Jeremy Grantham, who we really respect, weighs in on the Presidential Stock Cycle and career of risk of straying too far from the crowd and how it contributes to asset bubbles. From his latest letter,
So, where are we now? Although “quality” stocks are very cheap and small caps are very expensive (as are lower quality companies), we are in Year 3 of the Presidential Cycle, when risk – particularly high volatility, but including all of its risky cousins – typically does well and quality does poorly. Not exactly what we need! The mitigating feature once again is an extreme value discrepancy in our favor, but this never matters less than it does in a Year 3…
As a simple rule, the market will tend to rise as long as short rates are kept low. This seems likely to be the case for eight more months and, therefore, we have to be prepared for the market to rise and to have a risky bias. As such, we have been looking at the previous equity bubbles for, if the S&P rises to 1500, it would officially be the latest in the series of true bubbles.
We especially like this and the great chart,
Moving on to asset bubbles and how they form brings us to Exhibit 1. It shows how I think the market works. Remember, when it comes to the workings of the market, Keynes really got it. Career risk drives the institutional world. Basically, everyone behaves as if their job description is “keep it.” Keynes explains perfectly how to keep your job: never, ever bewrong on your own. You can be wrong in company; that’s okay. For example, every single CEO of, say, the 30 largest financial companies failed to see the housing bust coming and the inevitable crisis that would follow it.
Naturally enough, “Nobody saw it coming!” was their cry, although we knew 30 or so strategists, economists, letter writers, and so on who all saw it coming. But in general, those who danced off the cliff had enough company that, if they didn’t commit other large errors, they were safe; missing the pending crisis was far from a suffi cient reason for getting fi red, apparently. Keynes had it right: “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him….
Keynes also had something to say on extrapolation, which is very central to the process of momentum. He said that extrapolation is a “convention” we adopt to deal with an uncertain world, even though we know from personal experience that such an exercise is far from stable. In other words, by definition, if you make a prediction of any kind, you are taking career risk. To deal with this risk, economists, for example, take pains to be conservative in their estimates until they see
the other guy’s estimates.But there is a central truth to the stock market: underneath it all, there is an economic reality. There is arbitrage around the replacement cost. If you can buy a polyethylene plant in the market for half the price of building one, you can imagine how many people will build one…The problem is that some of these cycles happen really fast, and some happen very slowly. And the patience
of the client is three point zero zero years. If you go over that time limit, you are imperiled, and some of
these cycles do indeed exceed it.
(Click here if chart is not observable)
