Bubbles Again: Setting Up for a Deal Frenzy
Despite a shocking 2.9% setback in first quarter GDP (quarterly decline at annualized rate), the extent of which was
forecast by no one, and despite a substantial decline in NIPA corporate earnings, the market has climbed slowly
but steadily in recent months. Market volatility has declined to very low levels despite these setbacks and despite
Middle Eastern problems. (The negative January Rule this year has, for that matter, also been ineffective so far.)
So, all is apparently well, as we have arrived within three months of the dreaded (by bears) Presidential third year.
Accordingly, my recent forecast of a fully-fledged bubble, our definition of which requires at least 2250 on the S&P,
remains in effect.
What is worse for us value-driven bears, a further bullish argument has struck me recently concerning the probabilities
of a large increase in financial deals. Don’t tell me there are already a lot of deals. I am talking about a veritable
explosion, to levels never seen before. These are my reasons. First, when compared to other deal frenzies, the real
cost of debt this cycle is lower. Second, profit margins are, despite the first quarter, still at very high levels and are
widely expected to stay there. Not a bad combination for a deal maker, but it is the third reason that influences my
thinking most: the economy, despite its being in year six of an economic recovery, still looks in many ways like
quite a young economy. There are massive reserves of labor in the official unemployment plus room for perhaps a
2% increase in labor participation rates as discouraged workers potentially get drawn into the workforce by steady
growth in the economy. There is also lots of room for a pick-up in capital spending that has been uniquely low in this
recovery, and I use the word "uniquely" in its old-fashioned sense, for such a slow recovery in capital spending has
never, ever occurred before. The very disappointment in the rate of recovery thus becomes a virtue for deal making.
Previous upswings in deals tended to occur at market peaks, like 2000 and 2007, which in complete contrast to today
were old economic cycles already showing their wrinkles. Worse than being in full swing, they were usually way over
capacity. Thus, 2000 was helped along by the bubble in growth stocks to over 60 times earnings, allowing companies
like Cisco, possibly correctly, to believe they were dealing with a near-zero cost of capital in making deal after deal
for their massively overpriced stock.
In 2007 the housing bubble led to an extra one and a half to two million houses being built, with all the usual
accoutrements of furniture sales and more jobs for realtors, bank officers, and Goldman Sachs designers of ingenious
new ways to be of service to real estate speculators. Now that the smoke has cleared, the 2007 economy at its peak
looks to have been 2% or so above trend capacity (allowing, incidentally, for the overstating of the U.S. long-term
growth capability, a misjudgment that is still hanging around).
GMO Quarterly Letter – Second Quarter 2014 7
If I were a potential deal maker I would be licking my lips at an economy that seems to have enough slack
to keep going for a few years. Also, individuals and institutions did feel chastened by the crash of 2009 and
many are just now picking up their courage. And as they look around they see dismayingly little in the way of
attractive investments or yields. So, the returns promised from deal making are likely to appear, relatively at
least, exceptional. I think it is likely (better than 50/50) that all previous deal records will be broken in the next
year or two. This of course will help push the market up to true bubble levels, where it will once again become
very dangerous indeed.
My final thought on this issue is the following point, which I failed to make in my bubble discussion last
quarter: perhaps the single best reason to suspect that a severe market decline is not imminent is the early-cycle
look that the economy has. And even Edward Chancellor last quarter conceded that there was as yet no sign of
a bubble in the quantity of credit that was being created.