|Asset BubblesThe Investment U E-Letter: Issue # 436
Thursday, May 12, 2005 Asset Bubbles: Commentary from Jeremy Grantham and Eric Fry... 2 Original Wall Street Thinkers
By Dr. Steve Sjuggerud, Advisory Panelist, Investment U
I just returned from a week's vacation in the Dominican Republic. On my wife's orders, there was no financial reading allowed. Now that I'm back in the office, I've been busily catching up.
One thing I never miss is Jeremy Grantham's quarterly investing letters, so it was at the top of the pile. Grantham is one of Wall Street's few original thinkers. Quite frankly, you'd be surprised how few original thinkers are out there.
I read his latest letter commenting on asset bubbles, which just came out. It was excellent, as always, and my plan was to report to you on it. But later I read a letter by another one of Wall Street's original thinkers - Eric Fry. What was Eric commenting on? You guessed it Grantham's letter, like I planned to.
Eric Fry is not only a great thinker, he's a craftier writer than I am, too. So it doesn't make any sense for me to write you a letter about Eric's letter about Grantham's letter. Let's let the crafty and original-thinking Eric Fry do the talking today about the legendary Jeremy Grantham and his current investment thoughts on asset bubbles. So, what is an asset bubble? Read on...
The Australian Canary
by Eric J. Fry
Jeremy Grantham is a bubble-tracker. The chairman of investment firm Grantham, Mayo, Van Otterloo (GMO) seems to enjoy tracking and studying asset bubbles, much like a biologist might track and tag endangered California Condors.
Asset bubbles, however, are hardly an endangered species. Rare though they may be, several bubbles are currently frolicking in our midst, according to Grantham. In fact, he believes, a massive housing bubble is expanding throughout the English-speaking world at this very moment.
The British bubble is, by far, the most dramatic. But it is the Aussie bubble, he believes, that deserves the most attention. 'The Australian residential real estate market could be the canary in the coal mine - that is, a harbinger of bad things to come for a lot of us,' Grantham warns.
'Sydney house prices rose earlier and faster than any other. Australia also raised its rates earlier and further than England And both of these foreign markets have [a large proportion of] floating rate mortgages, so it would reasonably be expected that the effect of higher rates would impact prices faster.'
According to Grantham, the Aussie canary is already swooning a bit. 'Sydney prices are well off their highs,' he observes, 'although as yet far from a real bust.' But the 'real bust' is certain to arrive, he warns, because ALL bubbles do 'indeed move all the way back to (or below) the trend that existed prior to those bubbles forming.'
Grantham allows no exceptions, simply because he has never discovered a single exception in any financial market. Bubbles form; bubble burst; prices revert to the mean - this is the natural order of the financial universe.
Grantham and his research team have identified '28 good examples of previous bubbles' from within the world of global stock markets, currencies and commodities. 'I am patiently waiting for the current 28th bubble, the S&P 500, to go all the way back to trend - about 750 versus today's 1150,' he says. 'It fell to within 10% of trend in 2002, but still no cigar. But ALL the other 27 identified bubbles did indeed move all the way back to [trend].'
Applying the lessons learned from the financial markets to the real estate markets, Grantham reveals that inflated home prices are just as certain to burst as inflated stock prices, and therefore, just as certain to fall back to the trends from which they emerged.
'The key point in the U.S.,' Grantham emphasizes, 'is that in the recent three-year stock market decline, all the stock market wealth lost by the median family holding stocks was more than offset by a 21% advance in house prices. This favorable circumstance seems extremely unlikely to recur [next] time. The inevitable 30% to 40% decline in U.S. stock prices necessary to get to fair value, accompanied by flat to down housing prices, will pose substantially greater risks for consumer spending than last time.
'The 'best' reasonably likely outcome in the U.S.,' the bubble-tracker concludes, 'is that a moderate stock market decline in the next two years could be accompanied by up to one more year of average house prices rising, for the U.S. housing market has lagged the other countries and has some good potential for catch-up in certain regional markets
'But by this time next year,' Grantham warns, 'time would really seem to be running out for our U.S. housing semi-bubble. It also seems likely that by then the housing markets in England and Australia will have completely run out of steam.'
Thus spake the bubble-tracker.
P.S. A final note via Eric Fry: Jeremy Grantham is also forcing himself to consider the possibility of a bubble in crude oil prices even though he hopes not to find one.
Crude oil prices have, indeed, jumped two standard deviations above their historic trend, Grantham admits, which technically means that the price jump has reached bubble proportions. But he wonders whether crude oil might be that 'very rare bird - a paradigm shift.' In other words, he wonders if crude oil might be the first-ever bubble not to revert to its previous trend. He admits the odds of such an outcome are very slim.
'Over the years,' he explains, 'we have asked over 2000 investment professionals [if they knew of] an exception to our claim that every asset class move of 2 sigma away from trend had broken [back down to trend].'
Unfortunately, Grantham confesses, 'not one of the 2000 ever offered an exception! But we have always said that intellectually, you could imagine a paradigm shift in an asset class price, even if we have been unable to document one yet in history.'
He believes crude oil is capable of resisting the powerful forces of mean-reversion. 'It's the best possibility I've seen in my career,' he says. 'But the investment desert is littered with the bones of those who bet on new paradigms.'
P.P.S. Jeremy Grantham's quarterly letters are available here: https://www.gmo.com/America/Library/Letters/ (Registration Required).