Jeremy Grantham – Market will crash badly after S&P tops 2,250

The week has been really productive for me as I’ve managed to stay at home and read a few good articles and understand a bit on the valuation theories by various asset fund managers, one of which is Jeremy Grantham whose articles have been published a few times by fellow blogger Drizzt.

For those who are not familiar on the guy, he is the asset fund owner of asset management firm, GMO who has correctly predicted the dotcom market bubbles in 2000 and the housing market bubbles in 2008 based on his theory which I thought was interesting to share.

To him, a bubble is indicated by a 2-sigma event using Tobin’s Q indicator and when that happens, he believes the market will eventually corrected itself by reversing to the mean. Past market bubbles, including the dotcom bubble in 2000, have exceeded the 3.2-sigma before imploding while the 2008 GFC crisis was a >2-sigma event. The U.S Housing market in 2008 was an incredible 3.5-sigma event.

*Tobin’s Q is an indicator developed by Nobelate prize winner James Tobin that measures the market value over the replacement value of a company. A 1.0 indicates that the market value correctly reflects the book value of the company.

In 2014, the US stock market are currently a 1.4 sigma event as of 31 Mar 2014 when the S&P was at 1,880. Today, the S&P have breached the 2,000 point which indicates that it’s probably gone higher and closer to the bubble. According to Grantham, a 2-sigma event is when the S&P hits 2,250, so that’s just another 10% more from current levels.

The thing about this Tobin’s Q indicator is it measures a long time horizon and not short term. So an overvaluation sigma event can remain high for a number of years before eventually reverting to its mean and vice versa. As and when the market hits new high, it is always prudent to look at some indications and justify whether you are able to stomach the risk for a given level of returns for your portfolio.