Special Warning Update
This warning update was triggered by the publication yesterday (31Aug22) of Entering the Superbubble’s Final Act a new memo from legendary investor Jeremy Grantham, founder of Grantham Mayo Van Otterloo & Co.
I am a great admirer of Jeremy Grantham, who has long emphasized that warnings to investors about downside risks are all-too-rare. As he has observed, this is frustrating but not surprising:
"The combination of timing uncertainty and rapidly accelerating regret on the part of clients means that the career and business risk of fighting bubbles is too great for large commercial enterprises… Their best policy is clear and simple: always be extremely bullish. It is good for business and intellectually undemanding. It is appealing to most investors who much prefer optimism to realistic appraisal, as witnessed so vividly with COVID. And when it all ends, you will as a persistent bull have overwhelming company. This is why you have always had bullish advice in bubbles and always will."
In The Index Investor and Retired Investor, we have highlighted his past warnings that a “superbubble” was forming, involving substantial overvaluations across multiple asset classes, including equities, bonds, and housing. Our published asset class valuation analyses have reached the same conclusion. We have also repeatedly warned subscribers that the combination of asset class overvaluations and extremely uncertain macro conditions have made for a very dangerous situation. That is why both our systematic and discretionary model portfolio allocations have shifted significant percentages of their allocations to cash and gold.
Yesterday, Grantham reiterated many of the points we have made. That the Financial Times published a story about his memo today suggests to me that it will very likely have a large impact on investors’ thinking, and thus asset prices.
Grantham notes that, “Only a few market events in an investor’s career really matter, and among the most important of all are superbubbles (where prices deviate from their trend by 2.5 standard deviations or more). These superbubbles are events unlike any others: while there are only a few in history for investors to study (1929, 2000, and now 2021), they have clear features in common.
“One of those features is the bear market rally after the initial derating stage of the decline but before the economy has clearly begun to deteriorate, as it always has when superbubbles burst. This in all three previous cases recovered over half the market’s initial losses, luring unwary investors back just in time for the market to turn down again, only more viciously, and the economy to weaken. This summer’s rally has so far perfectly fit the pattern.
“The U.S. stock market remains very expensive and an increase in inflation like the one this year has always hurt multiples, although more slowly than normal this time. But now the fundamentals have also started to deteriorate enormously and surprisingly: between COVID in China, war in Europe, food and energy crises, record fiscal tightening, and more, the outlook is far grimmer than could have been foreseen in January. Longer term, a broad and permanent food and resource shortage is threatening, all made worse by accelerating climate damage.”
In terms of fundamentals deteriorating, our information collection, analysis, and forecasting process is based on our model of how developments in different issue areas interact in a rough chronological sequence (albeit in a complex manner) to produce different global macro regimes (which we label Normal Times, High Uncertainty, High Inflation, and Persistent Deflation) and asset class returns.
Our most important current concerns in these areas (about which we regularly write) include the following:
Technology
Persistent talent shortages (and the inability or unwillingness to improve the performance of education systems that are their root cause) are causing more investment to be made in labor substituting rather than labor augmenting automation technologies. Over time this will very likely worsen inequality.
Talent shortages are also having dangerous consequences in the economy (e.g., the struggles to find the talent needed to build new semiconductor fabs in the US), and for national security (e.g., the stunningly small share of men and women in the US who meet the military’s requirements).
Health
The apparent spread of the current avian H5N1 epidemic around the world and signs that it is now able to infect some mammals has raised the probability (assuming certain gene mutations or reassortments happen) of another, and potentially far deadlier global respiratory pandemic.
Energy & Environment
As we have repeatedly emphasized, global climate is an extremely complex system, and all models of it contain substantial uncertainties. There are thus almost certainly paths that lead to critical climate thresholds or “tipping points” that have not yet been discovered. The increasing range, frequency, and severity of extreme climate events (e.g., wildfires, rates of ice melting, extreme heat, increasing methane levels from natural sources, prolonged droughts, and more intense rainfalls) in recent years is very likely evidence that the system is approaching a critical threshold, beyond which lie consequences that we have almost certainly not fully anticipated. Not the least of these is the potential impact on water and food supplies.
Speaking of food, thanks to the Ukraine War, supplies of wheat on world markets have been substantially reduced. As prices rise, it is very likely that we will see more political unrest in nations that are heavily dependent on wheat imports (Egypt, China, Turkey, Nigeria, and Indonesia). Rising global grain prices are also contributing to the destabilizing increase in inflation in many other countries.
The Ukraine War has also reduced the flow of energy exports from Russia, which has led to a substantial increase in fossil fuel prices. This will almost certainly cause a severe economic downturn, and increased social and political unrest in Europe this winter. Elsewhere, higher energy prices have contributed to the rise in inflation, as well as slowing growth as consumers cut back spending elsewhere.
Economy
In China, a slow motion crisis is underway in its highly leveraged real estate sector, which, along with COVID and the Party’s crackdown on the technology sector, has dramatically slowed growth, which will have a significant negative impact on the world economy.
High levels of debt in many developed nations will almost certainly interact with interest rate rises to slow inflation and weakening aggregate demand growth to produce a deeper recession than many seem to anticipate.
Emerging market nations have already begun to experience this, as the recent crisis in Sri Lanka painfully demonstrated.
National Security
We have a war between Russia and the Ukraine and a high level of uncertainty about whether and when it could escalate to involve NATO.
At the same time there is a very high level of uncertainty about the potential nature, timing, and severity of a war between China and the US and its allies over Taiwan. It is not at all clear that the United States would win this war. What is clear is that it could rapidly escalate (e.g., to include cyber attacks on US and other nations’ critical infrastructure, and, in the worst case, the use of nuclear weapons), and would almost certainly cause major long-term damage to the world economy, with very unpredictable social and political consequences in many nations.
If China and the US go to war over Taiwan, it is also very likely that either North Korea and/or Iran would take advantage of the situation to launch their own attacks. If that happens, we would effectively be facing World War Three.
While the World War Three scenario surely strikes many as fanciful, over our many years of forecasting we have always kept in mind the conclusion reached by a 1983 CIA study of failed forecasts: "Each involved historical discontinuity, and, in the early stages…unlikely outcomes. The basic problem was…situations in which trend continuity and precedent were of marginal, if not counterproductive value."
Society
As Martin Gurri and other analysts have found, many nations today are characterized by worsening economic inequality and growing popular anger at various elites, due to a combination of their clueless conspicuous consumption and their allegedly incompetent management of institutions. Moreover, as Gurri notes, denser electronic networks than in the past (e.g., smart pones and easy internet access) and the growth of social media has intensified popular anger undermined nations’ capacity for collective action in the face of dangerous threats.
Politics
Popular frustration and anger (abetted by new media models that depend on sensationalism) have led to and been reinforced by political polarization. The increasing dominance of politics by parties’ extremes and extreme parties has weakened institutions and in some cases belief in democracy itself. This has also reduced national capacity for effective collective action in the face of dangerous threats.
As previously noted, we share Grantham’s view that the coming asset class revaluation and economic downturn will be more severe than many people currently expect.
However, our concerns go far beyond that, and focus on the far greater and more dangerous threat that our national social and political systems may no longer be able to effectively address the complex, interrelated crises that are bearing down on us.