At a high level we often talk about the need for any successful investment strategy to be split between your attack and defence. This blog is about why you need such a defence – it is not to deal with run-of-the-mill falls, but ones potentially catastrophic for your life plans. Though written for DIY investors using FundExpert, such a defence is at the heart of our DFM portfolios.”
I have been observing, researching and writing about bubbles and crashes for decades. Jeremy Grantham has passionately added to this in recent days, and introduced and defined a scary new category – the superbubble. Here I look at his analysis, what might happen next, but more importantly what is already happening right now.
I have been writing about, and sidestepping, bubbles and crashes since the 1990s – I can’t say the 1980s too, as the 1987 Crash was not a bubble, though I definitely sidestepped it. Jeremy Grantham has been doing similar since the 1970s, and always produces compelling analysis.
He notes the obvious but often under-appreciated fact that bubbles “are often the most exhilarating financial experiences of a lifetime”. The bubble stage can last quite a few years, as has this one in US equities. You just need to piggy-back it and then hold your nose, as I said a few years ago. And, of course, have a robust stop-loss plan to limit any pain.
Yet, exhilarating or not, there comes a point when even a bubble goes off the scale and becomes extremely dangerous – Jeremy calls this a superbubble, for which he identifies three requirements, and I quote him:
“a. Speculative investor frenzy that generated stories for distant decades, which we have had for well over a year;
b. A penultimate blow-off phase where stock gains accelerate, as we had in 2020;
c. And the ultimate narrowing phase – unique to these few superbubbles – where a decreasing number of very large blue chips go up as riskier and more speculative stocks underperform or even decline, as they did in 1929 and 2000 and as they have done since February 2021.”
You can’t define “investor frenzy” with precision, but for those who know their financial history, one of the most relevant precedents might be the Tulip Mania in the 1630’s. A single bulb sold for about one million dollars at the peak of the mania. Nassim Taleb said the Bitcoin frenzy is like the Tulip Mania but without the aesthetics, and disguised as “currency”. For our part we have documented this in real time in the “Mania Chronicles” part of our teleconferences.
There was a blow-off phase from the pandemic low of 2020 in the US stock market, which I will highlight again in the next teleconference.
The “narrowing” has also been covered in recent teleconferences. As the US stock market rose to its peak earlier in January, one-third of the companies in the tech-orientated NASDAQ index were already down 50% from their highs – an increasingly narrow number of stocks were taking the US stock market to its peak. The latter has occurred (plus the sharp falls in a variety of other “hot” assets from early 2021) because stock market bubbles first start to deflate at the riskiest end of the market.
With those three elements in place, Jeremy notes that there have only ever been three superbubbles in the US stock market, including this latest one. The other two in the US were in 1929 and 2000.
Those three elements are reasonably distinct, but also rare when found together. They also occur in other asset classes, such as housing in the US in 2006 and housing in Japan in 1989.
It is Japan in 1989 which is particularly interesting. You have heard me talk about “The Japan Problem” many times – the one where huge bubbles burst and values stay a long way down for many years – below the peak for more than 30 years in the case of the Japan bust from 1989.
The thing about Japan is that it wasn’t even an ordinary superbubble – it was even worse than that, with a bubble in housing in particular, and the property market in general.
This means that the pain of the stock market fall (down 80% at worst, and still 30% below the 1989 peak) was shared by many homeowners. This was a very wide and deep shock.
The US today doesn’t just have a superbubble in its stock market, where we have given a broad-brush range for falls of 55-85%. Housing prices have never been more expensive, and are even above the bubble peak of 2006, based on multiples of family income.
Hmmm. This is all sounding horribly Japanese, 1989 vintage.
The US central bank’s reaction to these dangers? Nothing. As Jeremy puts it, they are “dangerously incompetent”. As I put it in a recent teleconference, with inflation at 30-year highs and interest rates at 300 year lows, basic economics is broken.
The problem goes back to 1987 as we looked at in “The Awaited Policy Error. It’s Behind You…”. It is a big hole which has been dug, and there remains no clear idea on how central bankers will extricate the US economy and stock market from it.
As an investor based in the UK, you just need to understand the scale of the problem, the risks, and how you can both limit those risks (over shorter periods) and be positioned to make good money (over longer periods).
This blog was first written on 4th February 2022, on the research hub of our sister company FundExpert. This will be particularly interesting for those advisory clients who are using our discretionary fund management (DFM) service, or those who are contemplating doing so.