This Is What a Real Market Crash Looks Like

By Scott Cendrowski, writer-reporter

December 6, 2011: 12:50 PM ET

Investor Jeremy Grantham thinks stocks are overpriced, and he shows how long it could take the market to recover after another crash.

FORTUNE — Investing sage Jeremy Grantham sounded a little guilty in his latest report to clients, titling it “The Shortest Quarterly Letter Ever.” He should hold the apologies. Grantham, one of the pithiest market writers around, includes a chilling graphic in the four-page note that is one of the most mesmerizing market visuals of 2011.

Grantham is a value investor who oversees nearly $100 billion at his Boston-based firm, GMO. Using historical averages of prosaic data like profit margins and price-to-earning ratios, he’s made a series of prescient market calls. This spring, as U.S. stocks quickly rose, he told investors to flee the market because of escalating global fears. (He was right.) And back in 2009, he famously published a bullish note titled “Reinvesting When Terrified” at the market’s nadir.

Today he’s sounding the alarm again on stocks, and he seems as wary as ever. “Since the spring,” Grantham explains, “the equity markets have been absolutely bombarded by bad news.” Between the eurozone crisis and fears of a slowdown in China, there’s as much bad news as ever, he says. Yet the S&P 500 keeps recovering whenever crises ease for a just few days, thanks to sky-high profit margins and historically low inflation. Those two factors are driving U.S. stocks past Grantham’s estimate of the market’s fair value of 975-1,000 for the S&P 500 (SPX).

This is where his analysis starts to get scary. Profit margins will fall back to historical levels eventually, he says, and stocks will come down with them. Then there’s an inflection point. If any unresolved crises remain on the table when this happens — the eurozone crisis; a slowdown in China; budget impasses in the U.S. — then U.S. stocks could start to look a lot like those in Japan.

For two decades the Federal Reserve has bailed out stock markets, he argues. Former Fed Chairman Alan Greenspan cut interests rates to near zero percent at the slightest indication of economic decline. And today, Chairman Ben Bernanke has followed the same course, stimulating the market so drastically in 2009 that after stocks crashed they took only three months to recover to a long-term upward trend.

“This pattern is unique,” Grantham writes. And now that the Fed’s balance sheet is stuffed full with debt, he adds, it may not come to aid during another stock downturn.

“GMO has looked at the 10 biggest bubbles of the pre-2000 era and has calculated that it typically takes 14 years to recover to the old trend,” Grantham says. The important point of all this, he writes, is that almost none of today’s professional investors have experienced anything like this because the Fed has come to the rescue.

“When one of these old-fashioned but typical declines occurs,” he writes, “professional investors, conditioned by our more recent ephemeral bear markets, will have a permanent built-in expectation of an imminent recovery that will not come.”

That sets up an environment that Grantham dubs, “No Market for Young Men.” Grantham shows how long it may take U.S. stocks to recover if they crashed today:

Read the rest here.

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