A “super-bubble” appears dangerously close to its “final act” after the recent rally in US stocks lured some investors back into the market on the brink of a possible “tragedy,” according to Jeremy Grantham, legendary co-founder of the Boston-based investment firm GMO.
Grantham, who has repeatedly warned investors about bubbles in the markets, said in a newspaper on Wednesday that “superbubbles are events like no other” and share some commonalities.
“One of those features is the bear market rally after the initial derating phase of the decline but before the economy has clearly started to deteriorate, as always happens when superbubbles burst,” Grantham said. “This has recouped more than half of the market’s initial losses in all three previous cases and lured unwary investors back just in time for the market to go down again, only more viciously, and the economy to falter. So far this summer’s rally fits perfectly into the scheme.”
The US stock market plummeted in the first half of 2022 as investors expected rising inflation to lead to a tightening Federal Reserve. The S&P 500 closed this year at a low of 3,666.77 on June 16, before rallying along with other equity benchmarks over the summer amid investor optimism at signs the highest inflation in decades is easing.
Fed Chair Jerome Powell recently capped that rally with his Aug. 26 speech at the Jackson Hole, Wyoming Economic Symposium, where he erased this month’s gains when he reiterated that the central bank will continue to tighten monetary policy to counter the rising to curb inflation. He warned that the Fed will fight inflation until the job is done, even if it could hurt households and businesses.
“The US stock market remains very expensive and a rise in inflation like this year has always hurt many times over, albeit at a slower than normal rate this time,” Grantham said. “But now fundamentals are also starting to deteriorate tremendously and surprisingly: between COVID in China, war in Europe, food and energy crises, record fiscal tightening and more, the outlook is far bleaker than could have been foreseen in January. ”
Grantham had warned in a January paper that the US was nearing the end of a “super-bubble” spanning stocks, bonds, real estate and commodities after massive stimulus during the COVID-19 pandemic.
See: ‘Much luck! We all need it”: The US market is nearing the end of the “super bubble”, says Jeremy Grantham
In his Wednesday newspaper, Grantham said: “The current super-bubble features an unprecedentedly dangerous mix of asset-wide overvaluation (with bonds, real estate and equities all critically overpriced and now rapidly losing momentum), commodity shock and Fed hawking.
According to Grantham, the bursting of super bubbles has several phases.
First the bubble forms and then there’s a “setback” in valuations — like in the first half of 2022 — as investors realize that “perfection” won’t last, he said. “Then there is what we just saw – the bear market rally” before finally “fundamentals deteriorate” and the market falls to a low.
“Bear market rallies in superbubbles are easier and faster than any other rallies,” he said. “Investors are assuming this stock sold for $100 6 months ago, so it must be cheap at $50 or $60 or $70 now.”
By the intraday top on Aug. 16, the S&P 500 had recouped 58% of its losses since its June low, according to Grantham. It was “eerily similar to those other historical superbubbles.”
For example, “from the November low of 1929 to the April high of 1930, the market rallied 46% — a 55% recovery in loss from the peak,” he said.
He also highlighted the “speed and magnitude” of other bear market rallies.
“In 1973, after the initial drop, the summer rally recouped 59% of the S&P 500’s total loss from the high,” he wrote. More recently, in 2000, Grantham wrote that “the Nasdaq (which had been the main event of the tech bubble) recouped 60% of its initial losses in just two months.”
US stocks closed lower on Wednesday, with all three major benchmarks posting a fourth straight day of declines on the last day of August. The Dow Jones Industrial Average DJIA, -0.88%, fell 0.9%, while the S&P 500 SPX, -0.78%, fell 0.8% and the tech-heavy Nasdaq Composite COMP, -0.56%, decreased by 0.6%.
Read: The stock markets’ summer rally ended in August. Here’s what the story says about September.
“Economic data inevitably lags major turning points in the economy,” Grantham said. “To make matters worse, at turning points like 2000 and 2007, data series such as corporate profits and employment can subsequently be massively revised downwards.”
“It is during this lag that the bear market rally usually occurs,” he said. And now the current super-bubble appears to have “paused between the third and final acts,” according to Grantham.
“Prepare for an epic finale,” he said. “If history repeats itself, the play will be a tragedy again. We have to hope for a smaller one this time.”