The signs are everywhere, after years of central-bank collusion to douse the world with free money: historically low yields even on the riskiest cov-lite junk bonds; corporate profit margins at the upper extreme of the range; record valuations of stocks and other assets…. Heck, even startups: median Series A valuations – the first major VC money after seed money – have gone berserk and are now higher in inflation-adjusted terms than the median Series B valuations were 10 years ago!
And all this in a historically crummy global economy.
Valuations are going to revert to the mean. They always do. And when they do, they’ll overshoot in the process. The business cycle still exists. The great unwind will happen in an environment when nearly everything is overvalued. But those who have dared to stamp a near-term date on that event have gotten hammered by reality. Now, prudent wiggle room is getting built into the scenarios.
Junk bonds are enjoying the most extraordinary bubble ever, as investors – particularly bond funds – are desperate to get some yield in a world where central banks have moved heaven and earth to expunge yield. They’re stretching and reaching for it, and that has created demand that has driven down the very yield they’re so desperately reaching for. Their justification: junk-bond default rates hover near historic lows of about 2%.
Sure. As long as cheap new money is available to service or pay off old debt, defaults are rare. The issue arises when the new money gets more expensive and investors more prudent. Suddenly, new money won’t bail out old money. That’s when default rates soar. Investors will lose their shirts. It will happen. It always does, says high-yield expert Martin Fridson. The “next junk-bond implosion” will kick $1.6 trillion in junk bonds into default over a three-year period, he says. But not now. In 2016, he figures…. [“$1.6 Trillion in Defaults Coming,” Legend Says].
Jeremy Grantham, co-founder and Chief Investment Strategist of GMO, wrote of a similar scenario for stocks: a tough environment of crazy valuations where the future looks bleak – but that future hasn’t arrived yet.
Already a year ago, he saw the bubbly conditions in the US markets – “badly overpriced” is what he called them at the time in GMO’s third-quarter letter – and predicted that the US stock market would “work its way higher, perhaps by 20% to 30% in the next year or, more likely, two years….”
In the year since, the S&P 500 has gained 15%. Right on target. He added:
And then we will have the third in the series of serious market busts since 1999 and presumably Greenspan, Bernanke, Yellen, et al. will rest happy, for surely they must expect something like this outcome given their experience.
Ah yes, “we the people, of course, will get what we deserve.”
And he had an “Inconvenient Conclusion”: “Be prudent and you’ll probably forego gains. Be risky and you’ll probably make some more money, but you may be bushwhacked and, if you are, your excuses will look thin. Your call.”
This scenario of bubbly conditions, followed by some nasty downdrafts would create negative average returns over the next seven years of -2.1% for US large stocks and -3.5% for small caps per year (chart). Gloomy. But in the future.
So far, he has been right. GMO’s Q3 2014 newsletter, released on Tuesday, resumes the theme of party now, pay later, but not much later….
Stocks are supported for the moment by some positives, including the “Presidential Cycle,” but they also face some negatives: the end of QE, “talk of rate increases early next year,” a possible escalation of “several minor but intractable wars,” topped off by the Ebola outbreak. And then there’s “the very substantial overpricing of the US market,” though it may not have any short-term effect whatsoever.
And so he comes to this chilling conclusion:
My personal fond hope and expectation is still for a market that runs deep into bubble territory (which starts, as mentioned earlier, at 2250 on the S&P 500 on our data) before crashing as it always does. Hopefully by then, but depending on what the rest of the world’s equities do, our holdings of global equities will be down to 20% or less. Usually the bubble excitement – which seems inevitably to be led by U.S. markets – starts about now, entering the sweet spot of the Presidential Cycle’s year three, but occasionally, as you have probably discovered the hard way already, history can be a snare and not a help.
This is the new theme: we see the problems, they’re everywhere. We track them, we chart them, we understand them, we know they’re huge, and denying or rationalizing them would make us look silly, though plenty of folks are still denying and rationalizing them. There will be a reset of some sort, these crazy valuations will unravel, corporate profit margins will revert to the mean by overshooting it, defaults will cascade through the system, trillions will go up in smoke.
This will be a rough time for unprepared investors, the meme goes, but for now, the party is hopping. Money is still free and plentiful. Times are still good. Profits now. Apocalypse later.
But does the smartest guy on the block really want to party till the last minute, whenever that may be? Perhaps not. Warren Buffett impeccable sense of timing has apparently kicked in, but he doesn’t want to spook the markets. Read… Buffett Is Dumping Stocks out the Backdoor
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