My asset allocation is roughly 60% equities (80% long, 20% short equities, 50% developed, 50% em equities). 30% bonds (40% developed, 60% em debt), 10% gold, silver, oil and hedge funds.
My model is surprisingly signalling a BUY for global equities. Technicals are also positive. So I remain aggressive for now.
Stock rally ending not with a bang but a whimper
Market bubble expert says US equities will limp downwards with decade of low returns
What comes next? We have had the political surprise and the counter-intuitive response as markets grabbed on to one of the most powerful narratives for the forthcoming Trump administration — a new era of growth fuelled by tax cuts. Now, with stock markets wobbling slightly but still not making any change of direction, the question is whether the rally can be sustained and whether there is a risk of a bubble if it does.
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The bull market of the last eight years has seen US stocks rise threefold without any of the animal spirits that normally mark the top of a bull market — and talk of a “rational bubble” driven by low bond yields. Now, animal spirits are back, when valuations are near the top of their historical range. Using Robert Shiller’s cyclically adjusted earnings multiple, the S&P 500 entered the election at almost exactly the valuation at which it peaked in 2007 and a little higher than its peak in 1966.
It is also at its level of 1996 when then Federal Reserve chairman Alan Greenspan launched a brief attempt to talk down share prices by warning of “irrational exuberance”. We know the sequel. We instead moved to the “Greenspan Put” — a perceived promise that the Fed would support share prices — and US stocks went into a historic bubble. We are still paying the price.
If Trumpflation pushes the market up now, is that what awaits us? Intriguingly, GMO’s founder Jeremy Grantham, the world’s best-known diagnostician of market bubbles, published a letter to investors on election day to say that this would not happen.
He said he had come to believe that “we bubble historians have been a bit brainwashed by our exposure in the last 30 years to four of the perhaps six or eight great investment bubbles in history”. He added: “Well, the US market today is not a classic bubble, not even close. The market is unlikely to go ‘bang’ in the way those bubbles did.”
This is not, alas, reason for rejoicing. He cautioned that, instead, mean reversion to normal valuations would be slow and incomplete with “dismal” consequences for investors. Rather than with a bang, this bull market would end with a “whimper” and “limp into the setting sun with very low returns” for a decade or more.
I asked him if the return of animal spirits with the Trumpflation trade had changed his diagnosis. Only slightly. The chance of a true bubble has risen a bit — but remains unlikely. The chance of an old-fashioned bear market, taking down stocks by 20 per cent, has risen more.
Here is his reasoning. A bubble would require a move to about 3,300 on the S&P within a year or two. It also requires genuine strength of fundamentals — true bubbles always start from healthy positions and take them too far, as happened in the booming 1990s. The chances have risen with the advent of Mr Trump but remain slight.
Meanwhile, the risk of a perceived “regime change”, in which markets grasp that the “Greenspan Put” has ended, has also increased somewhat. A few rate rises would not accomplish this on their own but a sweeping change in personnel at the Fed would do so. That would allow the “whimper” to play out much faster.
Most importantly, Mr Grantham thinks the risk of an “old-fashioned, inflation-driven bear market” has also risen. This is because of the labour market. As he puts it, the recovery under Obama has seen 10m new jobs for those with some college education but maybe only 100,000 jobs for people without college.
Before the election, data showed that wage inflation was beginning to increase. In these circumstances, with an incipient shortage of graduates, “even a modestly strong economy [now more likely with a probable fiscal stimulus from Mr Trump] may well be enough to push labour inflation up, despite the lack of jobs at the lower end”.
The response to rising inflation would be higher rates, at a much faster speed than now expected, which would force down equity multiples. “That isn’t a bubble breaker. It’s quite different. And for a year it can sink the market by 15 or 20 per cent. And that looks quite likely.”
So as far as Mr Grantham is concerned, there is now a high probability of an inflation-driven bear market “without the need of a bubble and a crash”. It is a sound argument.
