Will the Next Bubble Be Housing or Equities?

 Jeremy Grantham, of GMO LLC, writes a quarterly newsletter for investors.  In his most recent issue, he predicts market behavior and speculates about what the next great stock market bubble will be.

 He Believes that a Bubble Does Not Currently Exist in Our Stock Market (No Corrections for the Time Being!)

 He says that bubble conditions would involve the S&P 500 being about 10% higher than it is. 

They would also involve a much more bullish attitude on the part of investors, which he feels we don’t currently have in equities at the moment.

The Facts Seem To Bear This Out. 

The interested are pleased, certainly, that the bear markets of early this year did not last, but a certain amount of caution remains. 

The S&P 500 has mostly been climbing over the past five months but losing since the beginning of this month. 

Investors may be slow to be wooed back from safer investments like treasuries, which may keep equities down for the time being.

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However, Grantham Remains Optimistic About Future Equity Growth

Grantham does not believe that equities are going to reach their upper limit by the next election—no six-month growth followed by a plummet. 

Again, the evidence so far bears this out, with a general upward trend in the S&P 500 that has lasted for all but this month. 

It is his assertion that equities may, in fact, be on an upward trend that will continue to grow long past this November.

Other Areas of the Market that Grantham Feels Bullish About

• Oil stocks, particularly in the next five years
• The farming sector, which he has high hopes for
• Technologies developed to reduce the output of CO2

Grantham Does Believe, However, that the Formation of Another Bubble in Our Markets is Inevitable

This, of course, is not such good news.  It is his assertion that given the Federal Reserve’s actions—or perhaps more to the point—their lack thereof, that the formation of a bubble somewhere in the market is, in fact, absolutely coming. 

He just isn’t one-hundred percent certain where or when such a bubble will form, though he has his guesses.

An Idea, Which Looms Large in His Mind, For Instance, is the Housing Market

Though nowhere near at the levels it was at in 2006, the housing market is at what he calls one and a half sigma, which is an upward deviation from its historical market levels. 

In plain English, housing prices are considerably above what they have averaged in the past.  If they stay where they are, no bubble will necessarily form around them.

However, Housing Prices, Far from Being Stagnant, Continue to Grow

If it stays on its current trajectory, housing will be at one and three-quarters sigma by June.  For reference, it was at three sigma in 2006 before the bubble burst.

Apparently, Grantham believes the housing market to be a potential site for his predicted stock-market bubble and a particularly ironic one at that.

He Considers the Less Dramatically High Sigma, for Instance, to be Part of the Problem.

The housing correction was insanely painful when it finally happened.  So much so, that one would expect that investors would do just about anything to avoid it happening again. 

However, one-and-a-half sigma is considerably lower than three sigma—exactly half, in fact—so it’s entirely possible that investors are ignoring the warning signs.

“Pricing is nowhere near that insane three sigma it used to be,” would be the rationale, “so what could go possibly wrong?”  According to Grantham, plenty.

This is What He Calls an “Echo” Bubble

One-and-a-half sigma is so much smaller a deviation than the three sigma at which the last disaster took place that people fail to pay it any mind.  It’s a little like someone who has survived a broken foot being unlikely to worry much about a stubbed toe.  And that, he believes, is where the danger comes in.

If prices do not slow down, he opines, our next market disaster may come in a year or two, and the culprit will once again be the housing market.

However, and This Bears Repeating, He Does Not Believe that There is Currently any Bubble in the Markets

Again, he feels that the markets are at least 10% too low to suffer any downward correction at the moment.

Conclusion

Some of what Grantham has to say has fairly serious ramifications for the next couple of years on the markets. 

But, he also spent a large section of his newsletter calling himself out for a failed prediction about running out of certain finite resources. 

It may be that none of what he is predicting comes to pass, or that it does but not to the degree that he fears.

Only time will tell.