Grantham, After Forecasting Rally, Warns That a Reversal Is Approaching

Last Updated Jan 17, 2010 4:42 PM EST

Jeremy Grantham earned his reputation as one of the most astute financial analysts in part by sticking with his forecasts and waiting for them to be proven accurate. The most recent example occurred earlier this year when - as Wall Street remained panic-stricken - he predicted that the Standard & Poor's 500-stock index would rise beyond 1,000 and as far as 1,100.

Many of his peers make wrong calls altogether, while others who are initially correct trip themselves up by refusing to take yes for an answer. After their target is reached, they let their money ride, raising the target instead of following their original advice and cashing in. When the trend changes, as nearly every one does, they give back much of the gain.

Now that the S&P has reached the upper end of his anticipated range, Grantham, chief strategist at the portfolio manager G.M.O., is reiterating the call for caution that he made as the index rallied into four digits. In his quarterly newsletter, released on Tuesday, he drew comparisons between the stock market today and in 1930.

A furious rally following the crash of 1929 carried prices to within 18 percent of the pre-crash peak, and investors were relieved that the worst was over for the economy and stocks - only it wasn't. Economic conditions had deteriorated and would continue to slide, and stocks embarked on another leg down, losing an astounding 80 percent.

Grantham points to a tendency for investors to dismiss a recent climactic decline as irrational and see the previous advance as the real deal and therefore a phenomenon that can and will be repeated. But he warns that numerous economic imbalances need to be corrected and that this will be a sufficient drag on growth to produce "seven lean years" for the stock market.

"Major imbalances are unlikely to be quick or easy to work through," he predicts. "For example, we must eventually consume less, pay down debt and realign our lives to being less capital-rich. Global trade imbalances must also readjust."

Grantham foresees a sizeable readjustment in the S&P 500. The decline could be as mild as 15 percent from the high of 1,098, he said, but more likely it will move below fair value, which he judges to be 860, or 22 percent below the peak.

He acknowledges that the market's momentum, the zeal of the Federal Reserve to stimulate the economy and the so far insatiable appetite for risk could keep the index rising for a while.

"It is hard for me to see what will stop the charge to risk-taking this year," Grantham writes. "With the near universality of the feeling of being left behind in reinvesting, it is nerve-wracking for us prudent investors to contemplate the odds of the market rushing past my earlier prediction of 1,100. It can certainly happen."

But he won't raise his target for the index, despite that possibility, and now that it has been achieved he is preparing for the next decline. He understands that investors are often irrational for far longer than saner market participants expect but that they are not irrational forever.

"I have some modest hopes for a collective sensible resistance to the current Fed plot to have us all borrow and speculate again," he went on to say. "I would still guess . . . that before next year is out, the market will drop painfully from current levels."

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