Jeremy Grantham Warns of an ‘Unexpectedly Dire’ Final Phase of the Downturn

Longer term, GMO’s Grantham argues that the declining population, raw material shortages, and climate change are the biggest challenges for investors.

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Investors have reached the final phase of the market downturn, but that doesn’t mean the investment outlook is getting any rosier for GMO’s co-founder, Jeremy Grantham.

“The pricking of the supreme overconfidence bubble is behind us, and stocks are now cheaper,” Grantham wrote in a whitepaper published Tuesday. “But… a continued market decline of at least substantial proportions, while not the near certainty it was a year ago, is much more likely than not.”

Grantham provided a list of unfavorable factors that may cause further losses for the market. For one, there’s a high risk the housing bubble could burst. “Housing busts seem to take two or three times longer than for equities,” Grantham wrote. He added that a global housing meltdown may have a more significant knock-on effect to the economy than one in the equities market. That’s because extremely high stock prices are only present in the U.S.

Some unexpected mishaps in 2022 may also complicate the final phase of the current market downturn, including Russia’s invasion of Ukraine, the surge in inflation, and the slow growth of the Chinese economy due to strict Covid controls, according to Grantham. “Because of the sheer length of the list of important negatives, I believe continued economic and financial problems are likely,” he wrote. “I believe they could easily turn out to be unexpectedly dire.”

Grantham has been warning investors of a major market crash since early 2018, when the stock market had been posting a succession of new highs. The bubble finally burst last year, with the S&P 500 down close to 20 percent. The fear of a recession has been mounting in the second half of 2022 as macro uncertainty keeps rising.

“[A]fter a few spectacular bear market rallies we are now approaching the far less reliable and more complicated final phase,” Grantham wrote. “At this stage housing markets, which are always slower to react, have not fully rolled over yet; neither has the economy gone into recession, nor have corporate profits yet been severely hit. The length and depth of continued market decline from here depends on how precisely the deterioration from perfect conditions will play out.”

A few positive factors may pause or delay the next down leg in the market, according to Grantham. They include the U.S. presidential cycle, abating inflation, the strong labor market, and China’s reopening. The presidential cycle, in particular, has boosted equity performance since 1932. Grantham found that the average annualized return of the S&P 500 index between October 1 of the second year in each cycle to April 30 of the third year in each cycle is equal to the return that the index generated in the following 41 months.

“This has a less than one-in-a-million probability of occurring by chance, pretty remarkably, and it has been about as powerful in the last 45 years as the previous 45 years,” Grantham wrote. “Suffice it to say that this positive influence may help to support the market for a few more months.”

Emerging markets and value stocks have stood out as the most attractive investment opportunities in what Grantham calls a tricky environment. In 2002, for example, EM stocks were down only 2 percent, while the S&P 500 slumped 22 percent. Value stocks, which are those trading at lower prices relative to their fundamentals, are still attractively valued even after a good run in the past 18 months.