Grantham Gets Comfortable Living Within the Bubble

Jeremy Grantham has some good news and bad news for stock market bulls in his latest quarterly letter to investors. The market stands a good chance of continuing its ascent in coming months, perhaps to 1,500 on the Standard & Poor's 500-stock index, according to Grantham, chief investment strategist of the fund manager GMO (he's the G). But he warns that there remains no good reason for the rally - fair value for the index is about 900, in his view - and so what goes up will almost certainly come down hard, possibly later this year.

Meanwhile, he seems content to enjoy the ride. The stock market has three things in its favor, as Grantham sees it:

• Very low short-term interest rates.
• Timing; the third year of the presidential election cycle tends to be an excellent one for stocks.
• Saving the best for last...a maniacal appetite for risk among the public.

"On fundamentals, I still believe that the economies of the developed world will settle down to growth rates that are adequate, but lower than in the past, and that we are pecking our way through my 'Seven Lean Years.' We face a triple threat in this regard: the loss of wealth from housing, commercial real estate and, still to some extent, the stock market, which . . . resulted in a negative wealth effect; the slowing growth rate of the working-age population and increasing commodity prices and periods of scarcity, to which weather extremes will contribute. To judge the accuracy of this forecast will take a while, but it is clear from the early phases that this is the worst-ever recovery from a major economic downturn, especially in terms of job creation."
No Gain, No Pain
Grantham believes that investors are so eager to enjoy further gain that they are almost ensuring that pain will follow. That's a pattern consistent with market bubbles of the past, and he expresses near certainty that if a market worth 900 goes as high as 1,500, it must be in a bubble. For investors who want to take a chance and glide on the thermals anyway, he offers some developments that would herald the almost inevitable downdraft:

"As a simple rule, the market will tend to rise as long as short rates are kept low. This seems likely to be the case for eight more months and, therefore, we have to be prepared for the market to rise and to have a risky bias. . . . All of the famous bubbles broke, but only after short rates had started to rise, sometimes for quite a while. . . . The very famous, very large bubbles also often give another type of warning. Probably knowing they are dancing close to the cliff and yet reluctant to stop, late in bubbles investors often migrate to safer stocks, and risky stocks betray their high betas by underperforming. We can get into the details another time, but suffice it to say that there are usually warnings, sometimes several, before a bubble breaks. Overvaluation must be present to define a bubble, but it is not a useful warning in and of itself."
There is another warning sign that has presaged pops in the past: when honest-to-God investment gurus, after warning for months that a bubble was inflating, change their strategy from avoiding the market to peacefully coexisting with it. An adage on Wall Street is that stocks go down when the last bear turns bullish. Grantham may not be the last bear to go over to the other side, but if he has - even reluctantly and temporarily - there can't be too many others left.