Are We on The Verge of Final Melt-Up Before the Next Krach ? Jeremy Grantham Thinks So

According to Investopedia a « melt-up » is a « A dramatic and unexpected improvement in the investment performance of an asset class driven partly by a stampede of investors who don’t want to miss out on its rise rather than by fundamental improvements in the economy. »

This is exactly what could happen to financial markets, according to veteran value investor Jeremy Grantham.

In a note recently published on GMO, which he co-founded, Grantham shares his views on the current market environment.

Looking at financial history and previous market bubbles, he considers that a « price acceleration » would be a clear indicator that we are in the last phase of a market bubble.

« A range of 9 to 18 months from today and a price to around 3,400 to 3,700 on the S&P 500 would show the same 60% gain over 21 months as the least of the other classic bubble events », he writes.

Grantham uses a great qualification for a bubble : « Excellent Fundamentals Eurphorically Extrapolated. »

That’s precisely that. Currently, market participants are hoping, and brokers help them to think so, that the current goldilock environment (accelerating growth/low inflation) might be there for a while.

If more and more investors believe that’s the case and more and more brokers sell the idea that EPS growth will provide the adequate support to rising market prices, then classic herding behavior might take place.

You could see more and more money chasing equity returns, until this goes out of control and creates euphoria.

There is already a lot of optimism in financial markets right now. But this could be just the beginning of the last leg of the bubble a growing number of people fear it will explode.

As Grantham’s paper points out, euphoria will build on a number of factors. Concentration is one. « 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 », he writes.

Second principle is the « outperformance of quality and low beta stocks in a rapidly rising market. »

When would the market correct ? Difficult to say. Overvaluation is one condition but it’s not sufficient. Currently, per Robert Shiller’s data, S&P 500 is trading at 30x + CAPE, which only happened in 1929 and 2000. Pretty scary. Yet the sentiment in the market is that stocks have upside potential.

Usually markets correct for more fundamental reason : a recession (not a high probability right now), a monetary policy mistake (more probable if inflation spills out of control, even though the Fed is very cautious in how it’s raising rates and communicating a lot on how it will wind down its QE program and reduce its balance sheet).

Yet there are lots of signs that the market are probably ripe for melt-up, per Grantham’s observation : « increasing vindictiveness to the bears for costing investor money ; the crazy Bitcoins of the world ; and Amazon and the other handful current heroes taking over more of the press coverage. »

A good rule of thumb would be : when the main stream media will start talking more often of how the market is performing well, it might be a good time seeking for the Exit sign.

Other « technical » indicators might include a boom in IPOs (we had one last year in the US according to ThomsonReuters – record deals reached USD1.37 trillion).

Per Grantham’s : « Keep an eye on what the TVs at lunchtime eateries are showing. When most have talking heads yammering about Amazon, Tencent, and Bitcoin and not Patriot replays, we are probably down to the last few months. »