“…..bearish advice in bubbles always comes from old fogeys who “just don’t get it,” because I received that old fogey advice back then and just didn’t listen. I doubt speculators in the current bubble will listen to me now; but giving this advice is my job and possibly the right thing to do.”
“All 2-sigma equity bubbles in developed countries have broken back to trend. But before they did, a handful went on to become superbubbles of 3-sigma or greater: in the U.S. in 1929 and 2000 and in Japan in 1989. There were also superbubbles in housing in the U.S. in 2006 and Japan in 1989. All five of these superbubbles corrected all the way back to trend with much greater and longer pain than average.”
“Today in the U.S. we are in the fourth superbubble of the last hundred years.“Jeremy Grantham (https://www.gmo.com/americas/research-library/let-the-wild-rumpus-begin/)
Since the beginning of December this Insight has been talking about the emerging headwinds for the first half of 2022. It is as well to understand scale and depth of the issues as the Fed moves towards less policy support.
“the negative real yields of 2021 add to the already numerous economic headwinds for 2022.” Lacy Hunt.
“This assessment is based on four considerations. First, the history of negative real yields for the past century and a half indicates that the downward risk to economic activity is significant, a sharp contradiction to the importance of economic gains in late 2021. Second, the theory of real interest rates and how they are determined confirm the historical analysis. Third, historical
analysis indicates that negative real yields, combined with extreme over-indebtedness are an
even greater negative for growth as is confirmed by scholarly research. Fourth, increasing obstacles to growth will encourage subsiding inflation.”
The Treasury bond yield curve is already signalling a return to a long term low growth outlook. 30 year bond yields have fallen significantly relative to 5 year bond yields and are already back to 2019 levels.
This is at odds with the stock market.
Passive equity strategies continue to be at risk from mean reversion of excessive policy
Not only is the potential long term drawdown for stocks unacceptable following the extraordinary policy measures taken for many years, passive strategies now face significant cycle risk. Investment only makes sense if it is focused on a positive expected return. Passive investing is by definition based on long term expected return.
There are many ways to look at expected return, but it is hard to find credible long term positive expected returns for many assets classes today. Here is the 7 year expected real return as calculated by GMO, all negative with the exception of emerging markets:
Even though the markets had adjusted for tighter policy this year, Chairman Powell’s statements this week pushed up short rates even further. While Powell has changed his mind in the past it will take some time for him to walk back the intensity of his FOMC statements this week.
The big problem is that Powell and the Fed are so late in tightening and so far into supportive policy.
Tightening policy aggressively into what looks like back to back quad 4 (declining rate of change in growth and inflation) quarters in Q1 and Q2 2022 has raised market risks substantially. The VIX, the volatility of the S&P 500, is in a strong up trend, and above 30 it reflects significant risk conditions.