Veteran value investor Jeremy Grantham (Trades, Portfolio) said is his note published on Jan 5, 2021 that we are in the epic bubble on the scale of "South Sea bubble, 1929, and 2000." While it is impossible to know when this bubble will burst, we know it will sooner than later. As Grantham wrote in the note,
"These great bubbles are where fortunes are made and lost – and where investors truly prove their mettle. For positioning a portfolio to avoid the worst pain of a major bubble breaking is likely the most difficult part. Every career incentive in the industry and every fault of individual human psychology will work toward sucking investors in."
In the letter, Grantham cites several examples of bubble behaviour in the U.S. stock market. He points out that the Buffett Indicator is at record high and the Shiller price-earnings ratio is at the second highest level in history (second only to the 2000 bubble). He also points out the number of IPO's in 2020 are more than the number of IPO's in 2000, which often indicates yield starvation and taking advantage of bubble prices.
Another indicator which is followed by value investors, called the Tobin Q indicator, is also at an all-time record. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. This corroborates the conclusion of the Buffett Indicator and the Shiller price-earnings ratio of extreme overvaluation in the US stock market.
Grantham notes that since the short-lived bear market last March 2020, the market as represented by the S&P 500 has almost gone vertical. While half of the rise could be in reaction to the bear market, the other half appears to be sheer exuberant momentum, an indicator of the late stage of market mania. He says that with prices moving further away from the trend, at accelerating speed and with growing speculative fervor,
of course my confidence as a market historian increases that this is indeed the late stage of a bubble. A bubble that is beginning to look like a real humdinger.
The chart below shows that the S&P 500 is up over 60% from the bear market bottom of March 23. This is quite extraordinary given how the real economy has been wounded by the global pandemic which we are still enduring.
What could cause this fever to break? I think the following are some clear risks which we will have to keep our eyes on.
- The economic recovery. If the market perceives that the economic recovery from the pandemic is anything other than V-shaped, this may cause the bubble to burst.
- The sudden appearance of inflation. Given the amount of liquidity pumped into the system following Covid, even if the economy does deliver a V-shaped recovery, inflation may rear its head. This will cause short term rates to rise, and with the Fed holding down long term rates, there is a risk that yield curve might flatten or reverse. This could cause investors to recalibrate as an inverted yield curve may portend a double dip recession in the near future.
- Something happens to the leaders of the stock market bubble, e.g., one of the FAANG stocks is affected by antitrust lawsuits or similar. Given that these stocks are "retail investor" favourites are now such an increasingly larger part of the S&P 500 index, a stumble by one or two them can trigger a run on the index due to margin calls and out of the money call options.
The following chart shows the outperformance of the FAANG stocks compared to the rest of the S&P 500 over the last eight years.
The following chart compares the price of Tesla (TSLA, Financial), a retail investor darling, with General Motors (GM, Financial) and the S&P 500 since March 23, 2020, which marked the bottom of the bear market. As we can see, Tesla's stock has gone ballistic.
Another sign of reckless behavior by investors is the sheer number of "call options" being bought.
Where to Hide?
Grantham offers a couple of suggestions on where to hide as this fever crests and then passes. High-quality bonds are also in a bubble as yields are so low, so they do not offer much protection.
Specifically, Grantham likes Value Stocks and Emerging Market (EM) Stocks and advises to avoid U.S. Growth Stocks. Value has underperformed growth for a few years now and the underperformance has been huge in 2020. Emerging market stocks have been far worse. As U.S. Growth Stocks "revert to the mean," Value Stocks should offer protection as they have not participated in the bubble as much, and EM's not at all.
The following chart shows the performance of S&P 500 index (GSPC) vs. Vanguard Growth Index Fund ETF Shares (VUG), Vanguard Value Index ETF (VTV) and share MSCI Emerging Market ETF (EEM).
Conclusion
There is no doubt the market is over-valued - I certainly agree with Grantham on that point. At the same time, it cannot be denied that market has bifurcated into bubble stocks and non-bubble stocks. It makes sense to lower risk in our portfolios, take some profits from the winners and start to rotate to areas of the market which are not as bubbly, such as Value Stocks and EM's.
This means avoiding bubble areas like technology, hot IPO's and electric vehicles and holding solid value companies like Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), which is one of my favourites, or undervalued sectors such as energy and real estate.
Disclosure: The author owns shares of Berkshire Hathaway.
Link to Grantham's note: WAITING FOR THE LAST DANCE.
Read more here:
- Lessons From the China Mobile - NYSE Flip-Flop
- CRH Medical - Don't Be Seduced by the Free Cash Flow
- Berkshire Is Still One of the Best Values in the Market
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