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Bram de Haas
Bram de Haas
Articles (294)  | Author's Website |

Are We Heading Into a 50% 'Melt-Up' Like Grantham Thinks?

Grantham of GMO fame came out with an unusual market view

January 08, 2018 | About:

GMO's Jeremy Grantham (Trades, Portfolio) just put out a new letter with his viewpoints last week. The firm is well-known for its asset class return predictions and an outlook on the bearish side. I'm not sure if they would agree with that qualification, but that's how I call it when comparing their work to other investment views I've read over the years.

This outlook is called "Bracing Yourself for a Possible Near-Term Melt-Up," with a caveat from Grantham that it's a highly personal view. The report places the current developments in the market in a historic context and looks at similarities and discrepancies in other heady times.

I've taken a few graphs out of the report to illustrate the points Grantham makes. He starts out by sketching where we are now:

That is, in a nine year bull market just coming off a strong year following a couple of years of stagnation. Afterwards, he dives into what would signal a bubble (emphasis mine):

In looking for signs of late bubble behavior, we have to reconcile to the fact that no two bubbles, even the classics, are the same. They share the fact that there are many signs of investor euphoria, sometimes indeed approaching the madness of crowds, but the package of psychological and technical indicators has been different each time. The historian has to emphasize the big picture: In general are investors getting clearly carried away? Are prices accelerating? Is the market narrowing? And, are at least some of the other early warnings from the previous great bubbles falling into place?

Price acceleration

Grantham sketches what it would take for the S&P 500 to accelerate into a classic bubble pattern and its 9-18 months of price appreciation to levels between 3400 and 3700. My takeway: We can't tick off this box yet.


Concentration is the essence of an escalating euphoria. By late-stage cycles, many buyers are fixating on “winners” with the purchase motive being further stock gains, rather than any logic of long-term value. Thus, as the market soars, attention is increasingly focused on those with the largest earnings and stock price gains, and interest in the B players falls away. (This concentration effect naturally favors larger companies, perhaps because they can better absorb a rising demand.)

We are observing this type of concentration with the S&P 500 outperforming the Russell 2000 by 13-20% over the past year. If we would further narrow it down, we would likely observe most of that gain being restricted to a relatively small number of names within the S&P 500. The magnificent advance of the FANGs is widely chronicled.

Low beta

The second principle is the outperformance of quality and low beta stocks in a rapidly-rising market. This is clearly odd behavior and is very rare, restricted as far as I can tell to some, but not all, late-stage bull markets.

We aren't seeing this yet, with the S&P 500 outperforming its low volatility version by about the same margin as it outperforms small caps. This phenomenon likely exists as a number of market participants understands things are heady but want to retain stock exposure. As a solution they move towards more defensive large cap names.

This strategy seems like a credible explanation as I'm doing the exact same thing and trying to invest more outside the U.S. Since the scenario has not happened yet. I think it is interesting to move towards low beta stocks. This could kill two birds with one stone: by taking advantage of this late cycle phenomon were it to occur and by move more into a stance that is warranted by valuations anyway.

Are investors getting carried away?

We aren't really seeing investors getting carried away. I'm observing hype surrounding the cryptocurrencies, Bitcoin and others, but not so much in regards to the stock market. For what it's worth, I do think there are a few very interesting cryptocurrencies, but that's for another article.

One possible explanation for a lack of foaming-at-the-mouth investors could be the great move from active towards passive management. Passive management means taking your hands off investment decisions and distancing yourself from your portfolio. It's harder to brag about your skills at cocktail parties if you are indexing. By definition, everyone is having the same results and there is no need to fish for stock tips, either.

Ultimately Grantham thinks a melt-up of about 50% over the next six months to two years is likely. It is a brave prediction as it is easily verifiable, precise and would be an unusual event. If it happens, he expects a decline of 50% afterwards.

Furthermore, he suggests owning as much emerging market equity and MSCI EAFE Index (designed to invest in markets outside of developed economies) as your career, business risk or stomach can tolerate.

He also thinks it could work to institute a small hedge with a few U.S. high-momentum stocks that could capitalize in a sensational way on a bubble forming. I do believe he intends this only in context of a portfolio that's not overly correlated to the S&P 500 otherwise.

His final words (emphasis mine):

if we have the accelerating rally that has typified previous blow-off phases, you should be ready to reduce equity exposure, ideally by a lot if you can stand it, when either the psychological signs become extreme, or when, after further considerable gain, the market convincingly stumbles. If you can’t cope with this thought and can’t develop and execute an exit strategy, then sit tight and ignore all this advice, except for an overweighting of Emerging.

Please read the original article as I hardly do Grantham's words justice. I think his interesting and unusual analysis deserves to get highlighted and read by as many investors as possible. I'm not as convinced we will see a market melt-up but am definitely taking note of this variant view and possibility. In addition, the key takeaways make a lot of sense to me, and I've been looking hard outside the U.S. for some time now.

Disclosure: Author is short a low volatility ETF listed in Europe.

About the author:

Bram de Haas
Bram de Haas is the managing editor of The Black Swan Portfolio.

Visit Bram de Haas's Website

Rating: 5.0/5 (5 votes)



Robertbloch - 9 months ago    Report SPAM

When the bears throw in the towel (Grantham), is that not yet another sign of THE TOP?

I respect Grantham, but this is surely nearly a reversal of opinion.

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