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According to Jeremy Grantham the U.S. is in the fourth super-bubble of the last hundred years…with the possibility of a 40-50% contraction being highly probable.
Market Deviations
@$The deviations of the market from its long-term exponential growth trend are easy to spot in the chart below:
As Grantham correctly notes, investors don’t want to admit that a correction of magnitude is possible…[but] all that is needed is a catalyst which, so far, has yet to appear…
Speculative Manias
@$$Charles Kindleberger noted that speculative manias typically commence with a “displacement” that excites speculative interest. Then, the speculation becomes reinforced by a “positive feedback” loop from rising prices…[which] ultimately induces “inexperienced investors” to enter the market. As the positive feedback loop continues and the “euphoria” increases, retail investors then begin to “leverage” their risk in the market as “rationality” weakens. A look at margin debt suggests investors have leveraged their risk in the market.
Blow-off Phase
Grantham believes that exuberant investor psychology leads to a “blow-off” phase in financial markets…
@$$$With that understanding, is it possible for the market to sustain a 40-50% retracement in a “mean reverting event?” That answer is “yes.” A logical retracement to previous long-term trendlines, as shown below, would be well within the context of a typical mean-reverting event. Those levels would be roughly 3800, retracing to the accelerated trendline from the 2009 lows. From recent highs, such would encompass approximately a 21% decline. However, a correction to the long-term trendline from the 2009 lows would be a 41% crash.
Fibonacci Retracements
Another way to view a corrections potential is Fibonacci retracement levels. Fibonacci retracement plots percentage retracement lines based upon the mathematical relationship within the Fibonacci sequence. These retracement levels provide support and resistance levels helpful in identifying target price objectives. Fibonacci Retracements get displayed by first drawing a trend line between two extreme points. Next, a series of six horizontal lines intersect the trend line at the Fibonacci levels of 0.0%, 23.6%, 38.2%, 50%, 61.8%, and 100%. Using the beginning of the bull market rally in 2009, we can view the potential Fibonacci retracement levels.
@$$$$The two most important levels for market watchers, given Grantham’s view of a “mean reverting event,” are the 38.2% and 50% retracement levels. The 38.2% level intersects the running support trendline from 2009. The 50% retracement level aligns with the lows from 2018 and March 2020. Should those two support levels fail, the market will likely search for a bottom at the 61.8% retracement level at the 2015-2016 lows…For example, the chart below shows the deviation of the market from the exponential growth trend overlaid with valuations and previous crisis events.
The Fed Put
…The one consideration, of course, is where does the Federal Reserve rush back to the rescue of the market. In 2018, it only took a 20% decline to see them quickly reverse course in tapering. In March 2020, the market collapsed 35% before the Fed could organize enough to intervene. The difference in both cases, however, is that the Fed did not have 7% inflation to deal with…
Conclusion
The biggest problem for the Fed is choosing between combating inflation or bailing out the markets….I suspect they will abandon their inflation mandate to support the financial system but, given the extreme buildup of debt and leverage in the financial system, a correction will quickly get out of their control and the resulting damage to the credit, financial, real estate, and labor markets will send economic growth plummeting too quickly for them to bail out.
Such is just my assumption, but when you look at the total amount of financial leverage in the system, you can understand why the risk is prevalent.
Whether you agree a bubble exists is largely irrelevant. Every investor approaches investing differently but…it is essential to understand that you can take action to mitigate the risk of such a crash, as follows:
- Avoid “herd mentality” – Just because everyone else is doing it, doesn’t mean its right.
- Do your own research and avoid “confirmation bias.”
- Develop a sound investment strategy including “risk management” protocols.
- Diversify your portfolio allocation to include “safer assets.”
- Control your “greed” and resist the temptation to “get rich quick.”
- Resist getting “anchoring” to a past values. Such leads to emotional mistakes.
- Remember that the larger the deviation from the mean, the greater the reversion will be. Invest accordingly.
Is Grantham’s view possible? Yes. Will it happen with certainty? No one knows…
The above version of the original article by Lance Roberts (realinvestmentadvice.com) was edited for a fast and easy read.
Editor’s Note:
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