There are few more eloquent and convincing proponents on the subject of the tendency of asset bubbles to burst than Jeremy Grantham.
So when the chairman and chief strategist of Grantham, Mayo, Van Otterloo, the Boston fund management house, becomes convinced he has found a rare asset class that has witnessed a paradigm shift rather than just experienced a bubble, investors would do well to prick up their ears.
Mr Grantham believes one asset class has transcended the natural order of markets “reverting to the mean”, and if true, it will have consequences not merely for investors in the asset but also for the global economy. The asset class is oil.
In the 30 completed bubbles that Grantham Mayo has studied, all of them fell back to their historical trend line. The surge in oil prices of the 1970s might appear to fit this model when given the slide from a peak in 1980 to a trough in 1998. Mr Grantham concludes that the oil rally from the mid-1970s was not a genuine bubble but rather a paradigm shift.
“For about 100 years before 1974, oil spent most of that time close to the mean price of $16 a barrel in today’s currency,” Mr Grantham says. “In 1974, when the oil cartel began flexing its muscles, the trend line moved from $16 to about $36 a barrel in today’s currency.”
If this paradigm shift took place three decades ago, what is the significance for today’s crude investors? For starters, it suggests those shouting that oil prices are ridiculously high may be misguided.
Grantham Mayo defines a bubble as an asset class that rises above its historic trend by what statisticians refer to as two “standard deviations”. A standard deviation is simply a measure of the dispersion of a set of data from the average. The extent of dispersion is sometimes described in multiples of a “sigma” event, referring to the Greek symbol for standard deviations in statistical equations.
If oil’s trend remains $16 a barrel, then the 1980 peak was a “5.2 sigma” event, which Mr Grantham notes is a 1 in 11m occurrence. Today’s $60 oil would be a 4.2 sigma event and “a wonderful shorting opportunity”.
However, if oil’s trend line is now $36 a barrel, the 1980 high was a mere 2 sigma event, a 1 in 40-year occurrence. Today’s $60 oil would be a mere 1.3 sigma event – above trend but hardly excessively so. Investors looking to short the price of oil “should not be frothing at the mouth until it hits about $80”.
In a world defined by mean reversion, why should oil have a paradigm shift? Oil is a finite resource facing seemingly inexorable growth in demand from China and India. Developing new supply lines from oil shale and tar sands will be costly and time intensive.
Of course, a higher trend line for the price of oil may carry implications for two current US bubbles identified by Mr Grantham: equities and housing. Grantham Mayo believes US stocks still have not completed the mean reversion from the epic bubble that popped in 2000. Right now, the US market is enjoying the “greatest bear market rally” ever, but Mr Grantham puts the S&P 500 index’s fair value at 780, about 36 per cent below current levels. Meanwhile, average US house prices are over two standard deviations above normal.
Mr Grantham has no idea when those two bubbles will revert back, but the fact that oil is unlikely to tumble soon should be deflating for both.