Can He Be Right?

Jeremy Grantham is quoted in this Marketwatch article saying the S&P 500 could lose 40% between late 2008 and the end of 2010.

We may all be as mad as this guy if he is correct.

It certainly seems reasonable that we could at least have to endure a normal bear market at some point between now and then but cutting in half, or coming close to it, twice in a decade is pretty far outside the fat tail.

However any scenario is possible and it makes sense to have at least a rough idea of what you would do if Grantham turns out to be correct.

A move of 40% over a period of 18 months or more (the time period implied in his statement) is sort of a slow decline. The kind of decline that many people will tell us not to worry about as we go. To frame this in the way I write about it (and think about it too) is that on the way to the down a lot he calls for is the the down a little that happens every now and then.

Any time the market goes down a little it could be on its way to down a lot. This does not happen very often but slow declines that result in down a lot hit down a little first. In this context sticking to whatever get-defensive strategy you believe in becomes of paramount importance.

An important point to remember is that if the market does actually go down 40% and you do a great job in protecting against most of it, you will still endure a decline of some magnitude--again, if you navigate this scenario fantastically well. Most of us, if we are lucky, will be down a lot but hopefully less than 40%. A 25-30% decline in a down 40% world would be a colossal success in my opinion.

That may not sound great to you but the average 10% annual gain includes all of the worst bear markets in history. Adding ten percentage points of outperformance in a one or two year period would be huge to your long term result.

I would suspect that in a slower decline, that is one without panic, diversification would work, that correlation would not go up between investments where it is usually low. In this environment I would want to own foreign currency and bonds, different sorts of countries (commodity based, surplus or in their own world), cash and big cap defensive stocks all come to mind as places to overweight. I would also hope that I had positioned the double short fund well going into this to neutralize some of that decline.

I have no idea if Grantham will be right and there is really not much need to correctly predict something like that either. Any time the market goes down a little (not the market condition to fear) it could devolve into down a lot (this is the thing to worry about). You can't know when it will happen so don't sweat being right, just stay disciplined and and hope to miss a chunk of it.

The picture is of Adam Arkin playing his recurring character of Adam in my all time favorite TV show; Northern Exposure.