Yesterday, we explained why Jeremy Grantham, a former bear, is now a short-term bull. Basically, he thinks the fire-hose of stimulus will drive stocks (if not the economy) up another 10%-20% by the end of the year. But please note the emphasis on “short-term.”
After our current rocket rally plays itself out, Grantham thinks, the market will once again crash and then stay in the dumps for at least seven years.
Because of the massive declines in our net worth, our debt problem, and compression of price-earnings ratios. Specifically, we’ve lost our shirts and we feel poor–which isn’t conducive to profligate spending. We still need to get rid of $10-$12 trillion of debt. This debt-reduction process will pressure profit margins (lower leverage) and pressure spending–because we’ll have to save more instead of spending it. We’ll also need inflation to reduce the real burden of the debt.
Stocks, meanwhile, have actually climbed back to fair value (900 on the S&P). And after long periods of over-valuation (the last 15 years), we’re due for a long period of under-valuation.
Here’s Grantham (full quarterly letter embedded here):
For the biblical record, Joseph, consigliere to the Pharaoh, advised him that seven lean years were sure to follow the string of bountiful years that Egypt was then having. This shows an admirable belief in mean reversion, but unfortunately the weather does not work that way. It, unlike markets, really is random, so Joseph’s forecast was like predicting that after hitting seven reds on a roulette wheel, you are likely to get a run of blacks. This is absolutely how not to make predictions unless, like Joseph, you have divine assistance, which, frankly, in the prediction business is considered cheating. Now, however, and deﬁ nitely without divine help but with masses of help from incompetent leadership, we probably do face a period that will look and feel painfully like seven lean years, and they will indeed be following about seven overstimulated very fat ones.
Probably the single biggest drag on the economy over the next several years will be the massive write-down in perceived wealth that I described brieﬂy last quarter. In the U.S., the total market value of housing, commercial real estate, and stocks was about $50 trillion at the peak and fell below $30 trillion at the low. This loss of $20-$23 trillion of perceived wealth in the U.S. alone (although it is not a drop in real wealth, which is comprised of a stock of educated workers and modern plants, etc.) is still enough to deliver a life-changing shock for hundreds of millions of people.
No longer as rich as we thought – under-saved, under-pensioned, and realising it – we will enter a less indulgent world, if a more realistic one, in which life is to be lived more frugally. Collectively, we will save more, spend less, and waste less. It may not even be a less pleasant world when we get used to it, but for several years it will cause a lot of readjustment problems. Not the least of these will be downward pressure on proﬁt margins that for 20 years had beneﬁted from rising asset prices sneaking through into margins.
Closely related to the direct wealth effect is the stranded debt effect. The original $50 trillion of perceived wealth supported $25 trillion of debt. Now, with the reduced and more realistic perception of wealth at $30 trillion combined with more prudent banking, this debt should be cut in half.
This unwinding of $10-$12 trillion of debt is not, in my opinion, as important as the loss of the direct wealth effect on consumer behaviour, but it is certainly more important to the ﬁnancial community. Critically, we will almost certainly need several years of economic growth, which will be used to pay down debt. In addition, we will need several years of moderately increased inﬂation to erode the value of debt, plus $4-$6 trillion of eventual debt write-offs in order to limp back to even a normal 50% ratio of debt to collateral. Seven years just might do it.
Another factor contending for worst long-term impact is the severe imbalance between overconsuming countries, largely the U.S. and the U.K., and the overproducing countries, notably China, Germany, and Japan. The magnitudes of the imbalances and the degree to which they have become embedded over many years in their economies do not suggest an early or rapid cure. It will be hard enough to get Americans to save again; it will be harder still to convince the Chinese, and indeed the Germans and the Japanese too, that they really don’t have to save as much. In China in particular they must ﬁrst be convinced that there are some social safety nets.
A lesser factor will be digesting the much shrunken ﬁnancial and housing sectors. Their growth had artiﬁcially and temporarily fattened proﬁt margins as had the general growth in total debt of all kinds, which rose from 1.25x GDP to 3.1x in 25 years. The world we are now entering will therefore tend to have lower (more realistic) proﬁt margins and lower GDP growth. I expect that, at least for the seven lean years and perhaps longer, the developed world will have to settle for about 2% real GDP growth (perhaps 2.25%) down from the 3.5% to which we used to aspire in the last 30 years. Together with all the readjustment problems and quite possibly with some accompanying higher inﬂation, this is likely to lead to an extended period of below average P/Es.
WHAT THIS MEANS FOR THE MARKET
As I have often written, extended periods of above average P/Es, particularly those ending in bubbles, are usually followed by extended periods of below average P/Es. This is likely to be just such a period and as such historically quite normal. But normal or not, it makes it very unlikely with P/Es, proﬁt margins, and GDP growth all lower than average that we will get back to the old highs in the stock market in real terms anytime soon – at least not for the seven lean years – and perhaps considerably longer.
To be honest, I believe that most of you readers are likely to be grandparents before you see a new inﬂ ation-adjusted high on the S&P.
If we are looking for any further drawn-out negatives, I suspect we could add the more touchy-feely factor of conﬁdence. We have all lost some conﬁ dence in the quality of our economic and ﬁ nancial leadership, the efﬁciency of our institutions, and perhaps even in the effectiveness of capitalism itself, and with plenty of reason. This lack of conﬁdence will not make it easier for animal spirits to recover. This does not mean necessarily that we haven’t already seen the low, for, in my opinion, it is almost 50/50 that we have. It is more likely to mean a long, boring period where making fortunes is harder and investors value safety and steady gains more than razzle dazzle. (The ﬂaky, speculative nature of the current rally thus bears none of the characteristics that I would expect from a longer-term market recovery.)
The VL Recovery
So we’re used to the idea of a preferred V recovery and the dreaded L-shaped recovery that we associate with Japan. We’re also familiar with a U-shaped recovery, and even a double-dip like 1980 and 1982, the W recovery. Well, what I’m proposing could be known as a VL recovery (or very long), in which the stimulus causes a fairly quick but superﬁcial recovery, followed by a second decline, followed in turn by a long, drawn-out period of sub-normal growth as the basic underlying economic and ﬁnancial problems are corrected.