Jeremy Grantham, the 74-year-old chief investment strategist of Boston-based investment fund Grantham Mayo van Otterloo (GMO), has made his career forecasting market bubbles--with remarkable success. When writing an article on the slowing pace of global growth last week--for which Grantham's ideas provide significant fodder--my colleagues and I were spellbound by one statistic: of the 36 major bubbles GMO says it tracks, 33 have completely popped, or returned to their prior trends.
GMO won't say what most of these are, and according to the firm's quarterly letters, it also tracks a lot more less-major bubbles: 330 by its February 2013 count. For GMO, a "bubble" is simply when the price of an asset in relation to its real value (usually just the "price-to-earnings ratio" in investor-speak) has exceeded its average by a certain amount, and a "major bubble," a bigger amount (two standard deviations, for statistics aficionados.)
Among Grantham's accurate predictions: the 2006 housing bubble, the dot-com bubble of the late 1990s, the Japanese stock bubble of the late 1980s. More recent predictions: the Australian and UK housing market bubbles, which have yet to pop. Perhaps most worryingly, GMO has been warning of what fellow strategist James Montier calls (pdf) the "foie gras" bubble or the "near-rational" bubble, in which "investors are being force-fed higher risk assets at low prices"--a product of central banks' loose monetary policies.
The 36 major bubbles GMO follows are pretty improbable, statistically speaking--but in real life, they turn out to be less improbable than expected. In an interview with US TV host Charlie Rose (pdf) earlier this year, Grantham explained (the transcript is unedited):
A bubble we had to make a definition long ago and we decided to have a statistical definition of the kind that would occur every 44 years in a random world. It isn't a random world but it's closer than you think. The kind of event that would occur randomly every 44 year occurs in the real world every 30 years. It's much closer than we expected.
In other words, based on his calculations, markets are more volatile than mathematics says they should be. Grantham accurately predicted the housing bubble--which went along with a bubble in profit margins for corporations--in 2005 (pdf). According to his statistical methodology, this was a 1-in-5,000 year event (pdf). He wrote in February:
It is just statistics, full as always of assumptions, which in this case we hope approach rough justice. What it does definitely mean, though, is that it was extraordinarily unlikely that the extremely diversified U.S. housing market would shoot up like it did and, frankly, even more remarkable that Bernanke and his timid or incompetent advisors could miss it.
According to Grantham, the Federal Reserve (among the world's other central banks) has gone about its business ignoring bubbles, at least for the 15 years leading up to the financial crisis. He criticizes this approach (pdf, registration required), arguing that central banks should be tasked with mitigating bubbles before they get out of control, instead of focusing on strengthening economies.
In the real world, major asset bubbles are easy to see. They are nearly impossible to miss, in fact. But we travel in a world with a systemic bias to optimism that typically chooses to avoid the topic of the impending bursting of investment bubbles...[The Fed] doesn't want to move against bubbles because Congress and business do not like it and show their dislike in unmistakable terms.
GMO's remarkable track record of spotting bubbles--not to mention the severe and lingering economic impact of the US housing bubble--does lend credence to this view. The Fed was thoroughly embarrassed by its failure to treat the US housing bubble before it got out of control. But perhaps, with its threat to dial back its easy money policy in the near future, the Fed is taking a page from GMO's book.GMO declined to provide more details about its methodology or current bubbles it's tracking because those data are proprietary.
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