Thursday, January 14, 2021

Grantham, Kass, and Rocker on a stock market bubble

By Whitney Tilson

Veteran investors Jeremy Grantham of GMO, my friend Doug Kass of Seabreeze Partners, and David Rocker, formerly of Rocker Partners, have all argued in recent days (see below) that the stock market is in a bubble that will soon burst.

I think they're right... but just early.

1) Here's Grantham's provocative essay: Waiting for the Last Dance. Excerpt:

The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.

These great bubbles are where fortunes are made and lost – and where investors truly prove their mettle. For positioning a portfolio to avoid the worst pain of a major bubble breaking is likely the most difficult part. Every career incentive in the industry and every fault of individual human psychology will work toward sucking investors in.

But this bubble will burst in due time, no matter how hard the Fed tries to support it, with consequent damaging effects on the economy and on portfolios. Make no mistake – for the majority of investors today, this could very well be the most important event of your investing lives. Speaking as an old student and historian of markets, it is intellectually exciting and terrifying at the same time. It is a privilege to ride through a market like this one more time...

The market is now checking off all the touchy-feely characteristics of a major bubble. The most impressive features are the intensity and enthusiasm of bulls, the breadth of coverage of stocks and the market, and, above all, the rising hostility toward bears. In 1929, to be a bear was to risk physical attack and guarantee character assassination.

For us, 1999 was the only experience we have had of clients reacting as if we were deliberately and maliciously depriving them of gains. In comparison, 2008 was nothing. But in the last few months the hostile tone has been rapidly ratcheting up. The irony for bears though is that it's exactly what we want to hear. It's a classic precursor of the ultimate break; together with stocks rising, not for their fundamentals, but simply because they are rising.

Another more measurable feature of a late-stage bull, from the South Sea bubble to the Tech bubble of 1999, has been an acceleration of the final leg, which in recent cases has been over 60% in the last 21 months to the peak, a rate well over twice the normal rate of bull market ascents.

This time, the U.S. indices have advanced from +69% for the S&P 500 to +100% for the Russell 2000 in just nine months. Not bad! And there may still be more climbing to come. But it has already met this necessary test of a late-stage bubble.

It is a privilege as a market historian to experience a major stock bubble once again. Japan in 1989, the 2000 Tech bubble, the 2008 housing and mortgage crisis, and now the current bubble – these are the four most significant and gripping investment events of my life. Most of the time in more normal markets you show up for work and do your job. Ho hum. And then, once in a long while, the market spirals away from fair value and reality. Fortunes are made and lost in a hurry and investment advisors have a rare chance to really justify their existence. But, as usual, there is no free lunch. These opportunities to be useful come loaded with career risk.

2) Here's Doug Kass' big call:

My Message Is Simple: Sell Stocks Now

* I find a record low number of stocks that meet my standards for purchase today

* Bookmark this missive!

* Stated simply...

"You're betraying your whole life if you don't say what you think – and you don't say it honestly and bluntly."
Charles Krauthammer

For the second time in the last few years, it is my view that, for investors with a less than one- to two-year timeframe, most equities should now be sold:

* The S&P has climbed from under 2,200 in March 2020, to about 3,800 today.

* Almost every traditional valuation metric is approaching all-time highs.

1. Warren Buffett's Favorite Valuation Metric (Market Cap/GDP):

2. Here is another:

 3. Here is a summary of several valuation calculations:

* The S&P's "fair market value" is about 3,100 – representing potential 18% to 20% risk to the senior indices.

* The upside reward is now dwarfed by the downside risk.

* There is little margin of safety for most stocks.

* Interest rates and inflationary expectations are rising – and should continue to advance in the months ahead.

* The Federal Reserve's ammunition is close to being exhausted as it takes more and more liquidity (and debt) to produce a unit of production.

* The U.S. deficit and debt load will likely serve as a governor to domestic economic growth over the next several years.

* The U.S. dollar is under attack and may fall further.

* Investor sentiment, as measured by every survey, has turned from fear to greed ("Group Stink" is forming a convoy).

* Consensus global economic and U.S. corporate profit growth forecasts are too optimistic.

* Small U.S. businesses have been gutted and will leave a gap in the aforementioned consensus economic projections.

* COVID-19 has accelerated trends which will slow aggregate economic growth. I believe strongly that the vaccination process will not be seamless and as timely as most project.

* A Democratic Senate may mean more stimulus but also higher taxes on income and investments. Moreover, political attacks on big tech are growing more probable and securities regulation may be more proactive.

* With the schism between "haves" and "have nots," social division in our country is approaching dangerous levels – more adverse and disruptive social and economic consequences likely lie ahead.

* The pivot from growth to value is underway and some value stocks are now more fully priced. Here are some examples: Disney (DIS) $80 to $180, Morgan Stanley (MS) $35 to $75, Goldman Sachs (GS) $190 to $290, Bank of America (BAC) $18 to $33, ViacomCBS (VIAC) $11 to $40, Penn National Gaming (PENN) $6 to $87, Hilton (HLT) $45 to $113, and General Motors (GM) $30 to $45.

* Speculative behavior has been normalized. Though many are currently enjoying profits among small caps – SPACs, etc. – and large caps – especially of a Tesla (TSLA) kind – speculation is now running amok and growing ever more irrational. A Janis Joplin mentality of "Get It While You Can" has infested the markets and its participants in recent weeks.

* The same commentators, strategists and "talking heads" whose heads were under the desk (and portfolios under water) are now confidently bullish (and many are mocking the bearish cabal).

I am a contrarian and not a Perma Bear. (In the depths of the March 2020 lows I wrote that I expected a "rip your face off rally and mother of all shorts." I went massive large long in exposure).

I consider myself a realist who has a good sense of the measurement of reward versus risk.

Bull markets emerge from bad news (March 2020) and bear markets emerge from good news (e.g., vaccinations and economic recovery).

As I write this missive, SPY was trading above $380 (up from $218 in March) and QQQ was trading at approximately $316.25 (up from $170 in March).

My message is simple, sell stocks now.

Please bookmark this opening missive and come back to me later in 2021 to assess its accuracy.

Position: Long BAC, GM, Short DIS, HLT, TSLA (large), SPY, QQQ

3) Last but not least, here's Rocker:

The Stock Market Bubble

The stock market last week reached an all-time high despite record coronavirus hospitalizations and deaths, a weakening economy with declining employment and political chaos culminating with the assault on the Capitol.

The market's relentless rise rests on two vast artificialities, both of which, ironically, are due to COVID-19.

The first is the interest rate policy of Jerome Powell's Federal Reserve, which has driven interest rates to near zero in response to the initial market decline in March. Massive monthly Fed purchases of bonds and mortgages have bloated its balance sheet to over $7 trillion and, by subverting the need for normal market financing, has essentially made the deficit functionally irrelevant. While its initial intervention was wise given the sharp contraction, subsequent guarantees that the Fed will keep rates low for years have had the effect of removing any perception of risk from the markets, are unsound.

They have had the effect of encouraging wild speculation and historic overvaluation. Junk bond yield spreads to quality issues are at record lows. Investors, seeing near zero rates from their traditional savings, have rushed into the stock market creating a self-fulfilling rise.

Public participation is at a high, and riskier assets have been favored. IPOs were 60% higher than they were in the tech bubble of 1999. SPACs (blank check companies) rose 500% last year from 2019's levels. Option trading was up 50% from 2019 and 12 times higher than in the 2020 bubble. Margin debt is up 50% in the last eight months. Stocks are at peak valuations by virtually all traditional measures like price/earnings ratios, price/sales ratios, etc. and in numerous cases are higher than they were in 1929 and 2000.

Powell says market valuations are not unreasonable given the low interest rates. But current rates are utterly fictitious and everyone knows it. Where would they be without the Fed's intervention? His justification is like the man who murders his parents and then throws himself on the mercy of the court because he is an orphan.

The second artificiality is the stimulus program itself. It too was crafted quickly as the economy collapsed in response to COVID-19, but subsequent analysis showed unanticipated consequences which propelled the stock market. An excellent review by the New York Times showed that stimulus led to a trillion dollar increase in personal income and the public's response to COVID-19 led to a $500 million decline in spending, so personal savings rose $1.5 trillion rather than declining as had been anticipated.

Credit card debt and borrowing declined sharply as people used the excess cash to pay down debt. It has been widely concluded that much of the stimulus found its way into the stock market. This disproportionately benefitted the relatively wealthy segment of society while so many of our citizens suffered terribly.

Despite claims to the contrary, inflation is not dead. It just shifted from consumables to physical assets. Stocks and housing have risen sharply in response to the low interest rates. Further, it is not unreasonable to expect inflation to rise from here. Many of the forces that kept prices low are now reversing.

Wages are finally rising, and 20 more states have embraced the $15/hour minimum wage. In the past, shifting production to cheaper offshore venues had lowered costs. The supply chain disruptions caused by COVID-19 are leading to a reverse flow as more goods will now be manufactured in the U.S. – at higher cost.

Our enormous deficits have led to a 10% decline in the dollar, which will make future overseas purchases more costly. Oil prices have recovered from their sharp selloff and may well rise further as the world economy recovers.

Yet the Fed, rather than being data dependent as it has been in the past, has claimed it will keep rates low for years and tolerate faster inflation than normal.

The offset to all this spending has been a massive expansion of debt, which represents an intergenerational shift of wealth to the present from our children. The increase in debt must be serviced by future generations, which will limit options for any desirable spending plans.

Ultimately, the higher debt burden will be a drag on future earnings growth, thereby justifying lower price earnings ratios on future earnings estimates rather than higher, as is now the case. The debt is not currently burdensome because of present low interest rates, but future projections show this to be temporary.

The low interest rates are also destroying the economics of pensions and endowment funds, which traditionally have earnings assumptions of about 7% annually, something they cannot attain in the current environment without shifting to riskier assets. They, including Social Security, are increasingly underfunded and this is hurting the economics of states and cities.

The government's own analysis has shown that only about 30% of the last stimulus was actually spent. Even though it now knows how badly targeted the prior stimulus program was, Congress is planning another similar one which will again tax the future by distributing assets to many people who do not need the help.

Anticipating this, markets continue their rise. How long this will last is unknown but as a bubble inflates, its walls get thinner, more fragile, and more vulnerable to bursting.

At some point, and likely for some currently unforeseen reason, the bubble will burst, suddenly hurting many unsophisticated people and unnecessarily endangering the economic health of the nation. At that time, because of the artificial policies of today, restorative options will be much more limited.

The Fed and Congress should recognize their dangerous role in creating this bubble, reintroduce risk and balance, and rationalize their policies now to give them greater flexibility in the future.

Best regards,


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Empire Financial Research

Whitney Tilson

Empire Financial Research founder and CEO Whitney Tilson is the editor of the Empire Investment Report, a monthly investment advisory that focuses on cheap, high-quality stock ideas.

Whitney graduated with honors from Harvard University and Harvard Business School, where he earned an MBA and was named a Baker Scholar. Whitney spent nearly 20 years on Wall Street, during which time he founded and ran Kase Capital Management, growing assets under management from $1 million at inception to a peak of $200 million.

Once dubbed "The Prophet" by CNBC, Whitney predicted the dot-com crash, the housing bust, the 2009 stock bottom, and more. Now, he's sharing his secrets and strategies with followers of his latest endeavor, Empire Financial Research.

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