressuring the euro. Throw in a Greek default/bailout and that puts upward pressure on the $US.
Third, in the last week we have also seen moves by the CME to raise commodity reserve requirements, introducing a new regulatory risk to the flipside commodity play.
Fourth, commodity inflation is hurting developing economies and rate rises continue. The tightening does not appear yet to be causing any great slowdown but is hitting commodity demand in advance of one.
These four forces are disrupting the driving narrative of the rally. For two years, the rally narrative has been the global reflation play emanating from the end of Bretton Woods II. It is the story that the US can no longer grow on internal demand stimulated by debt. The ongoing proof of which is still its collapsing housing market. It must find an external source of demand to grow. It does this through weak monetary policy that debases the $US. This, in turn, stimulates demand in developing economies through their currency pegs. China is inflated and its commodity demand rises. Commodities then get the double pump of developing economy demand and a fall in the $US, against which they are relatively priced. This is the global inflation play. Whenever the dollar rises, it is off. Simple as that.
Grantham also argued that he may be early on his call this morning. I disagree. I think he’s got the timing just right. We’re headed into weakness until the underlying narrative can be restored. The $US MUST weaken for equities to rise. The moot question, however, is must the $US also keep weakening to sustain the US recovery.
My best guess is that this will be a pause in the great reflation rally; a sell down of sufficient strength to be seen as the harbinger of a triple dip in US growth. When that idea takes hold, the Fed will move to QE3 and we will enter what I think will be the final up leg of the cycle. For now, however, Granthan is right.
As always in this rally, be aware that it’s for traders only. The next time someone advises you to buy and hold stocks, get up and walk out.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
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