‘Mean Aversion’: Why Grantham’s GMO Thinks The US Stock Bubble Is Bursting

US stocks screamed higher on Friday morning amid the latest trade trial balloon headline which this time revolves around the prospect of Beijing going on what Bloomberg describes as “a six-year buying spree to ramp up imports from the US.”

That’s according to “officials” who claim the sweeping offer, delivered during what everyone thought were largely fruitless negotiations in Beijing earlier this month, would entail China buying some $1 trillion in US goods over a half-dozen years with the ultimate goal of cutting the trade deficit to zero.

Amusingly, the US delegation is said to have been unsatisfied, effectively demanding that the Chinese eliminate the trade imbalance in a third of that time. This marks at least the third time in the past nine months that Beijing has attempted to placate Trump with an offer to purchase more US goods. If Trump rejects this offer (assuming it’s actually on the table) it would lend further credence to the notion that he doesn’t really want a deal and would actually prefer to keep the spat going in an effort to convince his base that he’s “fighting the good fight” (unless of course the Dow plunges 10%, in which case he’s calling up investors for advice).

Whatever the case, by lunchtime Friday, S&P futs had rallied more than 2% from levels seen just prior to Thursday’s WSJ “scoop”.

(Bloomberg)

The rally off the overnight lows on December 26 now borders on the absurd – especially for small-caps.

(Bloomberg)

Given all of the above, it might seem odd to highlight research that suggests “the US stock market bubble is bursting”, but that’s kind of the point – the juxtaposition is what makes it so fun.

The cold-water take comes from Martin Tarlie, part of the asset-allocation team at Jeremy Grantham’s GMO. Tarlie delivers his thesis in an 8-page white paper and it’s pretty interesting. He employs a “bubble model” as it appears in a July 2018 article in the International Review of Financial Analysis journal. His argument hinges on an inflection in sentiment. To wit, from the white paper:

In the context of market action over the past quarter, expectations of decelerating earnings growth — albeit still positive — reflect a negative change in sentiment. Furthermore, between August and December of 2018, estimated EPS for 2019 fell from $163.51 to $156.28, a decline of more than 4%. These earnings changes could reflect negative changes in sentiment. But other concerns, such as tightening by the Federal Reserve and trade tensions with China, can also cause negative changes in sentiment. And it is negative changes in sentiment — defined broadly — that can catalyze the pop.

Tarlie goes on to note the obvious, which is that for a bubble to pop, it has to have existed in the first place. It goes without saying that not everyone agrees with the premise that US equities were a bubble and he rolls out a variety of arguments to support the idea that they were. There’s valuations, for instance:

Tarlie writes that in the majority of cases, valuation is mean reverting, but “on rare occasions valuation is temporarily explosive, or mean averting, [and] this mean aversion goes hand in hand with expensive valuation and is the defining characteristic of a bubble.”

As you can probably imagine, Tarlie has a model to measure “mean averting behavior”. In other words, this is something that’s quantifiable. To wit:

The question of whether or not the stock market displays mean averting behavior is a statistical one. A positive mean reversion speed means that price reverts to fundamental value, i.e., mean reversion holds. However, a negative mean reversion speed means that price moves away from fundamental value and mean aversion, not mean reversion, holds.

[…]

The five periods of explosive dynamics are highlighted by the solid red circles in Exhibit 2. Also highlighted in the dashed red circles are the periods of stronger than average mean reversion that follow each period of mean aversion. Note, in particular, the dramatic move from the third quarter to the fourth quarter of 2018.

He goes on to zoom in on period 5 in the chart above – i.e., on the current episode of mean aversion suddenly giving way to a nauseating bout of mean reversion.

Tarlie says that although we didn’t get the stereotypical anecdotes about the ubiquitous “shoe shiners” handing out stock tips while polishing Gucci monk straps, there was no shortage of absurdity. “The optimism and enthusiasm surrounding Big Data, Artificial Intelligence, and Bitcoin, among other technological advances, are typical of bubble-like animal spirits”, he writes, before delivering a visual which illustrates the moment when “the data point for the fourth quarter of 2018 showed a dramatic change in the mean reversion speed, from an explosive, mean averting phase to a strongly mean reverting phase.”

There’s much, much more in the full paper (available here), but the key point for Tarlie is that bubbles inflate when things are going well and folks expect them to get better. When those conditions persist, valuations are high (reflecting the current good mood) and although he doesn’t say this specifically, that good mood can (and often does) feed into real economic outcomes which then serve as “proof” that rosy expectations weren’t misguided. That, in turn, leads to still more buying and higher valuations.

When this process reverses, the flip can be violent. “Sentiment cannot increase forever”, Tarlie remarks, adding that “when change in sentiment — not level — inevitably turns negative as hopes of even better times ahead are dashed, there is nothing left to fuel the bubble.” At that point, mean reversion reasserts itself and “with a vengeance”, as GMO puts it.

So what, you might well ask, does GMO recommend? Well, this:

Currently, we are faced with a volatile market that, through the end of 2018 at least, is down double digits from the September, 2018 peak. The volatility is consistent with a bubble bursting, though we caution that it is possible that the fourth quarter move in the mean reversion speed could be a head fake. While the dramatic nature of the move in the mean reversion speed to such strong mean reversion suggests that the odds are tilted toward this being the beginning of the end of the bubble of 2017-18, we cannot rule out reflation of the bubble, analogous to the event of late 1998-2000. Given that valuation is still high, our advice, consistent with our portfolio positions, is to continue to own as little U.S. equity as career risk allows.

Somehow, all of the above seems particularly germane on Friday, with stocks surging and The University of Michigan’s preliminary January sentiment index diving to the lowest levels since October of 2016.