Another crash could threaten the end of Western democracy itself
Acynic might say that when the last sane man bows to the zeitgeist and succumbs to speculative mania, it marks the absolute top of the bull market. GMO’S Jeremy Grantham, the apostle of “value investing”, fears we are heading into one of the great asset bubbles of all time: a 50pc parabolic “near-term melt-up” on Wall Street, followed by an epic crash. If he is right, we face a wicked political denouement.
He sketches a chain of events that would in my view threaten the destruction of market liberalism, or what Marxists might call the “final crisis of capitalism”. We should expect voters will seek Jacobin solutions if there is yet another episode of gross economic and financial mismanagement that leaves the rich unscathed while taxpayers pick up the pieces.
It was long assumed that deranged booms can occur only once in an average lifetime – a sort of Kondratieff cycle – since those burned by postminsky depressions collectively prohibit the recurrence of such excesses. But here we are in dangerous territory again barely a decade after the US and EMU authorities allowed their respective debt bubbles to spin out of control, requiring an emergency rescue of the Western banking system and leading to a lost decade that ultimately proved more intractable than the Thirties in a string of countries.
Grantham is horrified. He advocates old-fashioned, disciplined investing: buying shares with intrinsic worth that are cheap and unloved but will come back into favour one day by the iron law of “mean reversion”. It is a strategy that relies on a close study of corporate entrails – profit margins, book worth – yielding steady returns for the patient.
“The data on the high price of the market is clean and factual,” writes Grantham. “We can be as certain as we ever get in stock market analysis that the current price is exceptionally high.”
The 10-year cyclically adjusted “Shiller” price-earnings ratio for the S&P 500 is currently 33.08, higher than it was on Black Tuesday of October 1929. But momentum can trump value: “As a historian of the great equity bubbles, I recognise that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market.”
Grantham learned his lesson in the dotcom and subprime booms: you do not stand in front of a freight train. Mood carries all before it when liquidity is abundant and momentum builds. To be too early – and to miss the final surge – is just as negligent for a fund manager as exiting too late. “Value investors are historically painfully too early over and over again, as I know better than most,” he said.
Wall Street is not exhibiting signs of euphoria. The markets have been “climbing a wall of worry”. The pace of the rally has picked up but has not reached wild acceleration. Technical indicators are mostly well-behaved. What is missing is the “primal scream” of divergence, where traders chase ever fewer stars as weaker stocks decline: “In previous great bubbles we have ended with sensational gains, both in speed and extent, from a decreasing number of favourites.”
A torn Grantham advises clients to join the stampede and buy as many emerging market stocks as their “career or business risk can tolerate”, and to pad it out with a broad range of larger global equities. Those who can’t cope with the stress of trying to time the perfect exit in such a mania should “sit tight” and ignore the advice. His assumption is that the US Federal Reserve will remain an engine of moral hazard. The Greenspan-bernankeyellen Fed has pursued a policy for asymmetry for a quarter-century, promising help if times get tough but letting booms roll on unchecked. The markets have learned to take this for granted.
The Fed found excuses – implausible as they now seem – to argue that there was no bubble in 1999 or in 2006. Grantham thinks there is little evidence that the institution has changed since. Janet Yellen stated just months ago that she will not see another financial crisis in her lifetime.
It is harsh to blame central banks for accommodating a fresh cycle of debauchery. They were left to carry the load alone after the Lehman crisis, with no legal mandate for radical forms of “people’s QE”. They were forced to rely on the “wealth effect” of asset purchases as the only tool left to fight the downturn. In hindsight, the whole machinery of government and fiscal policy a l’outrance should have been used to inject stimulus directly into the veins of the economy.
Yet the Fed and its peers cannot wash their hands of responsibility, blaming the “Asian saving glut” instead for overwhelming the world with excess capital. The central banks themselves entered into a Faustian pact from the mid-nineties onwards, falsely thinking it safe to drive real interest rates ever lower with each cycle, until they became ensnared in what the Bank for International Settlements calls a policy “debt trap”. This has gone on so long, and pushed debt ratios so high, that the system is now inherently fragile. The incentive to let bubbles run their course has become ever greater.
Grantham’s melt-up thesis may of course be wrong. The BIS critique of central banks has hit home. There is a growing feeling that asset booms are dangerous and that the task of financial stability should be taken more seriously. It is not hard to imagine a scenario this spring where US core inflation suddenly jumps, leading to a thunderclap of hawkish rhetoric from the Fed. This in turn would set off a global dollar squeeze, sending tremors through emerging markets. It could hit just as the delayed effects of credit tightening in China bite in earnest. We could see another bout of capital flight from China and a repeat of the yuan scare that so frightened investors in early 2016.
Nobody knows how much tightening our ultra-leveraged global system can endure. The Fed’s Wu-xia “shadow rate” suggests that there may already have been 16 “synthetic” rate rises in the US since mid-2014, once the effects of reducing and reversing QE are included. We may be closer to the end of the tightening cycle – and to recession – than people realise.
But let us assume that Grantham is correct. The melt-up will be followed by a subsequent melt-down of 50pc or so – a “real humdinger” in his words.
The rise and fall do not cancel each other out, either mathematically or in economic terms. We know from research by the International Monetary Fund that boom-bust episodes are highly damaging. They smash the furniture and leave a trail of innocent victims.
How would the West’s bruised democracies respond to the spectacle of another Gatsby-esque obscenity on Wall Street and in the City, followed by a double-dip depression? The clean broom of Bernie Sanders and Jeremy Corbyn would be the least of our worries. The great settling of scores that never quite happened after the crisis in 2008 might this time sweep away the entire economic order.
‘We know boom-bust episodes are damaging. They smash the furniture and leave a trail of innocent victims’