Bracing for a near term melt-up

I wanted to follow up on Jeremy Grantham’s comments from yesterday and run through some of GMO’s asset allocation views from the perspective of an Australian investor.

Jeremy Grantham & Co. at GMO have put out two thoughtful (as always) pieces in the last 3 weeks. I rate the team there highly and so when I have a different view I take that as a sign that I need to go back and triple check all of my assumptions.

Article 1

In late December we got the latest quarterly, which was full of hand-wringing over what to buy when everything is expensive. Which I have a lot of sympathy for, trying to deal with the same issues.

First Ben Inker considers a depression scenario and an “inflation problem” scenario and the effect that he thinks each would have on a portfolio – neither are pretty:

He also looks at other assets which could save you and settles on emerging market equities as the winner.

To be clear, our fondness for emerging equities today is driven overwhelmingly by their cheaper valuations, not a speculative belief in their resilience against an event that has not occurred since emerging became an institutionally buyable asset class. But if worse did come to worst and inflation flared up, owning a good chunk of the only equities that remember what inflation is like seems like a decent idea.

Then Jeremy Grantham puts in his view:

Inside GMO there are three different views on whether and how rapidly the market will revert to its pre-1998 normal:

  • James Montier feels it will be business as usual and revert within 7 years. Ben Inker also holds out for a 7 year period, but includes a 33% chance it will revert to a higher average valuation (the “Hell” scenario). I believe that the reversion on valuations will take 20 years, and that profit margins will probably only revert two-thirds of the way back to the old normal.
  • All three outcomes are quite possible. This creates a difficult investment challenge.
  • My proposition, though, is that there is an optimal investment for all three outcomes: a heavy emphasis on Emerging Market (EM) equities, especially relative to the US.
  • To concentrate the mind, I fantasize about managing Stalin’s pension fund where the penalty for failing to deliver 4.5% real per year over 10 years is death. I believe only a very large investment in EM equities will give an excellent chance of survival.

He also highlights early-stage venture capital as being an opportunity.

There is a lot more to it, covering themes that we express here on this blog and that we spend a lot of time internally debating as well – mainly what tail risks are there, how likely are the outcomes and over what time frame will the themes play out.

Article 2

Last week, Jeremy then published his “Bracing Yourself for a Possible Near-Term Melt-Up (A Very Personal View)” piece:

I find myself in an interesting position for an investor from the value school. I recognize on one hand that this is one of the highest-priced markets in US history. On the other hand, as a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market. The data on the high price of the market is clean and factual. We can be as certain as we ever get in stock market analysis that the current price is exceptionally high. In contrast, my judgment on the melt-up is based on a mish-mash of statistical and psychological factors based on previous eras, each one very different, so that much of the information available is not easily comparable.

Grantham highlights that he (and another notable bubble expert, Robert Shiller) can’t see the signs that stock markets are overheated and euphoric.

Grantham highlights the advance/decline line as being one of the signs in the past, and that this is not delivering threatening messages.

Summary of my guesses (absolutely my personal views)
■ A melt-up or end-phase of a bubble within the next 6 months to 2 years is likely, i.e., over 50%.
■ If there is a melt-up, then the odds of a subsequent bubble break or melt-down are very, very high, i.e., over 90%.
■ If there is a market decline following a melt-up, it is quite likely to be a decline of some 50% (see Appendix).
■ If such a decline takes place, I believe the market is very likely (over 2:1) to bounce back up way over the pre 1998 level of 15x, but likely a bit below the average trend of the last 20 years, as the trend slowly works its way back toward the old normal on my “Not with a Bang but a Whimper” flight path.

Our interpretation

There is a lot in here, I’ll give a quick summary of our view and follow up more on these in later posts. Overall we have broad agreement with the views and market assessment – but we differ in a few key areas:

Inflation vs deflation

Ben is right that if runaway inflation becomes a problem, then every asset (excluding cash and inflation-linked bonds) are in trouble.

We contend that runaway inflation is unlikely to be the case, that rebalancing in China away from capex will constrain commodities, increasing inequality will constrain demand and generally high government debt levels will constrain fiscal expenditure.

Our portfolio is positioned for the opposite. There are risks, but our view is that low inflation is still the enemy. This inflation will be masked for a few years by Trump tax stimulus and the recent rise in oil prices, but until inequality reverses we do not expect any sustainable demand increase.

If you were equally worried about all scenarios, we can see why you would reach Ben’s conclusion. And over the next few years, we very well may see a spike in US inflation – it seems that Trump is trying to engineer a boom at a time of close to maximum employment after all. Our view is that this will be cyclical (i.e. a medium-term outcome) though rather than structural.

AUD Effects and Melt-up

We run a similar model to GMO when looking at long-term asset values. Here is GMO’s outlook:

In a relative sense, excluding emerging markets, we have a similar outlook. Our view is that a mix of international quality and value offers far and away the best returns at the moment. We also struggle to find US equities that are worth buying.

The main differences we have in our portfolio (excluding emerging markets which is covered below) are:

  1. Currency. We are investing in Australian dollars (GMO are investing from a USD perspective), and so at the end of historically high mining and housing booms, the risk is to the downside.  The end result of the twin booms is that Australia is expensive to business in due to high rent, high energy prices and high wages. We also hollowed out our manufacturing sector. All these add up to the Australian dollar needing to be lower to restore competitiveness. The Australian dollar also provides us with a useful hedge that the GMO doesn’t have when investing in USD.
  2. Timeframe. Our portfolios are sided with Jeremy on both the reversion to the mean and the melt up. Central bank action and the preponderance of the “extend and pretend” approach to debt crises suggests no quick resolution and so we are expecting a slower reversion to the mean in the long term. In the short term its hard to see any impediments to the market rising though. So we are cautiously long international, with an eye to many of the signs that the market is reaching the end game as a signal to wind back our equity exposures. But we agree that it is not yet time to get out of the stock market.

Emerging markets

There will be stocks that will perform well in emerging markets. I don’t like the blanket buy of emerging markets from GMO though.

First, I don’t think emerging markets are as cheap as GMO proport. At a headline level, emerging markets look cheap, but dig deeper and it is not true:

12 month forward Price / Earnings BY SECTOR/REGION
Global 12m Forward P/E by Industry

Source: Factset, Nucleus Wealth

Energy materials are cheap in emerging markets. How many Russian energy stocks would you like?

Finance stocks are cheap in emerging markets. How many Chinese banks would you like to own?

Utilities are cheap in emerging markets. Are you looking for a chance to buy government-regulated assets in 3rd world countries, dependent on the whim of leaders who want to keep electricity prices artificially low? Be my guest.

Flip to a sector that everyone wants to own. A growing middle class in China and India will be great for health care going forward. But these stocks are some of the most expensive stocks in the world, so be prepared to pay up for the privilege.  They aren’t cheap.

And that is before we look at Chinese state-owned enterprises – these are some of the largest companies in emerging market indexes, and so they trade at a discount because they answer first to the Chinese government before they answer to shareholders. Take these out and some of the average-priced emerging market sectors above start to look expensive.

Finally, as a general trend, I’m expecting robotics and automation to mean that (at the margin) more manufacturing is done in developed markets in coming years.

Summary

While I spent most of this post talking about the differences in our view, the reality is that I’m more heartened by the similarities in our outlook than I am concerned about the differences.

Australian investors face a different set of risks, and so need a different allocation.

Damien Klassen is Head of Investments at the Macrobusiness Fund, which is powered by Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.

Comments

  1. sydboy007MEMBER

    I suppose the question is would you still think moving cash out of the AUD into overseas shares?

    The AUD just keeps on keeping on. I’m starting to think we’ve discovered artifical gravity.

      • Interest rates are going down in Australia. This is the only way to stop the housing crash, or at least kick the can down the road.

        I expect QE from the RBA by 2020.

      • RE as Gough said, Nothing will save housing
        housing is related to debt is related to the ability to repay it is related to jobs is related to hourly wage for most.
        the quicksand has started under hourly rates jobs are next.
        A calamity in housing is assured…there is nothing which can alter the outcome

    • In the US,
      Quantitative Tightening will be abandoned this year.
      One more rate hike, but you can’t outlaw stupidity by the Fed. They might go twice.
      Economic data deteriorating.
      Plenty more weakness in the USD to come.

  2. We need to wait for this year
    The first sector to start heading lower is ANGLO property
    Aust Canada Scandamvia etc
    We have to see how that affects the economy in oz
    But I think Aust will be forced to cut int rates in the 2nd half of the year
    Then pressure on the AUD

    • No US Boom

      http://bonddad.blogspot.com.au/2018/01/a-us-economic-boom-in-2018.html

      Not as strong as it looks and all done on credit

      http://moslereconomics.com/2018/01/09/consumer-credit-small-business-index-jolts-rig-counts/

      With the Fed unwinding its balance sheet in a faster manner all the time and the US gov. looking to run 5% deficits at the top bonds could be hard to shift………..4% long rates will crush these financialised economies……..my old long bonds are rolling over now and 4% long bonds here is what I want. to reinvest.

      • Nyleta
        I agree that it’s debt that’s fueling this growth especially in Australia
        That’s borrowing money from the future and one day the future will come
        When that is that’s anyone’s guess

      • D. populations all over the globe have tried the pinko softly PC coloured style of leader in some sort of bizarre social experiment. Straya is right up there in the boot em out stakes, is it 5 in 11 years.
        but remember the punters wanted these past failures, including turnbull,
        Someone who can make a difference who is not in the pussycat mould of the past is TD.
        IN the US the punters voted for someone who will go to battle for the country. Make the US great.
        How many patriots in our govt, thus we still have to find that leader,
        but it wont be till after the collapse of the economy
        No one would be silly enough to take the wheel before then.
        How about in QLD the opposition LNP dont wish to have anything to do with governing the state,
        hence we have the current Lab govt to carry the can.

  3. Even StevenMEMBER

    I like the explanation of your positioning against GMO’s, Damien.

    I struggle with GMO’s proposition that the ‘EM will remain resilient’ (in the face of a developed market crash). I’m skeptical. Instead, a developed market crash could be the trigger for all the credit bubble behaviour in the likes of China to come undone.

  4. Ben is right that if runaway inflation becomes a problem, then every asset (excluding cash and inflation-linked bonds) are (sic) in trouble.

    Not precious metals … or are they too ‘barbarous’ for your liking?

    • We already have runaway inflation.

      It is just limited to the assets that the rich will buy like houses and shares. This is because of the way all this newly printed money is pumped into the system.

    • Damien KlassenMEMBER

      Yep – gold “may” be a hedge on inflation, but there are a lot of ifs and buts. It will be situational.
      In the last great inflation surge in the 1980s gold was not a useful inflation hedge.

      • Damien KlassenMEMBER

        Thanks for your charts – they illustrate my point nicely.
        In the 1970s gold was a great inflation hedge as inflation reached crisis levels.
        In the 1980s, gold fell 30-40% (depending on your starting point) while inflation ran at between 5-10% per annum. An inflation hedge is an investment that doesn’t decline for a decade while inflation runs at greater than 5% per annum.
        This is exactly my point – gold can sometimes be an inflation hedge and sometimes it isn’t.
        You might be confusing a “crisis hedge” with an “inflation hedge”. Gold tends to be a good crisis hedge.

      • All I can tell you is that I saw inflation coming in the early 70s, bought gold, and sold it near its peak. The profits insulated me from the damage the inflation caused over the entire 1975-85 period.

        Maybe I was lucky. Or maybe I’m a very canny investor 👌

  5. if these US rates keep strengthening and differentials expand, swap spreads expand, wouldn’t the USD strengthen?

    • This is my view too. I am basically clinging to the old rule of “forex doesn’t make sense, until it does”.

      Give it time.

  6. My perspective:

    NASDAQ/NYSE feels like 2010 Sydney housing market. Everything is costly yet there is an eerie feeling that there is some unknown forces that will push it through the melt-up (exponential).

    To you give some background, I was not earning much at all in 2010. There was the talk of Sydney housing market being in a bubble and one my friends bought a very small 2bedroom unit in Berala(NSW) for $180K. I could have afforded that, if I had stretched. Everything appeared costly, but had an errie feeling that ‘this is not the end’. Being as logical and pragmatic as I am, decided to ‘ignore my eerie feeling’ and look at the data. Data said, “they are costly”. So did not do anything and I missed an opportunity.

    It is now 2018, NASDAQ/NYSE appears costly, data says “its costly, could be a bubble”. But damn it, my eerie feeling is back again saying “this is not the end”. This time around, I am not holding back. Plagiarizing this quote from this tweet (https://twitter.com/_mumbling_me/status/950856090123583489) “In God we trust, for the rest price action is the only thing that matters” 🙂

    • The Traveling Wilbur

      I am not alone! I thought I was going nutso for a while there.

      (no comment on the not buying Syd. prop. @ 180k though. bummer)

  7. Wow so much effort being expended to conclude that humans are social creatures and as such they love crowded markets. Call it the herd instinct but the bottom line is that we will always be focused on exactly those markets where our social group is also focused. Logically this crowding force produces both melt-ups and melt-downs. An investing mentor of mine used to say that momentum indicators contained very little factual, verifiable information beyond the sign. To be a successful Momentum investors all you really needed to know was the sign (positive or negative) and maybe the timing of the change of sign…although the latter was somewhat optional and was largely determined by the change in sentiment of your social group. From what I can tell nothing has changed in the thirty odd years since I first received this investing advice.

  8. “. . . but until inequality reverses we do not expect any sustainable demand increase.”

    You might be waiting a long time Damien!

    With historical perspective we can now see the industrial era – culminating in the 20th Century – was an anomaly which temporarily improved workers’ bargaining power.

    The industrial era saw human physical power and human physical dexterity replaced by machines, while humans themselves retained cognitive superiority. Indeed, industrialisation made workers’ cognitive superiority relatively more valuable since a properly trained human could control a much greater value of production. By striking (legally or otherwise) they could quickly impose on owners of capital greater pain they they themselves suffered.

    It is no coincidence that Piketty’s nadir of inequality occurred some 40 years ago, just as the industrial economy was giving way to the post-industrial services economy. Services changed the balance of power. If industrial workers went on strike, they would get a pay rise. If a fitness trainer or an Uber driver goes on strike, who would even notice?

    Such anomalies have occurred before. The Peasants’ Revolts of 14th Century Europe arose from the acute labour shortages caused by the Black Death.

    But just as the 14th Century revolts were crushed as soon as conditions permitted, so the industrial era “revolt” has been crushed.

    Farm wages in England doubled between 1350 and 1450 but then remained unchanged for 400 years (until the advent of mechanised farming improved bargaining power once more).

    With AI and robotics now removing the cognitive superiority of human workers, there is no reason to expect any quick end to increasing inequality.

    • YR dancing around the issue the mechanical revolution didn’t have the frictionless transfer of information to aid its roll out. How about this:
      Up to 30% of the hours worked globally may be automated in 12 years.
      Almost half of those made redundant will have to find entirely new occupations, since their old one will either no longer exist or need far fewer workers.
      The majority replaced will be city located,, mid-career,, workers, in their 30s, 40s and 50s
      And the key is to accelerate the roll out of AI robotics, because a slowdown “would curtail the contributions that these technologies make to business dynamism and economic growth.”

      WHY: The adoption of AI and robotics by companies restores the power management has over the “workforce”, to manage or micromanage their organization, and to receive unadulterated feedback on its performace. Management has lapped up this opportunity.
      As the older, more experienced people retire, their knowledge can be assimilated by software and built upon by youngsters who have no real experience in management.

      Artifical Intelligenge when compared to Humans has these advantages:
      Economics Much cheaper, and becoming more so
      Speed Much faster
      Accuracy Far more accurate and precise
      Reliability Far ahead (many have error correction built in)
      Rapidity of control Many machines are unstable and need AI to make them practical
      Freedom from boredom — An overwhelming advantage
      Bandwidth in and out — Again overwhelming
      Ease of retraining — Change programs, not unlearn and then re learn the new .
      Hostile environments War, space, underwater, radiation manufacturing situations
      Personnel problems Dominate management of humans but not of machines; with machines there are no pensions, personal squabbles, unions, personal leave, egos, deaths of relatives, recreation, meal times holidays, day or night is all the same.

      Once you program a computer is has an IQ at least equal to the highest in the nation
      The now near ubiquitous internet was designed to share information, knowledge.
      That this information is best shared by AI and robotics is to the absolute disadvantage of humans.
      We can’t down load a full upgrade for our brain. The internet for machines could develop an intelligence of itself to the detriment of humans.(it is not as though humans have set the benchmark on global kindness)

      The real killer is growth, human performance is limited by our physiology, it is linear, eg we can do just about the same as our parents and their parents before them. Say going back 120 years,
      We need time out for meals holidays family; humans have physical and mental limits.
      Computers grow exponentially, like compound interest , worse, we are just about exhausted with the development of humans, but we are just getting started with AI robotics.
      In another 20 years we will still be mostly the same, where will AI be?

    • Damien KlassenMEMBER

      I’m thinking that the rise of communism had a great deal to do with the fall in inequality – better give the peasants more in case they revolt. The fall in communism then meant that its now open slather on inequality.
      So, I agree we could be waiting a long time.
      I’m hoping that Trump’s swing to the right will result in a swing in the opposite direction, but I’m not making any investments on that basis – you are right that the trend is towards more inequality.

  9. High goverrnment debt levels don’t constrain government expenditure. The US has clearly shown how a fiat currency can be spent by government to create employment with the bonds issued being bought by banks, repurchased by the central bank which then receives the interest from the government but returns it to the treasury as a dividend. The banks which sold the bonds receive payment in terms of increased reserves on deposit at the central bank. The commercial banks don’t need to withdraw these reserves to lend as they (as the Bank of England has acknowledge in a published paper) can create money as loans from nothing (subject to compliance with a series of limiting factors imposed by government).
    With sovereign currency issuers like Australia, US, England, Japan, China (as opposed to states like California, NSW, Wales) taxation is not required to fund spending in the domestic currency.
    Default by sovereign issuers of fiat currency is a political act, not an inability to issue more currency.
    The constraints are inflation and the relative value of the currency.
    Where a country borrows unhedged in a different currency (eg Argentina) then it has a potential solvency or liquidity problem, but not if all its liabilities are in its domestic currency which it can spend/pay at will.

    • Damien KlassenMEMBER

      I agree that there is no theoretical constraint – I would prefer that governments spend more.
      The practical constraint is the existence of deficit hawk politicians who are fighting every step of the way.

    • The limit to these splurges is when the person on the street realises that their stored excess labour ( in whatever doubtful store of value is in vogue at the time ) is being devalued to the point of nullity.

      Then they rush to spend this storage before it disappears ………hence you end up with a currency crisis………..if the political and legal systems survive you end up with new currency ( New Australian Dollars…one for ten say ) otherwise all bets are off as one can after another gets kicked ( Argentina….once the richest per capita country in the world )

  10. I would have thought nathan birch moving into bitcoin was more important than what jeremy grantham thinks.