Highly regarded US funds manager Jeremy Grantham has warned that the US sharemarket has become highly risky, and now is not the time for prudent investors to be hanging around, in the hope of getting lucky.

Grantham, who co-founded funds manager GMO, which has $107 billion in assets under management, had previously predicted that the US sharemarket would rise strongly this year, powered by the immense power of the US central bank.

Markets, he predicted, would benefit from extra financial stimulus that the US central bank typically provides in the third year of the presidential cycle, in an attempt to boost the economy and improve the likelihood that political incumbents will be re-elected.

Since 1932, he says, the average return from S&P 500 in year three of the presidential cycle (measured from October 1 to October 1) is 22 percentage points higher than the average return in years one and two.

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The Fed’s policy, he says, holds an implicit promise to speculators that they’ll be bailed out in the third and fourth year of the presidential cycle.

In addition, he predicted that the market’s rise would be fuelled further by the US central bank’s decision to embark on a $US600 billion bond-buying spree — dubbed QE2.

For speculators, Grantham says, it was “a kind of underlining of the seemingly eternal promise of a bailout should something go wrong, as if Noah had been sent not just one rainbow, but two!”

But now Grantham is becoming more worried. Typically, he says, in year three of the presidential cycle, markets rally hardest in the seven months between October and May, before easing back in the next five months.

In the seven months to the end of April, the S&P had already posted total returns of 21%, which suggests that much of the exceptional year 3 performance has already been delivered.

What’s more, he says, the sharemarket has rallied strongly, despite some savage blows. “All of this has occurred as if everything is normal: as if the economy is recovering strongly, as if the housing market has started to regroup after an unprecedented two years flat on its back, and, most importantly, as if special and exogenous shocks have not tried to tag-team Year 3. Yet, all of those presumptions are at least partly wrong.”

Grantham points out that the US sharemarket has shrugged off two major exogenous shocks — the political upheaval in the Middle East and North Africa, and the devastation caused by the Japanese earthquake and tsunami.

Now, generally speaking, exogenous shocks have little effect on markets, once the initial exaggerated psychological sell-off has subsided. But Grantham says the big exception is when it’s an oil shock. “An oil shock is like a tax on business and a tax on consumers … It will usually depress consumer demand quite quickly as gasoline prices rise; it will usually depress GDP growth, generally a little later; and it will always unsettle business confidence.” Generally the share market falls rapidly and severely if it senses a serious oil crisis.

But right now, markets are shrugging off the threat that the political upheaval could spread to Saudi Arabia and other Gulf states. “For once, in my opinion, the short-term effect is underestimating the potential for trouble — a real testimonial to the year 3 confidence (and speculation) effect.”

Similarly, the US sharemarket quickly resumed its climb after the disastrous Japanese earthquake and tsunami. Usually, catastrophes of this kind have few long-term negative effects on markets, but this time could be different.

In the first place, he argues, “the Japanese damage is unprecedentedly high and some of it will be long-lasting”. In addition, he says, the world is only realising how interconnected the global production process has become.

“The Japanese are important, near-monopoly suppliers of certain small parts, without which whole production lines can be brought to a standstill. And the global industrial system does not have the resilience it once had: the Japanese have taught us all to have lean and mean ‘just-in-time’ inventories, just in time for deliveries to be cut off, revealing one of the troubling vulnerabilities of that approach.”

In addition, Grantham points to another worrying development — the move by the giant US bond fund PIMCO to dump its holding of US treasuries, which he calls the “Bill Gross effect”.

“Bill invites us to consider the consequences of QE2 ending on June 30 and, perhaps with more impact, lets us know that he at least is nervous enough to completely bail out of US government bonds, not wanting to find out who will replace the Fed as the most recent buyer of last resort.”

Finally, he says, there’s the rise in global inflationary pressure caused by galloping commodity prices. “The relentless rise in resource prices is beginning to act as an economic drag as a primary effect and, as a secondary effect, it is causing inflation pressures to increase, particularly in developing countries. This inflationary pressure is being met in those countries by efforts to cool economies down, notably by interest rate increases. These more restrictive moves in developing countries might soon begin to affect business confidence in the developed world.”

Grantham argues that the combination of these factors — political instability in the Middle East and North Africa, the repercussions from the Japanese earthquake, the ending of QE2, and surging commodity prices fuelling global inflation — threaten to derail the US sharemarket recovery.

“With these headwinds, I do not feel the same degree of confidence that I did, which was considerable, that the Fed could carry all before it until October 1 of this year. A third round of quantitative easing would very probably keep the speculative game going. But without a QE3, there seem to be too many unexpected (indeed unexpectable) special factors weighing against risk-taking in these overpriced times.”

As a result, he says, investors should rein in risk in recognition of the fact that shares are currently trading at 40% above fair value (which he estimates at about 920 on the S&P 500), and bond yields have been artificially suppressed by the US central bank.

“The market may still get to, say, 1500 before October, but I doubt it, especially without a QE3, although the chance of going up a little more by October 1 is probably still better than even.”

But, he adds, “whether it will reach 1500 or not, the environment has simply become too risky to justify prudent investors hanging around, hoping to get lucky. So now is not the time to float along with the Fed, but to fight it.”

*This first appeared on Business Spectator.