Currently, we find ourselves in a moment ripe for impulsive decisions. It seems everyone is participating in this trend—perhaps you are too.
Traditional metrics like stock valuations and corporate earnings growth seem to have lost their significance. Why not simply invest in an S&P 500 index fund and let it run? Or, even more enticing, consider purchasing shares of Nvidia?
The semiconductor company’s stock has surged more than 170% in the last nine months. Perhaps it has the potential to double in value once more.
There’s nothing quite like a substantial stock market bubble to cloud judgment and inspire ideas that would normally seem far-fetched. One popular notion at the moment is that low interest rates justify inflated valuations. Another is the belief that the Federal Reserve can perpetually inflate stock prices with its vast credit supply.
However, these ideas may soon lose their luster. As they transition from being ripe to rotten, investors who are betting on always finding a “greater fool” may soon realize the consequences of overpaying for future cash flows. In simpler terms, future returns could be disappointing.
Investing demands a blend of analysis, judgment, risk/reward assessments, time horizon, and personal financial realities. Luck and timing also play crucial roles. You may seem to have everything aligned perfectly on the surface, yet still face unexpected losses.
This reality is especially pertinent in the world of stock market investing. It’s entirely possible to buy the ideal stock at the least favorable moment. As unforeseen events unfold, the market may quickly turn against you.
Diversifying your assets and carefully sizing your positions are essential strategies for mitigating these risks. Currently, an S&P 500 index fund alone may not suffice.
Fear and Greed
During pivotal moments in the stock market—like now—your long-term success hinges more on your inaction than on your actions. Above all, it’s crucial to avoid making impulsive decisions that could set you back a decade or more in your pursuit of long-term wealth accumulation.
The stock market stands at a critical juncture now. After hitting a peak of 3,386 on February 19, the S&P 500 experienced a sharp decline of over 33%, reaching a temporary low of 2,237 on March 23. Since then, despite all odds, the index has rebounded, closing at 3,722 (a new all-time high) on December 17. Alongside the S&P 500, both the Dow Jones Industrial Average (DJIA) and the Nasdaq have also achieved record closing highs.
The temptation to invest in stocks right now is strong. However, psychological factors in investing often contradict those in consumer purchases. While many can easily spot a good deal on jeans or a new television, investors frequently buy high and sell low, as emotions like fear and greed come into play.
As the economy begins to reopen, the prospect of a resurgence in growth seems plausible. Perhaps the recent COVID-19 vaccine will soon render this entire situation a bad memory. Under such circumstances, could now be the perfect moment to buy stocks?
This optimistic outlook appears to be fueling the confidence of many investors, driving stocks higher with each favorable vaccine update or new stimulus announcement from Congress.
Who can say? They may very well be onto something.
Yet, we harbor some skepticism. The current stock market landscape is fraught with risks. Numerous uncertainties remain regarding the economy and financial markets.
How extensively did the lockdowns harm the economy? How long will it take for a full recovery? What ramifications will the substantial deficit spending and monetary stimulus measures have? And when will this bubble eventually burst?
Grantham’s ‘Real McCoy’ Bubble in a World Gone Mad
On June 17, billionaire investor and co-founder of the Boston-based money management firm GMO, Jeremy Grantham, issued a cautionary message. In a CNBC interview with Wilfred Frost, Grantham underscored his belief that the rebound in the U.S. stock market during the pandemic represents a significant bubble that could hurt many investors in the long run.
“I’m becoming increasingly confident that this is, indeed, shaping up to be the fourth ‘real McCoy’ bubble of my investing career. Major bubbles can persist for extended periods and inflict considerable pain. However, it’s clear we are in one right now.”
Since Grantham raised this alarm, the stock market bubble has continued to swell, reaching new heights and contradicting GMO’s strategy to reduce its fund’s stock exposure to just 25 percent.
On November 24, Bloomberg reported that GMO’s flagship Benchmark-Free Allocation Fund was trailing the S&P 500 by 14 percent year-to-date, and investors withdrew $2.2 billion from the fund in the last ten months.
Nevertheless, we remain convinced that Grantham’s predictions will ultimately prove accurate. Those investors who choose to stand by him will likely reap the benefits of their patience. Why do we feel this way?
Grantham has a strong track record of predicting bubbles throughout his distinguished career. He accurately forecasted the Japanese Nikkei stock market bubble in the late 1980s, the dot-com bubble in 2000, and the housing bubble in the mid-2000s.
His investment philosophy centers around the principle of ‘reversion to the mean.’ This concept asserts that all asset classes and markets eventually converge to their historical averages, both above and below these levels.
Reversion to the mean is an acknowledgment that financial asset prices occasionally become disconnected from their intrinsic value. During periods of bullish exuberance, prices may rise to dangerous highs, while during bearish anxiety, they can fall to significantly low valuations.
Hence, the ideal time to purchase is when asset prices are low, while the best time to sell is when they are high. However, while reversion to the mean is a sound principle for predicting long-term price movements, it often falls short as a timing mechanism in volatile markets.
Bubbles can inflate much further and persist far longer than one might reasonably anticipate. In a chaotic landscape, price discrepancies can widen significantly before reverting to mean values. Nonetheless, Grantham’s insights and his warnings are worthy of serious consideration.
The fact that the stock market continues to reach new heights—including recent record close for the S&P 500, DJIA, and Nasdaq—since Grantham labeled it a ‘real McCoy bubble’ does not nullify his assertion; rather, it corroborates it.
In conclusion, while the current market offers enticing opportunities, it’s crucial to proceed with caution. The realities of investing demand careful consideration of risks, perspective, and historical insights to navigate this unpredictable landscape effectively.
Sincerely,
MN Gordon
for Economic Prism
Return from Grantham’s ‘Real McCoy’ Bubble in a World Gone Mad to Economic Prism
