Jeremy Grantham on a coming market correction

October 29, 2009Jon Brooks 2 Comments »

nysebull2So far today, the major market indices are up on the heels of the government’s GDP report, which showed a 3.5% growth rate in the 3rd quarter–the strongest GDP increase in two years. Just two more days of non-catastrophe on Wall Street, and we’ll have avoided any unwelcome October Surprise.

But one closely watched market guru says the market’s living on borrowed time and that a correction of 15%-plus is on its way. The blog Credit Writedowns posts a summar of Jeremy Grantham’s Quarterly Letter. Grantham is the chairman of the asset management firm GMO and is followed by many institutional investors and money managers. You can read his complete report here.

Just one man’s opinion, but he’s been right before…when most people were wrong.


Seven lean years

…Corporate ex-financials profit margins remain above average and, if I am right about the coming seven lean years, we will soon enough look back nostalgically at such high profits. Price/earnings ratios, adjusted for even normal margins, are also significantly above fair value after the rally. Fair value on the S&P is now about 860 (fair value has declined steadily as the accounting smoke clears from the wreckage and there are still, perhaps, some smoldering embers). This places today’s market (October 19) at almost 25% overpriced, and on a seven-year horizon would move our normal forecast of 5.7% real down by more than 3% a year…

Timing of decline

…what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors. First, the disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems, particularly pressure on profit margins as the quick fix of short-term labor cuts fades away. Second, the slow gravitational pull of value as U.S. stocks reach +30-35% overpricing in the face of an extended difficult environment. On a longer horizon of 2 to 10 years, I believe that resource limitations will also have a negative effect…

It is hard for me to see what will stop the charge to risk-taking this year. With the near universality of the feeling of being left behind in reinvesting, it is nerve-wracking for us prudent investors to contemplate the odds of the market rushing past my earlier prediction of 1100. It can certainly happen.

Range of decline

I would still guess (a well-informedguess, I hope) that before next year is out, the
market will drop painfully from current levels. “Painfully” is arbitrarily deemed by me to start at -15%. My guess, though, is that the U.S. market will drop below fair value, which is a 22% decline (from the S&P 500 level of 1098).

Limits of decline

Unlike the really tough bears, though, I see no need for a new low. I think the history books will be happy enough with the 666 of last February. Of course, they would probably be slightly happier with, say, 550. The point is that this is not a situation like 2005, 2006, and 2007 when for the first time a great bubble – 2000 – had not yet broken back through its trend. I described that reversal as a near certainty. I love historical consistency, and with 32 bubbles completely broken, the single one outstanding – the S&P 500 – was a source of nagging pain. But that was all comfortably resolved by a substantial new low for the S&P 500 last year. This cycle, in contrast, has already established a perfectly respectable S&P low at 666, well below trend, and can officially please itself from here. A new low (or not) will look compatible with history, which makes the prediction business less easy.

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