Legendary money manager Jeremy Grantham warns that 'junk' stocks are leading an excessive rally based on unrealistic hopes, writes Proinsias O'Mahony

WITH US markets almost 50 per cent off their lows, Wall Street is once again full of raging bulls. Strategists at Goldman Sachs, Credit Suisse, Barclays, HSBC and Nomura have all raised their forecasts for global equities in the past fortnight, citing improved economic fundamentals and better-than-expected earnings reports.

Legendary money manager Jeremy Grantham this week cautioned against growing euphoria, however, warning that it is better to wait for value rather than buying in after the strongest rally since 1938. In his quarterly letter to clients, he says markets have a “record speculative bias”, with “junk” stocks leading the rally.

Grantham, a British investor who oversees $89 billion (€63.3 billion) with Boston-based institutional money-management firm GMO, says the market run has been “excessive”, and recommends “taking some risk units off the table” if momentum continues to drive markets higher. He notes that the most volatile stocks have outperformed the least volatile stocks by 48 per cent since March, while stocks under $5 have outperformed stocks over $50 by 90 per cent – far in excess of figures registered at the major market bottoms of 1974, 1982 and 2002.

The speculative nature of recent gains is also noted in a report by research firm Bespoke Investment Group. Since July 10th, the 50 most shorted stocks have gained approximately twice as much as the 50 least shorted stocks, implying that markets have run up as desperate shortsellers are forced to cover their positions.

The 50 stocks with the lowest analyst ratings thrashed those with the highest analyst ratings. The stocks that fell the furthest during June’s correction have gained by more than double that of June’s top performers, while the stocks with the lowest price/earnings ratios have outperformed all others.

“I understand a rally in junk after the record decline,” Grantham writes, “but this was excessive” and based on “unrealistic hopes for a strong, sustained economic recovery”.

His caution is echoed by Gluskin Sheff’s David Rosenberg, who says the nature of the market leaders attested to a “low-quality rally . . . best left for traders and speculators”.

Sceptical strategists also point to lacklustre trading volumes. Data from Bespoke Investment Group shows that 84 per cent as many shares were traded daily on the New York Stock Exchange between May 1st and July 20th, compared with the average from January 1st to April 30th – the steepest slowdown since 1989.

Meanwhile, the latest Vickers Weekly Insider Reportshows that company directors are selling shares at the fastest rate since October 2007.

Still, many expect higher prices in the near term. Nomura analyst Ian Scott this week projected further upside of 13 per cent for global equities, noting that the US earnings season has seen positive surprises beating negative surprises by a ratio of 3.3 to one, with actual earnings exceeding consensus estimates by 10.8 per cent.

The sustainability of those earnings remains in doubt, however, with companies beating earnings forecasts by aggressive cost-cutting while coming up light on revenues. More persuasive, perhaps, is the $3.5 trillion “money mountain” – that is, cash that remains on the sidelines, earning less than 1 per cent in money-market funds – remarked upon this week in a Merrill Lynch report. Near record highs, “this cash is a future source of demand for US equities and a contrarian bullish signal for the US equity market”.

Even the more cautious Grantham says this potential fuel could carry the market higher still.

In an informal survey at a recent meeting of 150 or so institutions, Grantham notes, those admitting to feeling nervous about underexposure to risk outnumbered those feeling too aggressive by 10 to one. This, he adds, “suggests how a speculative rally can keep going longer than reasonable investors expect”.

If the SP 500 does make it to 1,000 to 1,100 – it is currently around 975 – Grantham recommends underweighting equities.

Renowned US fund manager John Hussman agrees, saying the recovery argument “relies strongly on the idea that this is a run-of-the-mill post-war recession”.

That is not the case, however. The definitive study on the aftermath of financial crises, conducted by Harvard professor and former International Monetary Fund chief economist Kenneth Rogoff, found that recoveries are protracted affairs, with the down phase of the unemployment cycle lasting an average of four years.

The last US recession – a much milder affair – ended in November 2001 but unemployment did not peak until June 2003.

Today, the consumer accounts for 70 per cent of the US economy, still above its long-term average of 64 per cent. Debt as a percentage of income is only barely below the record 133 per cent hit in 2008, compared to 65 per cent in the mid-1980s. Rogoff recently noted that “the kind of deleveraging we need to see takes six or eight years”, a “huge adjustment the whole world is going to have to absorb”.

Higher savings and lower consumption mean that strategists increasingly agree with Bill Gross, the world’s biggest bond manager, who this week reiterated that lower economic growth rates will become the “new normal” in future years. Accordingly, markets will probably “be looking for an excuse to be cheap” in the coming years, Grantham surmises.

The current rally is almost on a par with the post-crash bear-market rally of 1929, which saw stocks advance by 52 per cent before collapsing once more in the intervening years. However, even the sceptics do not envisage a similar fate this time. Hussman sees a “moderate overvaluation” in US markets, a stance shared by Grantham.

So what to do? Grantham says the highest-quality US bluechip stocks represent the only obvious long-term bet in global equities.

Having been “thrashed on a relative basis by the second-quarter rally in junk”, there is now an “extreme value gap over junky stocks – more than an 11 percentage point spread per year on our seven-year forecast”.

Index investors, meanwhile, should wait for markets “to be silly again” rather than lunging in after the massive run-up in prices. “In our strange markets,” Grantham concludes, “you don’t usually have to wait too long for something really bizarre to show up.”