William J. Bernstein
Comin' Around Again?
The wise investor ignores the economy (macrobabble), market sentiment (animal spirits), and especially investment company strategists (astrologers, except I wouldn’t want to insult astrologers). As discussed in my previous piece, the better you are at tuning out the opinions of others and making judgments for yourself, the wealthier you will be.
I make one teensie exception: Jeremy Grantham, one of the few folks who arrives at expected asset-class returns the right way—by looking at current valuations laced with realistic analyses of per-share growth metrics, viewed on a background of historical pricing. Ed Tower at Duke recently analyzed Grantham’s asset-class forecasts; aided by extraordinary market conditions and perhaps a little bit of luck, Grantham predicted in exact rank order, and with an astonishing 0.90 R-squared, the performances of the major category returns over the next several years. (The absolute returns were a bit off the mark: no surprise, since the seven-year standard error of equity is on the order of 10-20% per year.)
It gets my attention, then, that in his April 2007 newsletter to clients (available with a free registration), Grantham made a startling statement: Everywhere he looked, he saw a bubble.
He has a point, of sorts. If the expected-returns landscape in 1999 was mountainous, from the deep valley of large-growth equities around the world to the peaks of emerging markets, small, value, REIT, and precious-metals equities, then today’s terrain is a vast, flat steppe consisting of stocks everywhere selling at around 20-25 times trailing earnings. Thus, at best, we’re looking at low single-digit returns. And that’s with earnings inflated, I might add, by questionable accounting and the peak of a global economic boom.
Universally overvalued? Certainly. A bubble? That’s not how I’d define one. I’d want to see at least Ben Graham’s "New Era" with multiples of 40+ or, better yet, the madness of the nineties, when the very mention of the word "earnings" caused more hilarity than a case of Moët.
The late Hyman Minsky defined the two basic requirements for a bubble: liquidity and displacement, by which he meant a transformative technology. A displacement could be of the garden-variety sort—think commerce with the South Seas in the eighteenth century, the railroads in the 1840s, aircraft and radio in the 1920s, or electronics in the 1960s. It could also be financial, such as the introduction of sophisticated futures markets in Holland in the 1630s and John Law’s equitization of government debt in the 1720s.
A few weeks ago, Jim Wiandt, the founder and publisher of Journal of Indexes, sent me, almost tongue-in-cheek, a listing of ETF issuances expected for later in the year. The list boggled the mind. Aside from the usual single country and slice-and-dice packages, there were, I kid you not, funds based on nine different NAREIT benchmarks, a "Dynamic Brand-Name Products Portfolio," an Inverse Materials ETF, a Healthy Lifestyle fund, an Ellioit Wave ETF, a Georgia (the state) ETF and, my favorite, an "Ultra-Short S&P 400 MidCap 400 Citigroup Growth" ETF. I began counting and lost track at 500.
Over the years, I’ve learned that disagreeing with Jack Bogle is not a good idea. I originally thought his view of ETFs was unduly alarmist: little speculative cherry bombs with which investors could blow up their savings. After all, the first Barclays products sported minuscule fees and mirrored most of Vanguard’s market-segment offerings—surely, they would be carefully assembled into efficient portfolios with a long view out to the horizon. And once again, the Sage of Valley Forge won the point: As the splinters get thinner, they grow sharper, and the odds of folks hurting themselves with these pointed objects now approach one hundred percent.
Worse, here is Minsky’s displacement, in spades: a "new" financial instrument. The first ETFs tracked broad market indexes and were rather difficult to push around, and so not much given to speculative excess. But how much capital does it take to move—I’m not making this up—the HealthShares Infectious Disease Index? At some point in the not too distant future, it’s likely that several, or even several dozen, of these cherry bombs are going to flare off. With only the slightest nudges from the fund-company marketing departments and an assist from gullible financial journalists, the forces of human financial nature will push the least liquid of these into the stratosphere. From there, the fever may spread to the wider market, and we’re off and running.
How likely is such a scenario? I’ve always thought that Minsky’s two criteria for a bubble were insufficient and that two more conditions needed to be met. First, investors have to forget the last frenzy, particularly how it ended. This usually takes a generation; it’s been only seven years since the dot-com blowup, so it may be too soon yet. But with each passing year, and with each new wave of yet-more-improbable products, the danger grows. Also, the usual valuation metrics have to be disregarded—in short, investors have to forget how to do long division. With the stretching of multiples in small stocks, emerging markets, and particularly REITs, this may already be underway.
I don’t give such a scenario more than even money—it’s just been too soon, and the target baskets may have market caps too hard to budge to excite the rubes. But if it does happen, the first clue will be ever more ludicrous fund launches, followed by significant premia in the prices of the funds over their intrinsic NAVs as market discontinuities overwhelm the normal arbitrage mechanisms built into the system. On the way down, these premia will reverse, and with a vengeance.
The Jeff Skilling Ultra Rapid Capital Depreciation Index ETF, anyone?
Copyright © 2007, William J. Bernstein. All rights reserved.
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