Jeremy Grantham Warns of a Third Bubble in the Making

Last Updated Apr 25, 2010 7:09 PM EDT

Jeremy Grantham's quarterly letters are must-reads for contrarians. His long investing career has given Grantham, chief strategist for the portfolio manager G.M.O., an uncanny ability to spot nonsense when he sees it, and when he does, he relates it in his letters with a dry, acerbic wit.

Given that his subject matter is Wall Street and the markets, there is usually plenty of nonsense to comment upon. Grantham finds more than the usual amount these days, and that may leave investors in an especially thorny predicament.

In his latest quarterly letter, Grantham warns that the stock market became overvalued about 25 percent ago and is on the verge of entering bubble territory. He reckons the chances are about 50-50 that the market will continue all the way along that path, with prices running up further and then crashing back down again.

Such a journey is more likely than it ought to be, in his opinion, because of Ben Bernanke. The Federal Reserve chairman and his predecessor, Alan Greenspan, helped to create two other bubbles in the last decade, in stocks and home prices, by keeping credit too easy. As he demonstrates in this passage, Grantham believes that investors understand that better than Bernanke does.

"Speculators are not stupid. They see that after each crash, a long, artificial period of low rates and easy financial borrowing has been delivered. They see that Bernanke is an unreconstructed Greenspanite in that he refuses to address bubbles but will leap to help ease the pain should a bubble break. With asymmetry like that, why not speculate? And so another bubble appears and then another."
One way that a bubble could be averted, in Grantham's view, is if clear-cut signs of an economic recovery emerge, rates rise and stocks embark on a benign decline. By contrast, he writes, continued sluggishness will keep interest rates close to zero and funnel more money into stocks. The result of that is uncertain, he says, but probably unpleasant.

"The end of such events is always hard to predict, but usually bubbles break for almost any reason when they are big enough. Of course, the larger the asset bubble, the bigger the shock to the economic and financial system."
So should you make a graceful exit from stocks, fearing the worst, or hang around and hope that his more optimistic scenario comes to pass or that you'll be able to beat the rush out of the market if and when the bubble starts to pop? Grantham offers a third alternative, emphasizing a roving and discerning eye. Come back Thursday for details.