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Grantham: Bubbles are all that matter [ClearOnMoney]
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Grantham: Bubbles are all that matter

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Commentary

Grantham: Bubbles are all that matter

26 Jan 2011 by Jim Fickett.

Asset bubbles present a huge opportunity if you can get in and out at the right time. The top is almost never reached while interest rates are kept low, and investors tend to move to safer assets near the peak.

Jeremy Grantham released his quarterly letter yesterday (registration required).

His comments on the current situation, and current investment choices, are more or less unchanged from the last letter. He still foresees a rising market for most of the year, due to the presidential cycle, and recommends “quality” stocks and long-term resource investments.

More interesting to me were further comments on bubbles. Exaggerating for effect, he makes the claim that bubbles are all that matter:

I believe the only things that really matter in investing are the bubbles and the busts. And here or there, in some country or in some asset class, there is usually something interesting going on in the bubble business. …

Stock market sectors have also bubbled unfailingly – growth stocks, value stocks, Japanese growth stocks, etc. In fact, they’ve been very dependable. To ignore them, I believe, is to avoid one of the best, easiest ways of making money. …

Let me end by emphasizing that responding to the ebbs and flows of major cycles and saving your big bets for the outlying extremes is, in my opinion, easily the best way for a large pool of money to add value and reduce risk.

I have been convinced for a long time that, while looking for a safe return for a good part of your money is always a good idea, volatility is the best way to make money. Individual assets, whole markets, and sectors go through wild swings, and it is silly to ignore the opportunity when things are vastly under- or overpriced. I think Grantham would agree with that, but he means something more. GMO has a formal definition of bubbles, and they have carefully researched many, many individual bubbles, trying to find the commonalities. He is not about to give away all that they've learned, but he does present some interesting commonalities.

  • Bubbles start with something that does add real value – all bubbles need a good story
  • Bubbles grow because of herd behavior – to keep your job it is fine to be wrong if everyone else is wrong, but disastrous to be right when no one else is right
  • Bubble peaks are rarely recognized because of this herding, and because economists mostly project past trends, waiting for someone else to say that there is a real problem
  • When profit margins are high, stock market investors tend to forecast more of the same, and to pay higher prices when, in fact, they should pay lower prices because profit margins are mean-reverting; this is a major factor in stock market bubbles
  • Bubbles need cheap rates, and tend to grow as long as short-term interest rates are kept low; bubbles almost never break before interest rates rise
  • Overvaluation is never enough to signal the top, but there are some warning signs, for example investors moving to safer assets