Financial markets are in a “fully fledged epic bubble,” according to Jeremy Grantham, co-founder and chief investment officer of Boston-based Grantham, Mayo & van Otterloo (GMO).

“Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.,” wrote Grantham in "Waiting For The Last Dance," a blog posted Tuesday to GMO's website, noting that bubbles are usually where fortunes are made and lost.

The current bubble has created opportunity for investors in the areas of value stocks and emerging markets, said Grantham.

“Value stocks have had their worst-ever relative decade ending December 2019, followed by the worst-ever year in 2020, with spreads between growth and value performance averaging between 20 and 30 percentage points for the single year!” said Grantham. “Similarly, Emerging market equities are at one of their three more or less coequal relative lows against the U.S. of the last 50 years. Not surprisingly, we believe it is in the overlap of these two ideas, value and emerging, that your relative bets should go, along with the greatest avoidance of U.S. growth stocks that your career and business risk will allow.”

During more normal periods of market performance, small outperformance can be achieved by “valuation-based” investors, but asset allocation is not a “very important” element for success, writes Grantham. In most bear markets, which are “short and brutal,’ investors are frozen into inaction, giving asset managers an opportunity to reposition their portfolio and retain their business.

Long bull markets, on the other hand, can pressure clients into action, said Grantham. “And when price rises are very rapid, typically toward the end of a bull market, impatience is followed by anxiety and envy. As I like to say, there is nothing more supremely irritating than watching your neighbors get rich.”

Regardless of monetary support from central bankers, Grantham believes that the current bubble will burst in due time.

“It will very probably end badly, although nothing is certain,” wrote Grantham. “I will also tell you my definition of success for a bear market call. It is simply that sooner or later there will come a time when an investor is pleased to have been out of the market. That is to say, he will have saved money by being out, and also have reduced risk or volatility on the round trip. This definition of success absolutely does not include precise timing. (Predicting when a bubble breaks is not about valuation. All prior bubble markets have been extremely overvalued, as is this one. Overvaluation is a necessary but not sufficient condition for their bursting.) Calling the week, month, or quarter of the top is all but impossible.”

In fact, Grantham said the bubble could break “any day” or the markets could keep roaring upwards for a few months longer, but guessed that it will not survive past the late spring or early summer when the Covid-19 vaccines are rolled out to a broader segment of the population. At that time, the “most pressing issue facing the world economy” will have been dealt with, but investors will finally realize that the economy is still in poor shape and that “valuations are absurd,” with prices far diverged from the underlying economic realities.

But Grantham acknowledges that it is difficult to idenitiify the “pin” that bursts the bubble, even in hindsight.

Investors are challenged because they cannot discern the effects of market behavior from the impact of manager decisions, and the world is too far removed from previous market downturns – in 2000, 2008 or 1989 in Japan – to have evidence of a manager’s ability to cope with volatility. As in many late-stage bubbles, bears will face “rising hostility” from emboldened market optimists.

Grantham noted that he called the market tops and lows correctly in 2008 and 2009, but was not as successful in calling the top of Japan’s Nikkei index in 1989, pulling out of the market almost three years too early, or the 2000 dot-com crash  in the U.S., when GMO sold its discretionary U.S. positions in 1997, again, three years before the actual top.

“The single most dependable feature of the late stages of the great bubbles of history has been really crazy investor behavior, especially on the part of individuals,” wrote Grantham. “For the first 10 years of this bull market, which is the longest in history, we lacked such wild speculation. But now we have it. In record amounts.”

Grantham cited investor “mania” for high-flying electric vehicle stocks like Tesla and Nikola, and for bargain-hunting in stocks ike Hertz and Kodak. He notes that  at it’s current market $600 million capitalization, Tesla is worth $1.25 million for every car it has sold, versus $9,000 per car for General Motors.

He also cites the “Buffeft indicator,” the ratio of the total stock market captiaization to GDP, which has blown thorugh its previous high set in 2000, and the surge of new IPOs in 2020 in the midst of a pandemic, driven in part by a boom in SPACs.

This bubble is different, according to Grantham, because in previous markets a bubble is accompanied by accommodative monetary policy and “near-perfect” economic conditions which are extrapolated indefinitely into the future. However, this bubble is occurring amidst a “wounded economy” harmed by the economic devastation caused by a global pandemic. Investors are extrapolating low and negative rates indefinitely into the future, which, to them, justifies lower yields and higher asset prices.

“Yet the market is much higher today than it was last fall when the economy looked fine and unemployment was at a historic low,” wrote Grantham. “Today the P/E ratio of the market is in the top few percent of the historical range and the economy is in the worst few percent. This is completely without precedent and may even be a better measure of speculative intensity than any SPAC.”

Investment managers now face a crossroads, said Grantham. Bears will suffer during the “vertical” phase of a late-stage bubble, which is usually short. Bulls will suffer when the bubble bursts. And no one can know exactly when a market cataclysm will occur.

“Requiring that you get the timing right is overreach,” wrote Grantham. “If the hurdle for calling a bubble is set too high, so that you must call the top precisely, you will never try. And that condemns you to ride over the cliff every cycle, along with the great majority of investors and managers.”