Famed investor Jeremy Grantham says the stock market is in the midst of a “super bubble.” That means prices are even more out of whack than in an ordinary bubble, and it indicates that stocks aren’t finished plummeting.
A garden-variety bubble is when the market, or a stock-price index, rises quickly, ignoring significant risks that eventually send prices plummeting. In those ordinary instances, indexes rise to two standard deviations above a recent average of prices.
In a super bubble, the figure goes to 2.5 or higher. That is where the market was in 2021, as stocks soared from the lows they reached early in the pandemic.
Grantham, co-founder of Grantham, Mayo, & van Otterloo, which manages some $70 billion in assets, has often been viewed as a market skeptic. He is arguably a “perma bear,” or perpetual pessimist, though he has taken a bullish view of the market at times.
Still, he outlines a compelling case that where stocks are today—and how they got there—perfectly fit the phases super bubbles go through.
Stage one is when the bubble forms and stocks are soaring. Stage two is when there is a meaningful decline in response to some grim political or economic event. A bear-market rally ensues as people assume they can see a day when stocks return to their highs because the economic challenges are easing. That sets the stage for the final drop.
It all sounds a lot like the events of the past few years. First, the S&P 500 more than doubled from its March, 2020 bottom to early January this year. Low interest rates and fiscal stimulus powered economic activity, corporate earnings, and equity valuations.
The setback came in the first half of this year. The index fell by more than 20% to its mid June low as investors factored in the economic shock that would result from the Federal Reserve’s effort to fight inflation. Consumer prices were already rising, but the picture darkened when Russia invaded Ukraine, unleashing a surge in commodity prices.
The bear-market rally seems to have come since markets hit their lows in June. The S&P 500 surged by a percentage in the mid teens, recovering just over half of its loss, before cooling down in late August.
Compare that to the treacherous markets of the past century. In the rally off the 1929 low, early in the Great Depression, the market recovered just over half of its loss before heading lower again. The same is true for the rally off the 1973 low. In 2000, the Nasdaq Composite recovered 60% of its bear-market loss from the technology bubble.
“The current event, so far, is looking eerily similar to these other historic super bubbles,” wrote Grantham.
The question now is what would bring the market down from here. Grantham mentions the twin shocks of inflation and the higher interest rates meant to stamp it out. While the market is already down from its summer peak, it is also falling through key technical levels, signaling that more declines could be on the way.
A few factors on the ground are critical to assessing what comes next. Investors need to monitor how fast the rate of inflation declines because that is critical to when the Fed will slow down in raising interest rates. Expectations that economic demand will diminish have dented forecasts for earnings, but the profit outlook could still get worse.
More declines seem likely for stocks, but how ugly they will be isn’t clear.
Write to Jacob Sonenshine at firstname.lastname@example.org