Is now the time to fight the Fed?

May 12, 2011, 2:26 PM UTC

Looking for a bubble? Look no further than the U.S. stock market.

So says value investor Jeremy Grantham. He warns in his latest letter to investors that stocks’ liquidity-fueled cruise will end in a headlong collision with the rusty garbage scow of economic reality.

The result, he predicts, will be a plunge of 30% or so in the S&P 500, recently at 1340 (see chart, right).

Fear of heights

Stocks are so inflated and so certain to fall, he says, that they rank with the other megabubbles of recent memory: The big-cap Nifty Fifty stocks in the early 1970s; Japan in the late 1980s; and the U.S. housing bubble that popped a few years ago.

Grantham previously said he thought stocks, though overvalued, might continue to march higher through the early fall, thanks mostly to billowy Fed policy and stocks’ tendency to rise as a presidential election approaches.

But he now says a series of shocks – riots in the Middle East, the tsunami and nuclear disaster in Japan, the sharp rise in commodity prices – have turned the adage about following the central bank’s lead on its head.

“The environment has simply become too risky to justify prudent investors hanging around, hoping to get lucky,” he writes. “So now is not the time to float along with the Fed, but to fight it.”

As always, he urges investors to raise cash and focus on big, high-quality, domestic stocks with strong earnings prospects, and faster-growing emerging market equities that aren’t so overvalued. This will mean sitting out the rest of whatever stock rally is in store over the next few months, he concedes, but so be it.

“Risk now should be more reflective of an investment world that has stocks selling at 40% over fair value (about 920 on the S&P 500) and fixed income, manipulated by the Fed, also badly overpriced,” Grantham writes.

Grantham admits that though he warns of an imminent crash, his track record suggests timing is not his strongest point. He was at least two years early in calling the Nifty Fifty, Japan and housing bubbles, he notes – a feat of prognostication that enabled him to lose a bunch of money before the market turned.

If you are very “experienced,” a euphemism for having suffered many setbacks, you try hard to reserve your big bets for when assets are very cheap. But even then, unless you are incredibly lucky, you will run into extraordinarily cheap, even bizarrely cheap, assets from time to time, and when that happens you will have owned them for quite a while already and will be dripping in red ink.

It’s worth noting that Grantham was making a similar case at this time last year. At the time, he said a selloff could be just the medicine to bring some semblance of sanity back to the market. As it happened, the S&P declined by 15% over the next six months.

But then Ben Bernanke interrupted the fun with his plan to buy Treasury bonds to prop up domestic demand for goods and services. Stocks shot off to the races, gaining 28% even with the banks reluctant to lend and unemployment staying near 9%.

The prices of metals and energy and food jumped too, you may have noticed, taxing strapped consumers and holding down growth. That is not going to help stocks stay near their postcrash highs, Grantham says. And unless events take a strange turn and something happens that gives Bernanke political cover to roll out a third round of quantitative easing, Grantham says reality could bite stocks soon – and hard.

“A third round of quantitative easing would very probably keep the speculative game going,” he writes. “But without a QE3, there seem to be too many unexpected (indeed unexpectable) special factors weighing against risk-taking in these overpriced times.”

Of course, this is hardly the first stock bubble warning you’ve heard, and it almost surely won’t be the last. But a few more days of 5% pullbacks in oil and it could soon get very interesting in the stock market.