What happens before a market melts down? It melts up, of course

Jeremy Grantham of US wealth manager GMO is a well-known sceptic on the market.

He’s believed for a long while that the S&P 500 is clearly overvalued. That’s cost him clients, which is what happens when you’re bearish in a long bull market.

But Grantham is anything but blindly bearish. While he’s been clear about the US market’s overvaluation, he’s also recognised that there simply hasn’t been the sense of enthusiasm that you’d require for a real bubble to get going.

However, that’s changed, he says. Which means the market is on borrowed time.

But before it comes back down to earth, we could see it surge by another 30%-odd from here – what’s known as a “melt-up”.

Could the market really surge by another 30% from here?

Another 30% higher in the market? After such an extraordinarily good year last year? That sounds exciting. How might that unfold?

Grantham starts by pointing out that the US market is clearly overvalued. I don’t think many people would seriously disagree with that. You might argue that the overvaluation is justified (by low interest rates, etc) but you can’t deny that, relative to its own history, the stockmarket is expensive.

But “price alone seems to me now to be by no means a sufficient sign of an impending bubble break”, says Grantham. You need to see “extremes of euphoria”. That’s a lot harder to measure. Valuation can be measured with ratios – but sentiment is a lot more “touchy-feely”.

And it’s only in the last few months that signs of excess and irrational behaviour have been creeping higher.

Looking back at previous bubbles, Grantham argues that the key to a proper bubble dénouement is acceleration – markets moving a lot higher over a very short period of time (just over 18 months, normally).

And to cut a long story short, if the S&P 500 follows the typical pattern, then you’d be looking at a surge to between 3,400 and 3,700 over the next nine to 18 months. That’d take the market to roughly 60% above where it was in the first half of 2017.

That’s quite a call. What makes him think that now is the time? Firstly, a great bubble is all about “excellent fundamentals euphorically extrapolated” – and the fundamentals finally look bullish (solid global growth and falling unemployment).

Secondly – more intriguingly – high-quality stocks are outperforming low-quality ones. This has tended to happen prior to past bubbles bursting too. In theory, high quality “safe” stocks shouldn’t beat the lower quality ones, because investors are meant to reap greater rewards for taking more risk.

Grantham argues that the outperformance of high quality in bubble periods is down to professional fund managers. They know that the market is overvalued, but they can’t sit the party out. So they pile into the best stocks they can find, so that when it all goes pear-shaped, they hopefully lose less than the market.

In short, Grantham reckons there’s a more than 50% chance of a “melt-up” in the next six months to two years. But if there is one, then a subsequent crash of around 50% is also likely.

What if Grantham’s right?

I don’t find much to disagree with in Grantham’s take. Many crazy things have been happening in other parts of the asset markets (bitcoin, the bond bubble), but, until recently, euphoria – as judged by nothing more scientific than “gut feel”, I hasten to emphasise – has been broadly absent from the stockmarket.

However, I think that’s changed now. Suddenly every 1,000-point move in the Dow is a cause for celebration. Fear of missing out is growing more powerful than fears of another big crash. The tone of coverage has gone from: “This is unsustainable” to “Why would this ever end?” very quickly.

Meanwhile, otherwise sensible financial bloggers with maybe a third of Grantham’s time in the markets are taking the mickey out of his call, demonstrating a cockiness that suggests they’re succumbing to “bull-market genius” syndrome. Indeed, that might be one of the most contrarian signals I’ve seen yet.

Caution, in short, is finally being thrown to the winds, because it has proved to be a losing strategy.

So what comes next? I don’t know, obviously. But here’s my theory, for what it’s worth.

I’m betting on an inflationary boom. One that will eventually end in a panicky mess, once investors realise that this is just another cycle, that “secular stagnation” is nonsense, and that the robots are not going to replace us any more than they did the last time we got worried about all this stuff. Interest rates will be forced to break higher rapidly, and that’ll bring it all down.

So stick with markets for now. Don’t worry about how to take advantage of the “melt-up” in the S&P 500 specifically. If that happens, pretty much whatever you own in terms of individual markets will benefit – eg, Japan is looking good and the FTSE 100 looks cheap and disliked (in relative terms) – you won’t struggle to find markets that will do well.

Grantham favours emerging markets in particular. My own take is that while I like them (a lot of my own pension fund is in emerging markets) I still struggle a little with the idea that they could decouple from a US market crash. I’m not saying for a moment that you shouldn’t own them – I just wouldn’t be making any huge changes to your asset allocation on that front right now.

What I would do is increase your allocation to commodity-related stocks (miners, probably energy stocks too). If we get an inflationary end game, they’ll do well. Hold some gold if you don’t and feel free to hold a bit more if you do (it had a relatively mediocre year last year and should have scope to play catch-up this year if the psychology does turn inflationary). Be very sceptical of bonds.

And watch for signs of inflation perking up. Our roundtable experts looked at this topic in more detail in the most recent issue of MoneyWeek magazine – you can check out the piece online here.