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Which super bubbly market does Jeremy Grantham think is about to pop?

Jessica Bebel  |  17 Feb 2022Text size  Decrease  Increase  |  
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Jeremy Grantham, the long-term investment strategist at his namesake firm, Grantham, Mayo, Van Otterloo & Co., or GMO, which he co-founded in 1977, joined the latest episode Morningstar's The Long View podcast.

Here are excerpts from Grantham's conversation with Morningstar's Christine Benz and Jeff Ptak:

Super Bubbles, Housing Bubbles, and Bubbly Sectors

Benz: So, you just used the term super bubble, and you're saying the U.S. market is in a super bubble, you believe. Can you explain what you mean starting with your definition of a regular bubble and then what makes this current one super?

Grantham: Yes. About 25 years ago, we felt in order to talk about bubbles, we should probably define them statistically. And so, we did just that. And we picked a standard statistical term of a 2-sigma. A 2-sigma event is the kind that should occur every 44 years in a perfectly random world. And with human beings who are capable of being a little inefficient, they occur every 35 years in the equity markets, close enough, I would say, for government work. And we noticed that all of them in the developed world in modern times in equity markets went back to the trend. And the trend is easy to measure. The 2-sigma is pretty straightforward statistics. And the fact that all of them went back without exception, we find a very compelling idea.

The complexity comes from the fact that some of these 2-sigma events continue to go up. And the three of them in the U.S. have gone up to 3-sigma, which is the kind that you would expect every 100 years, but as I like to say, humans do seriously crazy pretty well. So, they are much further away from random than 2-sigma. And two out of three, certainly more than half of 2-sigma go on to 3-sigma in recent times. And the 3-sigma events, we have 1929, 2000 and today, in the equity market, and Japan as a major market overseas in 1989. And it doesn't change the outcome. You go back to trend. But since by definition, you've gone further up, it takes longer and more painful and more pain to come down. And the quicker the bubbles end, the better off everybody is. And we mentioned this one as a 2-sigma back in July of 2020 or August about 3,500. The trendline is about 2,500. 2-sigma is about 3,500 and 3-sigma is 4,500, 4,600. We got to 4,800 in December. And if you're going to have a bubble, it's better to break from 3,500 to 2,500 than it is to break from 4,800 to 2,500. And therefore, the real McCoy super bubbles are extremely painful in terms of a reduction of perceived wealth. And there is a wealth effect. When they mark down your portfolio or your house, you spend a little less the following year or two.

The Bursting of the US and Japanese Housing Bubbles

Ptak: You've said the bursting of the Japanese and U.S. housing market bubbles was devastating because in those cases you had manias in both the stock market and important economic sectors. What about now? Are you seeing the same dangerous combination?

Grantham: I have to admit the housing market doesn't seem to have the kind of psychological accompaniment of a crazy bubble like the stock market does. And it didn't worry me much back in July of 2020. But then, it decided to go into warp drive, and we've just had the biggest move in a 12-month period in the history of U.S. real estate, about 20% in the last 12 months, and quite a bit in the previous five or six months. So, since the U.S. equity market reached 2-sigma, a bubble territory, the housing market in the U.S. has shot upwards with great determination, and it actually sells at a higher multiple of family income than the housing bubble of 2006-2007 because of that 20%. 20% is a lot more in housing than 20% is in the stock market. That is just an amazing move. And it has certainly made the U.S. housing market extremely expensive, the highest price it has ever been as a multiple of your ability to buy at family income.

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And history has been pretty straightforward. Whatever you do don't have gloriously overpriced housing markets at the same time as you have a stock market bubble. Japan tried it, the biggest land and real estate bubble in history anywhere, arguably the greatest bubble of anytime anywhere, and simultaneously, they had 65 times earnings it was said at the time in the Japanese stock market. That was the ultimate definition of potential pain as you had to mark them both down and they did. And as I said, stock market isn't back to '89, but the land market isn't back to '89, either. So, you had double jeopardy of last decade, and you could say that those two bubbles from way back in '89 are still casting a shadow on the Japanese economy.

Should Investors Worry About the Bubbly Housing Market?

Benz: So, thinking about the U.S. housing market, isn't it strong mainly because there's so little supply, and if that's the case, is there any reason to doubt that the fallout will be as severe as the last time that housing market was bubbly?

Grantham: Yeah, that's actually exactly my view that the housing market is not as reliably mean reverting as the stock markets have been. And the reason why not is because of zoning and all manner of inefficiencies that unfortunately surround the housing market. If you weren't let people build houses, then you get a chronic housing shortage. And most of the great markets in the world today have chronic housing shortage. They haven't been building enough in the U.K. for decades, or the Australia and New Zealand and many European markets, so simply underbuilding, generating a shortage, and people simply have to pay more and more of their limited resources to buy a house. We didn't fall in that category until recently.

And you could divide the housing bubble into two groups – those where you had strict zoning and restraints on building. And when the housing bust occurred, they went down a bit, but they regrouped and went to new highs. And then, you had the three markets, where they were really cranking out new housing. In Ireland, they were covering the whole island with new houses; in Spain, they were building as if everybody had to have two houses; and in the U.S., they were cranking out an extra 1.5 million houses a year over normal. And in those three markets, they caught up, they flooded the market, and the great housing bubbles collapsed and went all the way back to trend in the case of all three of those markets and below trend in all three of those markets. And this time, we have insufficient housing. So, you can't depend on the speed and extent of the decline.

The problem is, if the U.S. equity market goes down, if it casts a shadow on confidence, if it weakens the economy a bit, if there are other economic problems, then I expect the U.S. housing market to weaken. The way I described this is the potential for write-downs in asset prices and perceived value of your assets. If you are a record distance above trendline price in the U.S. housing market, even though there's no immediate reason why the house market should collapse, you will expect at some indefinite period and the time when people are pessimistic, the potential is there for substantially lower house prices. And one thing you should bear in mind is that housing is a complete creature of the interest rate through the mortgages. Mortgages – there's nothing like that in the stock market. Huge leverage. They're fixed term. They're completely institutionalized, they're completely socially acceptable, and they give you a level of leverage that you could only dream about in the stock market on very favorable terms in the case of the U.S. And if they lower your mortgage, why would you not pay more for your house?

Someone says to me today, well, why should I need to buy a house? My attitude is, look, they're badly overpriced. Here's the data. They are higher priced compared to your income than they have ever been. But the mortgage is the lowest price it's ever been. The mortgage, if anything, is more underpriced than your house is overpriced. If you can guarantee to keep it for the life of the mortgage, 30 years, and you are prepared to rent it out if you have to, it's highly likely that you'll do okay. You may not do brilliantly, but you should do okay. And you may do very well. So, housing is a complete creature of interest rates. Makes it easier to understand also why interest rates drive asset prices than it is in the stock market where it's a little more complicated.

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.

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