What is a stock market "melt-up"?

By: Tim Bennett

Stock market cycles follow a pattern says Jeremy Grantham at GMO. Tim Bennett sums up why he thinks we have reached the “melt-up” phase and what that means for investors.

What is a stock market “melt-up”?

Stock markets around the world have started 2018 with something of a bang, with major indices in the US and the UK setting new all-time records. However, a few observers are worried that this bullishness is evidence of the market entering the final throes of an upswing that has lasted, on and off, for a decade since the Financial Crisis. One man, in particular, Jeremy Grantham, the founder of GMO and a stock market veteran, warns that, as we enter stage three of a classic bubble cycle (below), we may be about to see a “melt-up” that will presage a huge correction. What investors need to consider is whether they agree with him and what, if anything, they can do about it.

The past rhymes…

What follows is a brief synopsis of his recent paper – you can find the full version here;
Grantham bases his conclusions on his study of a number of previous stock market bubbles, listed below. His chief findings are that past bubbles have followed a pattern, which includes a final phase lasting about 3.5 years, within which the final, rapid “melt-up” lasts around 21 months before the bubble bursts and prices fall far and fast.

But how can you tell when markets might be entering this final phase before a crash? Grantham thinks you should watch out for the following factors;

·              Price acceleration

·             Increasing concentration of buying

·             Outperformance from quality stocks

·            Extreme expensiveness

·            Evidence of frothiness

Let’s take each of these in turn.

Price acceleration

A quick glance at the S&P 500 chart (below) reveals a long period of steady price rises, a plateau where the market trended sideways just a couple of years ago and the current phase of more rapid price gains. Looking at the way past bubbles have played out, Grantham thinks the cracking recent form of stocks could indicate that we have embarked on the final 21-month phase of this bull cycle. Whilst that does not mean a crash is imminent, the longer and harder this final phase is, the greater the probability and scale of the subsequent bust.

A focus on winners

As investor pile into the market they need to find a home for their money and will tend to choose the easiest and most obvious ones. Grantham suggests this is reflected in rapid price appreciation for those large firms perceived as market leaders, such as technology giants Amazon or Tencent. The reason is simple – being already large they are more easily able to absorb new money than their smaller peers. As a result the market starts to polarise more aggressively.
By itself however, this is not enough. What Grantham suggests you also need to see is a shift into quality, or defensive, stocks such that they start to outperform. The reason this is a danger sign is that quality stocks, by their nature, do not normally offer significant price appreciation within a market cycle that favours market-leading growth stocks. However, under pressure to buy something, rather than sit on the sidelines, fund managers start to buy these “safe” stocks as an alternative to sitting in cash. Whilst Grantham does not yet see evidence that quality stocks are on a rampage he does note their relatively strong performance recently when set against the broader S&P 500 in the US. If this trend continues into 2018, investors should heed of the signal it could be sending them.

Extreme expensiveness

Market observers disagree all the time about which measure best captures whether a particular market is cheap or expensive. Grantham is in no doubt. If you look at the Shiller price/earnings multiple, he notes that the US market has rarely been more expensive than it is now. And whilst this alone is not enough to trigger a crash, it is a necessary precondition for one, according to him.

Evidence of froth

This is perhaps the most subjective of his tests. What we are looking for here is evidence that markets and investors have got well ahead of themselves and are ignoring classic risk signs. Some of the red flags include;

·         Record levels of M&A and IPO activity

·         Very high confidence levels

·         Investor exuberance evidenced in sentiment surveys

·         A willingness to buy anything (Bitcoin?)

What should you do?

Grantham concedes that it takes a brave investor to simply sit out the final phase of a boom as they risk missing out on some serious short-term gains. That said, if we are in the “melt-up” phase only a fool would “jump in with both feet” and follow an all-out risk-on equity strategy.
Grantham does believe that there is still value to be had in emerging markets for those seeking remaining pockets of relative value. Meanwhile, we would suggest, as ever, that you are primed and ready at all times for the possibility of a correction. Above all, you do not want to be a forced seller of stocks during a sharp downturn. That means reviewing your cash and near-cash holdings against your known future cash requirements and commitments over the coming few years and balancing your allocation to equities, bonds and cash accordingly. This is something an Investment Manager can help you with.