I am not a full-time trader, and investment is supposed to be fun for me. Hence my motto: "Relax, Invest". But I have to say I have all but relaxed in the past few weeks regarding my investments. Why am I worried, and what am I doing about it? Let's first learn from the smartest on the field.
The case for a looming financial disaster, by Jeremy Grantham.
OMG, this folk is depressing. Listening to Grantham puts you in an excruciating position, so why should we listen anyway? Jeremy Grantham is co-founder and chief investment strategist of GMO asset management firm with at least a hundred billion USD under management. He was also involved in creating the world's first index funds in the early 1970s. So plenty of experience in the market. He primarily built his legend by identifying speculative asset bubbles as they unfolded. He correctly identified the Japanese equities and real estate bubble in the late 1980s and the internet bubble in the late 1990s. A decade later, he limited his exposure to the housing bubble before the 2008 crash.
Last year, he started warning of a new bubble in the US equity market. 10 months later, the meltdown started in the so-called "growth stocks", with about 40% of the Nasdaq listed companies shedding 50% or more in market value.
Now, according to Grantham, this is just the beginning. It follows a classic bubble bursting pattern of impacting the most speculative part of the market to then spread to the broader indexes, just like in the Internet bubble. This unraveling can take months to years, but Grantham is positive that it has already started.
His central argument for it is a model his firm built based on the indexes prices, multiples and fundamentals which, according to him, has now reached a 3 sigma deviation. This is a statistical measure of really, really rare statistical deviations, the kind that happens once in a century in statistics, on once every 30 years in the stock market. I wish GMO were more transparent about their model, at least explaining or open-sourcing it, but they aren't, so I can't abide by it.
What makes Grantham extremely bearish is that this equity bubble is supposedly combined with 2 other bubbles, one in treasury bonds prices and one in the US housing market (which increased 20% in the past 12 months, unseen in the history of the US real estate). The latest inflation reading is just more fuel for the fire to begin.
What does Grantham think will happen? The S&P500 will lose about 50%, all the way down to 2500, starting in the next few months, and the bear market could last for years... 😰 This is about as bearish as it can get, scary stuff...
What about "don't try to time the market" or "the best way to time the market is to constantly invest". etc.?
Even though the US market has constantly returned an average of 7% (inflation adjusted) since its creation, it sometimes took longer to recover from massive crashes. Everything depends on your time horizon. The S&P500 took about 7 years to recover from its pre-Internet bubble burst and about 4 years from the pre-2008 crash high. Of course investing on a recurring basis makes these recovery times shorters, but still... The crisis from the late 1920s took even longer, but nothing compares to the Japanese bubble burst, which is just starting to see prices it had back in.... 1991 🤯. So, if bubble bursting there is in the next 12 months, you better not retire in the 5 years, or you are probably f$%$ed. In my case, I pretend to be able to retire 8 years from now, so if this is true I need to cover my ass just in case the worse happens, otherwise bye-bye financial freedom by 2030.
Any optimists amid such doom-saying? Can somebody turn Grantham to ridicule? Please?
Why not start with the person probably most affected by the so-called bubble bursting: Cathie Wood. Cathie Wood is the ARK Investment fund's founder, specializing in "disruptive innovation", the exact kind of company that got slammed in market valuation in the past few months. In fact, the ARKK ETF has lost 55% of its value in the past 12 months. One could argue she has less to lose now. I disagree as her career and reputation are in line big time. Here are her latest readings of the market and economy in general.
Round 1: Housing Market
She first seems to disagree that the housing market is in a bubble, but neither Grantham nor Cathie give a robust analysis either way. So it's a tie.
Round 2: Value vs. Growth valuations
This is the most glaring contradiction between Grantham and Cathie. Grantham says, "take refuge in value stocks, as these have never been so far under the market median", while Cathie says the exact opposite. Granted, "value stock" means whatever you want, as you can see stocks trading for 30 times earnings and still be undervalued on a future cash flow modeling.
Talking about growth and value stock is very misleading. Growth is only one factor driving differences in market-to-book ratios and price-to-earnings ratios. Return on Invested Capital (ROIC) is also critical. McKinsey's valuation gurus found no difference between so-called value and growth stocks in the distribution of growth rates. Nevertheless, they found that growth stocks tend to have high ROIC, while value stocks have lower ROIC. So-called value companies had a median return on capital of 15 percent, compared with growth companies' 35 percent.
Phone a friend: what does the NYU Stern valuation professor, Aswath Damodaran, think of the current market valuation?
Aswath has been teaching valuation at NYU Stern for 35 years (since I was born😵!). He recently wrote about both the current FAANG (FB, AMZN, AAPL, NFLX, GOOG) stock valuation and the S&P500 valuation. In his view, both are not far from their fair value. Aswath is a champion of transparency, so he always shares his models and datasets. I took his model for a spin and customized it to reflect a more conservative view of the economy. I increased the Equity Risk Premium (what investors expect in exchange for greater risk) from 5 to 6%. 6% is in the upper hand of the standard deviation he computes. I also updated the risk-free premium to the actual 10 yrs treasury bond yield to 2%. Finally, I upgraded the risk-free rate from 2.5 to 3% five years from now to put us in the scenario where inflation is here to stay. I kept the analyst earnings forecast and the terminal growth rate unchanged. It gave me that the S&P500 is roughly 30% overvalued with an intrinsic value of 3500. So not as bad as the 2500 Grantham believes, but still bad.
I give a point to Cathie here for transparency as ARK will open-source all of their valuation models. Aswath doesn't seem to see irrational behaviors or extreme bubbles as Grantham does. Still, if inflation keeps surprising us on the wrong side, and the economy flips towards a recession, be ready for a significant bear market that could last years.
Round 3: Inflation and recession
Talking about the recession, Cathie is not very optimistic about the economy either. She mentions the decrease in the workweek, the workers' loss of purchasing power, the bleak outlook Amazon and Meta gave in its earnings, the rise in inventory and the diminishing consumer confidence index. But this is exactly why she does not worry about permanent inflation, as she is forecasting a steep slowdown in consumption. She mentions the recent restart of US oil fracking to explain why oil prices should be kept under control. She does not talk about recession as Grantham, even though highly disruptive companies should not be too exposed to a downturn (for example, the gene-editing tech will grow whatever the economy does). I guess it is why she affirms her price targets for disruptive stocks remain unchanged.
Grantham instead does see inflation as a long-term structural problem. He mentions the worldwide decrease in birth rate as to why the worker base will keep getting smaller, putting pressure on wages and potentially on consumption. For him, ESG imperatives + past commodity price crashes trauma made drillers and miners underinvest their CAPEX for the past 20 years. The commodity capacity shortage has no end in sight (a new mine is a significant undertaking that can take up to 10 yrs before becoming operative). He also mentions climate change as a reason for food shortages to become more frequent. These structurally high commodity prices are yet another reason why inflation would only go up in the medium term and should force the FED to take a stricter stance. A recession shall follow.
Here I see both having solid arguments, but I think Grantham takes a longer view of the forces behind inflation. I give the point to Grantham
Professor Aswath Damodaran summarizes it like this.
"If you believe that last year's surge in inflation is a precursor to a long high and above expectations inflation, you should be shifting your holdings away from financial to tangible assets, and within your equity holdings, towards small-cap stocks, stocks trading at lower pricing multiples (PE, Price to Book) and companies with more pricing power. If, on the other hand, you believe that inflation worries are overdone, and that there will be a reversion back to the low inflation that we have seen in the last decade, staying invested in stocks, and especially in larger-cap and high growth stocks, even if richly priced, makes sense."
Round 4: War
War was not on their radar when they wrote their pieces, and even if its impact on revenues should be muted for European and US stock markets, it will not help with commodity price pressure on inflation. As the West's sanctions on Russia will probably remain for years to come, such pressure won't ease in the short term.
So this is another point for Grantham´s gloomier view
Round 5: Insiders
Neither Cathie nor Grantham talks about Insiders, but this is my personal addition. I will focus on US insiders as it is more transparent with their insider's transactions rules. After seeing a peak of insider buying trx in November and December 2021, principally in the beaten up Software Industry, they have been shyer so far in 2022. It seems their approach is leaning toward a "wait and see" stance. It´s a tie again.
Grantham gets 2 points, while Cathie gets 1. We are in a highly uncertain economic environment, which means high volatility, higher equity risk premium hence lower valuations than a year ago. With that in mind, the US equity market looks like a dangerous place to be invested right now. Some will say times like that are when fortunes are made. Even if you believe Grantham's doomsaying is overdone, it's hard not to worry about one's portfolio in the medium term. What am I personally doing (not investment advice)?
I am highly exposed to US-based high PE stocks. Still, I revisited the valuation of each of my holdings with a very conservative view, both in terms of the equity risk premium and future trading multiples. I have been trimming the ones that look pricey with these new variables over the past months and added to the ones with a decent margin of safety according to my model. Still, if the market crashes, the market won't care much about fundamentals, and all kinds of equity will be affected in the short to medium term.
So I have been progressively hedging my portfolio by shorting the S&P500 with a non-levered cheap instrument: the SH index (available on eToro). There are also levered short indexes: SQQQ or SPXU to name a few, but these are costlier and not designed to be held for more extended periods. About 15% of my portfolio is a short position, while another 15% is used for defensive instruments such as Cash, Gold and Carbon-offsets. It means I am not "market neutral" but would still feel less pain in case of the bear market is here to stay. In fact, if the market were to pull back another 30%, my short position would grow between 20 and 25% of my total portfolio. It could then be turned into cash to buy astonishing businesses at attractive prices. Suppose the market rebounds instead and grows another 30%. In that case, my short position will shrink to between 5 and 10% of my portfolio, which would "only" grow about 15%. It works both ways; I would "only" lose about 15% of my portfolio the other way around.
Remember investing should be fun? I am buying my peace of mind to "relax and invest" again.
For now, each time I open a new position in a company (I will keep investing), I will mirror it with a short position on the S&P500 to make it market neutral. It means the mix of the two should cancel out market momentums (whether positive or negative) to avoid general market risk and provide uncorrelated returns. Market neutral strategies with this method comes down to companies fundamental exclusively.
That´s it! Stay rookie, stay thirsty, and happy investing! I will keep you posted on how it goes for me from here.