Think the bear market in U.S. stocks has been rough? The hard part may still lie ahead, according to longtime stock market investor Jeremy Grantham.
The legendary co-founder of Boston-based investment firm GMO argued in a Tuesday paper, cheerfully titled, “After a Timeout, Back to the Meat Grinder,” that “the first and easiest leg of the bursting of the bubble we called for a year ago is complete.”
The 2022 rout left the most speculative growth stocks that led the market on the way up “crushed, while a “large chunk of the total losses across markets that we expected to see a year ago have already occurred.”
It gets trickier from here. While the downturn has wiped the most “extreme froth” off the market, valuations remain well above long-term averages, he said, noting that in the past they have tended to overcorrect, falling below their long-term trend line as fundamentals deteriorate.
Where would that leave stocks?
Grantham estimated the trend line value of the S&P 500 index, adjusted upward for trend line growth and expected inflation, will be around 3,200 by the end of 2023. The investor said it was a 3-to-1 bet the S&P 500 reaches that level and spends at least some time below it this year or next. A drop to 3,200 would mark a roughly 17% fall for the year and a drop of around 20% from the S&P 500’s Tuesday finish at 4,019.81.
Such an outcome wouldn’t be “the end of the world but compared to the Goldilocks pattern of the last 20 years, pretty brutal.
“To spell it out, 3200 would be a decline of just 16.7% for 2023 and with 4% inflation assumed for the year would total a 20% real decline for 2023 — or 40% real from the beginning of 2022,” he wrote. “A modest overrun past 3200 would take this entire decline to, say, 45% to 50%, a little less bad than the usual decline of 50% or more from previous similarly extreme levels.”
Grantham said that while such an outcome remains highly likely, investors should have far less certainty about the timing and extend of the market’s next leg down.
A variety of factors, including the “underrecognized and powerful Presidential Cycle, but also including subsiding inflation, the ongoing strength of the labor market, and the reopening of the Chinese economy — speak for the possibility of a pause or delay in the bear market,” he said. “How significantly corporate fundamentals deteriorate will mean everything during the next 12 to 18 months.”
The presidential cycle holds that stocks see a pattern over the course of a presidential term, with a tendency to gain ground in the seven months from Oct. 1 of the second year of the cycle through April 30 of the third year, Grantham said. In other words, stocks are now in the “sweet spot” of the cycle.
When it comes to the big picture for equities, long-run issues of declining population, shortages of raw materials and rising damage from climate change are beginning to “bite hard” into growth prospects, Grantham said.
“The resource and geopolitical shocks of last year will only exacerbate those issues. And over the next few years, given the change in the interest rate environment, the possibility of a downturn in global property markets poses frightening risks to the economy,” he wrote.
The S&P 500 fell 0.1% on Tuesday, while the Dow Jones Industrial Average finished around 104 points higher, up 0.3%, after erasing an earlier loss. The Nasdaq Composite shed 0.3%.