US markets can rally higher before it becomes a full bubble

Looking to 2016, we can agree that uncertainties are above average. I must admit to feeling nervous for this year’s equity outlook in the U.S. But I am not entirely convinced. Sure, we can have a regular bear market. That is always the case. But the BIG ONE? I doubt it..

But I think the global economy and the U.S. in particular will do better than the bears believe it will because they appear to underestimate the slow-burning but huge positive of much-reduced resource prices in the U.S. and the availability of capacity both in labor and machinery.

The ability of the market to hurt eager bears some more is probably not exhausted. I still believe that, with the help of the Fed and its allies, the U.S. market will rally once again to become a fully-fledged bubble before it breaks. That is, after all, the logical outcome of a Fed policy that stimulates and overestimates some more until, finally, some strut in the complicated economic structure snaps. Good luck in 2016.

Earth has limited resources says Jeremy Grantham

It takes little experience in the investment business to realize that investors prefer good news. As a bear in the bull market of 1999, I was banned from an institution’s building as being “dangerously persuasive and totally wrong!” The investment industry also has a great incentive to encourage this optimistic bias, for little money would be made if the market ticked slowly upwards. Five steps forward and two back are far more profitable. 

Similarly, we environmentalists were shocked to realize how profoundly the general public preferred to believe good news on our climate, even if it meant disregarding the National Academies of the world. The fossil fuel industry, not surprisingly, encouraged this positive attitude. They had billions of dollars to protect. If the realistic information were to be widely believed, most of their assets would be stranded. When dealing with realistic limits to growth it is also obvious how reluctant everyone is to accept the natural mathematical limits: There simply cannot be compound growth in a finite world. A modest 1% growth compounded for the 3,000 years of Ancient Egypt’s population would have multiplied its economic output by nine trillion times!

Yet, the improbability of feeding 10 billion or so global inhabitants in 50 years is shrugged off with ease. And the entire economic and political system appears eager to encourage optimism on resources for it is completely wedded to the virtues of quantitative growth forever. Hard realities in these three fields are inconvenient for vested interests and because the day of reckoning can always be seen as “later,” politicians can always find a way to postpone necessary actions, as can we all: “Because markets are efficient, these high prices must be reflecting the remarkable potential of the Internet”; “the U.S. housing market largely reflects a strong U.S. economy”; “the climate has always changed”; “how could mere mortals change something as immense as the weather”; “we have nearly infinite resources, it is only a question of price”; “the infinite capacity of the human brain will always solve our problems.”

Having realized the seriousness of this bias over the last few decades, I have noticed how hard it is to effectively pass on a warning for the same reason: No one wants to hear this bad news. So a while ago I came up with a list of propositions that are widely accepted by an educated business audience. They are widely accepted but totally wrong. It is my attempt to bring home how extreme is our preference for good news over accurate news. When you have run through this list you may be a little more aware of how dangerous our wishful thinking can be in investing and in the much more important fields of resource (especially food) limitations and the potentially life-threatening risks of climate damage. Wishful thinking and denial of unpleasant facts are simply not survival characteristics.

Let me start with one of my favorites. For the 50 years I have been in America, Business Week and The Wall Street Journal have been telling us how incompetent at business the French are and how persistently we have been kicking their bottoms.

If only they could get over their state socialism and their acute Eurosclerosis. And as far as I can tell we have generally accepted this thesis. Yet France’s median hourly wage is up 180% in 45 years! Japan is up 140% and even the often sluggish Brits are up 60%. But the killer is the U.S. median wage. Dead flat for 45 years! These are the uncontestable facts. So, all I can say is that it is just as well the French have not been kicking our bottoms. But how is it that we can believe so firmly in something that just ain’t so, and by such a convincing amount?

While other developed countries continued to increase their participation rate, that of the U.S. declined from first to last in fairly rapid order. What a far cry this reality is from the view generally accepted by our business world.

But if you really want to be worried about our comparative health you should take a look at the death rate for U.S. whites between the ages of 45 and 54, which happily these days is when very few people drop off. Since 1990 there has been a quite remarkable decline for other developed countries, about a one-third reduction, including for U.S. Hispanics. But for U.S. whites there is a slight increase! Further analysis for that group reveals that the general increase is caused by quite severe increases in deaths related to alcoholism, drug use, and suicides. Had the rate for U.S. whites declined in line with the others there would have been about 50,000 fewer deaths a year! (For scale, this is nearly twice the yearly number of traffic deaths in the U.S.)

You have to be careful these days when you suggest connections. For example, people have been told off for proposing that dramatic increases in population can help destabilize societies. Syria had two and a half million people when I was born and has 29 million people now. You can guess how much worse the situation is because of this, but you should not talk about it. Similarly, Prince Charles has been extensively criticized by professors in The Guardian for suggesting that a several-year drought in Syria exacerbated social tensions by ruining many farmers. As if! (You cannot prove precisely what effect climate damage had, but you certainly cannot prove that it did not have a large effect. It certainly had a contributory effect.)

Even as more people can see the problems with climate damage, the richer countries can convince themselves that the damage is not that serious. Poorer countries, meanwhile, do not have that luxury and about 20% more are actively concerned (about 80% versus 60%) than are the richer countries.

And this brings me to the last and my absolute favorite of these false propositions, which I label, “I wish the U.S. government wouldn’t give so much to foreign countries (especially when times are bad)!” Now, I do not think I have met a single American who does not believe that the U.S. government is generous in its foreign aid. Yet, it just ain’t so, and by a remarkable degree.

Conclusion

We in the U.S. have a broad and heavy bias away from unpleasant data. We are ready to be manipulated by vested interests in finance, economics, and climate change, whose interests might be better served by our believing optimistic stuff “that just ain’t so.”

We are dealing today with important issues, one so important that it may affect the long-term viability of our global society and perhaps our species. It may well be necessary to our survival that we become more realistic, more willing to process the unpleasant, and, above all, less easily manipulated through our need for good news.

I recently found myself looking at a cover story for The Economist (Nov 7, 2015) that seemed to be a wonderfully convenient example of my general thesis: the efforts that are made by vested interests to exploit our reluctance to face inconvenient facts. The Paris climate talks have begun and a large number of reasonable speeches and articles are putting their best foot forward in support of sensible progress. But The Economist’s special coverage on climate is not one of them. In fact, I urge you to realize that this normally reasonable newspaper, inadvertently I’m sure, is regrettably helpful in this report to the fossil fuel industry: Ignore carbon taxes, they suggest, and follow Bjorn Lomborg and his Copenhagen Consensus Center, which is discussed so favorably here, into scores of deworming programs before you waste money on combatting climate change.

When finally you spend any money at all, spend it on completely new technologies and not on solar and wind, which are by implication considered failed approaches despite the remarkably rapid decline in prices in recent years. But if we wait for entirely new technologies, climate damage may have by then gone beyond a tipping point. Indeed, a great majority of climate scientists would say that there is some chance of that and what chance of real disasters should we be willing to take? Any successful attempt to limit climate damage must at least include a price on carbon. Any suggested program that does not is either disingenuous or an outright con. They may argue that we can wait and research until we have a more perfect solution, but I believe that “wait” is their main purpose, not “solutions.”

Market near bubble becareful says Jeremy Grantham

The market is creeping toward bubble-land but isn't there quite yet, said GMO chief investment strategist Jeremy Grantham during his keynote at the 2015 Morningstar Investment Conference. 

He warned investors to pay careful attention as valuation metrics begin to approach a "2 sigma event," or 2 standard deviations away from the norm. 

"Every 2-sigma event is followed by an equal and offsetting 2-sigma reversion," he said, adding that the pattern occurred in 28 out of 28 of the major bubbles GMO has studied throughout history. "And they all went back half a year quicker than they went up," he added.

So, where's the mean and where are we today? Grantham cited a 21.1 price-to-earnings multiple on the S&P today versus a normal P/E of 16.0, while corporate profit margins are currently at 7.3% versus a norm of 5.7%. In a recent commentary, he further noted that the "Shiller P/E and Tobin's Q have moved up over the last six months to 1.5 and 1.8 standard deviations (sigma), respectively." (Tobin's Q is a ratio comparing the market value of a company to the replacement value of that company's assets). Reversion to the mean on those two scores implies a more 50% decline in the market from current levels, he said.

But although profit margins have been abnormally high, they have been curiously slow to revert to historical norms, Grantham noted. "My belief is that it has a lot to do with a regime shift to the Greenspan era and his acolytes," he said. "The [market] P/E in the new regime has been 60% higher than it was for 100 years before."

In addition, he argued that the rise of stock options in executive compensation has played a role in making profit margins stickier--but not without a cost.

"We've entered a world where 80% of remuneration comes from stock options combined with ... a fixation on short-term profit maximization," which encourages CEOs to undertake stock buybacks versus capital expenditures. A buyback is "much less dangerous than buying a new plant," Grantham said, and also happens to increase the value of those stock options by directly boosting the stock price.

For its part, the current Fed regime's low-rate policies have "made it desperately appealing to borrow cheap debt to buy your own stock back." The result has been dismal corporate capital expenditures, which in turn depresses wage creation and does little to stimulate the economy.

"You get mean reversion if capitalism is allowed to work in the normal way," Grantham said. "What's happening in the stock market now amounts to interference with the normal process. We're not allowing profit margins to mean revert. We're not expanding our economy. We're running away from it and protecting our stock options. There is no arbitrage mechanism, and unless we break it, it will be an increasing drag on our economy."

What Will Finally Pop the Coming Bubble?
"You need a trigger to break it," Grantham said. "Broad overvaluation [alone] has never done it."

Instead, he argued, "The market will follow the line of least resistance from the Fed, plodding slowly and steadily higher, waiting for speculation from individuals and deals."

Neither is the dreaded impending Fed rate hike likely to cause the pop. "From 2004 to 2006, the Fed raised rates [multiple] times. Markets went up without missing a beat," he said. "Why would a single rate hike have everyone in a fit?"

In the meantime, Grantham characterized investing in the market as "a wonderfully tricky game."

"Be prudent, of course. Be very prudent ... but not yet," he said. "I'm waiting to be very, very prudent. I'm going to be incredibly prudent starting closer to the election. I recommend the same to you."

From MorningStar

Energy Revolution is coming with new forms of energy

I have become increasingly impressed with the potential for a revolution in energy, which will make it extremely unlikely that a lack of energy will be the issue that brings us to our knees. Even in the expected event that there are no important breakthroughs in the cost of nuclear power, the potential for alternative energy sources, mainly solar and wind power, to completely replace coal and gas for utility generation globally is, I think, certain.

The question is only whether it takes 30 years or 70 years. That we will replace oil for land transportation with electricity or fuel cells derived indirectly from electricity is also certain, and there, perhaps, the timing question is whether this will take 20 or 40 years.

I have felt for some time that new investments today in coal and tar sands are highly likely to become stranded assets, and everything I have seen, in the last year particularly, increases my confidence.

China especially is escalating rapidly in its drive to limit future pollution from coal and gasoline and diesel powered vehicles. Increased smog last year in major cities led to an unprecedented level of general complaint.

China simply can’t afford to have Chinese and foreign business leaders leaving important industrial areas in order to protect the health of themselves and their families. Nor are they likely to be comfortable with a high level of sustained complaint from the general public. They have responded in what I consider to be Chinese style, with a growing list of new targets for reducing pollution. A typical example recently was an increase of 60% in their target for total installed solar by the end of 2015! Hardly a month goes by without a new step being announced.


One can easily see that in 10 years there could be a new world order in cars. Some emerging countries, notably China, are likely to take more dramatic and faster steps to reduce demand than we have ever thought about. Already they have 200 million electric vehicles – mostly motorbikes – almost as many as the rest of the world squared.

In short, with slower global economic growth, more fuel-efficient gasoline and diesel vehicles, more hybrids, cheaper electric cars, more natural gas vehicles, and possibly new technologies using fuel cells and, conceivably, methanol, it is certain that oil demand from developed countries will decline, probably faster than expected.

Total global oil demand at current prices or higher is likely to peak in 10 years or so. At much lower prices we would fairly quickly lose most of our high-cost production: deep offshore, fracking, and tar sands.

Times may be changing faster than we think. My guess is that oil prices will be higher than now in 10 years, but after that, who knows?

The idea of “peak oil demand” as opposed to peak oil supply has gone, in my opinion, from being a joke to an idea worth beginning to think about in a single year. Some changes seem to be always around the corner and then at long last they move faster than you expected and you are caught flat-footed.

Jeremy Grantham on profit margins reverting to mean

Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.

Markets will soar higher to bubble territory

Jeremy Grantham, founder of GMO, the asset manager in Boston, has predicted that rising dealmaking would “push the market up to true bubble levels, where it will once again become very dangerous indeed”.

Capitalism cannot solve every problem

People simply do not get the point that you can’t have sustainable growth forever. You can have sustainability forever, or growth for a few years. Capitalism does millions of things better than the alternatives. However, it is totally ill-equipped to deal with a small handful of issues. Unfortunately, they are the issues that are absolutely central to our long-term well-being and even survival.