Editor’s note: This article originally appeared in the Sept. 17, 2007 issue of Fortune.
Credit crises have always been painful and unpredictable. The current one is particularly hair-raising because it’s occurring amid the first truly global bubble in asset pricing. It is also accompanied by a plethora of new and ingenious financial instruments. These are designed overtly to spread risk around and to sell fee-bearing products that are in great demand. Inadvertently (to be generous), they have been constructed to hide risk and confuse buyers. How this credit crisis works out and what price we end up paying has to be largely unknowable, depending as it does on hundreds of interlocking and often novel factors and how they in turn affect animal spirits. In the end it is, of course, the management of animal spirits that makes and breaks credit crises.
But even if this crisis is contained, we are facing some near certainties that should be understood.
First, house prices may move on euphoria in the short term, but long term they depend on family income—the ability to pay mortgages and rent. At levels well above the normal four times family income, the market gradually loses first-time buyers until prices break and fall back to affordable levels. House prices are in genuine bubble territory in the U.S., Britain, and many other markets. In Britain and in some critical large cities in the U.S., for example, the multiple of family income has risen to over six times from below four times, and in London last year the percentage of first-time buyers was the lowest since records began. From these high levels, prices are guaranteed to fall. In doing so, they will reduce consumer borrowing and spending power. They will also increase mortgage defaults, most of which lie ahead, and lower financial profits and confidence.
Second, profit margins are at record levels around the world. They have lifted stock prices directly alongside the rising earnings. They have served to raise P/E multiples as well, for surprisingly, investors on average reward higher margins with higher P/Es. This is fine for an individual stock, but for the entire market, multiplying boom-time profits by high P/Es is horrific double counting and sends markets far too high in good times (and far too low in bad times). Higher margins also indirectly raise prices by providing more cash flow for buybacks and takeovers. So high profit margins offer multiple supports for the market, but they will certainly decline. They are the most dependably mean-reverting series in finance: If high margins do not attract greater competition, then a wheel has fallen off the capitalist machine. For U.S. and developed foreign markets, fair value (defined as normal P/E times normal profit margins) is about one-third below today’s level, and for emerging markets it is about 25% lower.
Third, and most important, risk will be repriced. Last year a broad base of risk measures—including volatility (VIX), junk and emerging debt spreads, CD rates, high-quality vs. low-quality stock values—reflected the lowest risk premiums in history. On some data, indeed, investors actually appeared to be paying for the privilege of taking risk. For fixed income, some spreads widened slowly at first this year and then unexpectedly widened rapidly in recent weeks. For equities, though, the process has hardly started. Junkier stocks continued to outperform into June, even as the subprime woes spread. At the end of the cycle, high-quality blue chips will once again sell at normal premiums or better.
Investment bubbles and high animal spirits do not materialize out of thin air. They need extremely favorable economic fundamentals together with free and easy, cheap credit, and they need it for at least two or three years. Importantly, they also need serial pleasant surprises in such critical variables as global GNP growth. All of this has been provided. These conditions always produce excess and are always extrapolated. Unfortunately, like almost all other investment factors, they eventually move back to normal. As wonderfully favorable factors cool off, asset prices will be under broad pressure, and risky assets will be under extreme pressure. If the credit crisis gets out of control, this will happen quickly and painfully. The important point to make here is that even if all works out well on the credit front, it will still happen slowly.
JEREMY GRANTHAM is chairman of investment firm GMO, where he oversees quantitative products and investment strategies.
