We’re in a “superbubble”, says Jeremy Grantham – so are we heading for a “superbust”?

The Nasdaq entered “correction” territory yesterday. In other words, it was down more than 10% from its most recent high – an all-time high set in November.

More than any other global stockmarket or sector, the US tech index has been the barometer for this particular bull phase.

So are we now on the slide? One of the smartest investors we know certainly thinks so.

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The air is already leaking out of the superbubble

Jeremy Grantham, the founder of asset manager GMO, has a long history of leaning towards the bearish side of things. But he also has a long history of being right about bubbles. And today he thinks the US is not just in a bubble, but in a “superbubble”.

In his latest research piece, Grantham notes that GMO has defined an investment bubble as a market that moves more than two standard deviations above its trend.

“Standard deviation” is the sort of term that brings many people out in an allergic reaction, but the gist of it is pretty simple: it describes how much of an outlier a particular data point is.

If markets were like toin cosses (or perfectly efficient), you’d expect a two standard deviation event to happen every 44 years, says Grantham. As it stands, GMO reckons they happen in markets every 35 years. That makes sense if you believe that investors are not as narrowly rational as they’re cracked up to be, and that emotion-led manias are regular occurrences.

Now, however, we’ve gone even beyond the “normal” bubble. Instead, says Grantham, the US specifically is in a “super bubble”, having moved three standard deviations from the trend.

This is the sort of thing that should only happen once every 100 years. It’s not quite that rare, but Grantham reckons it’s only been seen on five other occasions: US stocks in 1929 and 2000 (the tech bubble); US housing in 2006; plus Japanese stocks and property in the late 1980s.

“All five of these greatest of all bubbles fell all the way back to the trend.” Grantham notes that if the S&P 500 does the same from here, it could end up dropping to 2,500 (it’s currently around 4,500).

Grantham also reckons that the air started leaking out of the current bubble as far back as February last year, which is when the most speculative stocks on the market peaked (a glance at Cathie Wood’s ARK Innovation ETF is the best barometer of this one – it’s fallen in half since then).

Would the Fed really tolerate a halving of the S&P 500?

I certainly don’t disagree with Grantham’s bearishness. US stocks (specifically) are overvalued and there have been so many headline-grabbing moments of ridiculous exuberance that I could write a week’s worth of these emails just listing them.

What with markets now convinced that the Federal Reserve has turned into an aggressive anti-inflation establishment, it’s little wonder that markets are struggling.

I’d just add a cautionary note on the “return to trend” point. I’m not convinced about a scenario in which the Fed (or other central banks for that matter) is happy with the idea of the S&P 500 falling by 50%.

In 2008, for example, the market fell a lot, but by the standards of Grantham and others, it didn’t fall far enough to be cheap (or at least, not for very long), because central banks printed a lot of money.

The question now is, how far would stocks have to fall to trigger a reaction in central banks today?

On the one hand, 2008 was a serious emergency; the financial system was near collapse. On the other hand, 2008 also paved the way for central banks being very, very sensitive to market falls (which is not entirely surprising, as everyone has become much more exposed to asset markets precisely as a result of the reaction to 2008).

So, for me, the jury’s out on how far the market might fall overall. I suspect we’d get a startling level of money printing before that. That would exacerbate inflation and be bad news for the stockmarket in “real” terms, but it would probably arrest any nominal fall. In a way, this is splitting hairs – the inflation kills your return, rather than an explicit crash in the market.

Anyway – we’ll see what happens on that front. In the meantime, the big question of course for your portfolio is: what do you do about it all?

First, as I always say, don’t panic. Apart from anything else, why would you? You’re sensible enough to be a) diversified and b) if you’ve been listening to us at all, you probably have a decent bit of exposure to UK stocks which has done rather well this year, because it’s full of precisely the sorts of stocks that are the opposite of the Nasdaq.

Secondly, that takes us to the view from GMO on how to tackle this – and it isn’t too dissimilar to what we’ve been suggesting for a while. Avoid the overvalued stuff (mostly US equities). Own value stocks in emerging markets, Japan, and the other cheaper developed markets.

Grantham adds: “I also like some cash for flexibility, some resources for inflation protection, as well as a little gold and silver.” (For more on the case for gold this year, read Dominic’s piece on gold from yesterday’s Money Morning).

I find it hard to disagree with any of that. By the way, if you missed Merryn’s interview with Jeremy Grantham last summer – in which he spelled a lot of this out – catch up with it now.