A multiyear bubble in American stocks is now deflating as sentiment turns negative despite solid fundamentals, and investors should own as few U.S. equities as possible, according to GMO LLC.
The size and duration of the moves in stock prices in the final three months of 2018 toward their long-term average valuation is consistent with the moves linked with the bursting of the technology boom in early 2000 and the crash of 1929, according to Martin Tarlie, part of the asset-allocation team at the firm overseeing about $70 billion.
The firm is preaching caution even as U.S. shares head for a fourth weekly gain.
“The volatility is consistent with a bubble bursting,” he wrote, “though we caution that it is possible that the fourth-quarter move in the mean reversion speed could be a head fake.” The bubble could even reflate, as it did in 1998-2000, he said.
Problem is, timing the deflation is tricky. Owning as little U.S. equity as possible is the next best thing to do, recommends Tarlie, whose theoretical work on a bubble model appeared in the International Review of Financial Analysis journal.
Boston-based GMO is co-founded by Jeremy Grantham, 80, who is known for his prescient warnings of asset-price peaks before 2000 and 2008. He’s drawn skepticism for his often bearish stance during the current bull market in stocks as funds under management at the firm declined. Also, he said in January 2018 there might be a “melt-up” in stocks, just a few weeks before the volatility meltdown.
Tarlie says one reason to take his model seriously is that bubbles are rare.
“Since the late 1800s, we count only five episodes, including today’s,” he wrote in the report, the other four being the late 1910s, 1929, early 1980s and the late 1990s tech boom. “Four of these five are well known to market historians. It is likely that future market historians will learn to know the current episode as well.”
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