Coping With Crazy

FOR MORE THAN a year, veteran investment manager Jeremy Grantham has been arguing that the U.S. stock market is in a bubble. And not just an ordinary bubble, but “an epic bubble… one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.”

And yet, despite Grantham’s concerns, the market has only continued to march higher. In a recent interview, Grantham reiterated his concerns in even stronger terms. He cited these worrying signs:

1. Valuations are at extreme levels. Among the valuation indicators that Grantham tracks, eight out of 10 point to a market that is even more overvalued than it was at the peak of the tech bubble in 2000.
2. Not only are share prices increasing, but also they’re increasing at an accelerating pace. Prices are rising at two to three times their normal rates, says Grantham.
3. “Crazy behavior” is widespread. As an example, Grantham points to the boom in special purpose acquisition companies, or SPACs. These investments, Grantham says, are simply a “license to rip investors off.”

By his own admission, Grantham is a contrarian—so contrarian that Harvard Business School once featured his firm in a case study. And yet his three-part indictment has a lot of validity. I’m not quite as worried as Grantham, but as I commented last week, aspects of today’s market do remind me of The Emperor’s New Clothes.

But here’s the problem with bubbles: Unfortunately, there just isn’t a whole lot that can be done about them. In terms of futility, it’s maybe not as bad as complaining about the weather, but it’s close. Consider the challenges:

• Even if you had an ironclad guarantee that Grantham is right—that the U.S. market will face a reckoning—it’s impossible to know when that day will come. The frothiest part of the market has weakened in recent weeks, with Snowflake, Tesla, Teladoc, Zoom and Peloton all down more than 30%. Maybe this is the sign that the music has stopped. It might be—or it might just be a temporary setback. That’s the tough thing about the market: Sentiment can turn quickly.
• Just as it did in the mid-1990s, the market could continue to go higher before it goes lower. As a result, the future low might be no lower than where the market stands today.
• Assuming the market does drop at some point, you won’t know in advance how steep the drop will be.
• The shape and duration of every downturn are different. When the market does drop, it will be impossible to know—again, in advance—how long it will stay down.
• Just as we saw last year, external forces, including government action, can intervene in the market at any time. When the Federal Reserve stepped in with its bazooka on March 23 last year, everything changed overnight. These kinds of things happen all the time. Sometimes they’re positive, sometimes negative, but always unpredictable.

Given these challenges, what action can or should you take? Here’s the prescription I recommend:

1. If you’ve been experimenting with some of the market’s highflyers, including bitcoin, consider yourself fortunate, take your gains and move to higher ground. What if the gains are short term and would trigger a big tax? I can’t predict where any stock will end up, but I encourage investors not to lose sight of this reality: A short-term gain is always preferable to any loss.
2. If you’re in your working years and have a long runway before retirement, you shouldn’t fret at all. In fact, you should hope and pray that Grantham is right. A market downturn will enable you to add to your investments at lower prices. Counterintuitive as it sounds, young people should welcome a downturn.
3. If you’re losing sleep about the market, that’s usually a sign you should revisit your portfolio’s asset allocation. Ideally, your allocation should be structured so you’re insulated at all times from a potential multi-year market downturn. The operating framework I recommend is to assume that the market could drop 50% at any time, and that it might take five or seven years after that to recover.
4. Be sure to rebalance your portfolio diligently, if not religiously. This, of course, includes rebalancing between stocks and bonds. But don’t forget to rebalance within asset classes. Jeremy Grantham’s view is that you should move substantially all of your stocks out of the U.S. and into emerging markets. That’s too extreme for me, but the general premise is useful: If an asset class has run up in value, you should happily take some of those gains and move them into an asset class that’s been lagging.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, he advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman and check out his earlier articles.

Do you enjoy HumbleDollar? Please support our work with a donation. Want to receive daily email alerts about new articles? Click here. How about getting our newsletter? Sign up now.