When the Bough Breaks

"The great bubbles take their time. Quite a few years going up. Quite a few years coming down, and the market suffers from attention deficit disorder, so it always thinks every rally is the beginning of the next great bull market. My guess is that we will have a recession, I don’t know if it will be fairly mild or fairly serious, but it will probably go deep into next year. Every bubble has been greeted with a chorus of ‘soft landing,’ and there’s never been one. Each cycle is different, so each cycle, something else happens. It’s always a surprise, but you always have a surprise, so the very idea of a surprise is unsurprising.

I would argue you have to be brave buying when prices are extended and high, because you’re much more likely to lose money. The real bravery to buy when the market is smashed down to a bargain seems to me to be very little. That is not now. If you look at the most predictive measures, and Mr. Hussman does the best of those – very detailed historical record of which ones actually do the best – those measures are about as high as they’ve ever been, today. They’re in the top 2 or 3 percent of all time. There’s a spike in 2000 and a spike in 2021, and this is above 2000 but below the spike in 2021, but we are right up there.

In order to get the market down to where it would typically outperform the long bond by 5%, which you could argue it should, the market, just sheer arithmetic would have to drop by more than 50%. This is not my forecast. I have a very genteel forecast where anything below 3000 would make me think it was reasonable, and if everything works out badly, which it sometimes does, I would not be amazed if it went to 2000 on the S&P, but that would require a couple of wheels to fall off. And wheels tend to fall off when the great bubbles unravel, but it doesn’t mean they have to. It would be unlikely not to get to something close to 3000 on the S&P. You can’t get blood out of a stone. Sooner or later, the simple arithmetic suggests that you’ll either have a dismal return forever, or you’ll have a nice bear market and then a normal return, and the nice bear market will hopefully be less than 50%," Jeremy Grantham, GMO, Bloomberg UK (abridged), October 5, 2023.

Value-conscious, historically-informed, full-cycle investors place a great deal of emphasis on the relationship between the price an investor pays today and the cash flows they can expect to receive in the future. The reason is simple. For any given stream of future cash flows, the higher the price you pay today, the lower the long-term return you can expect, and the greater your downside risk. The lower the price you pay today, the greater the long-term return you can expect, and the smaller your downside risk.

It seems counterintuitive, but it’s true – lower expected market returns go hand-in-hand with higher risk of loss; higher expected market returns go hand-in-hand with lower risk of loss. That proposition seems to run counter to what’s taught in finance, but speaking as a former finance professor, that’s because the concept of “inefficient risk” isn’t discussed carefully enough. As I wrote in Return-Free Risk at the January 2022 market peak:

“Investors are familiar with the idea of a ‘tradeoff’ between return and risk, which is typically stated as a proposition that investors must accept higher risk if they seek higher expected returns. What investors are typically not taught is that this proposition applies only to ‘efficient’ risks. For example, if a portfolio is poorly diversified, one can typically find another portfolio that can target a higher level of expected return for the same amount of risk, or a lower level of risk for the same expected return. Likewise, in a wildly overvalued market, investors should expect not only poor returns but also higher prospective risk. Put simply, investors are not somehow rewarded for accepting higher levels of what Ben Graham described as ‘unintelligent” risk.’”