Learning to Love Bubbles - 8 February 2011

Jeremy Grantham loves bubbles. Given today's markets, you have no choice...

JEREMY GRANTHAM is a legend to me, writes Steve Sjuggerud in his Daily Wealth.

Chairman of the board at the Boston-based GMO asset managers, Grantham called both the 2000 stock market top AND the 2009 market bottom.

He was more right than any market watcher I'm aware of in both cases. I love that he didn't pull any punches either...

He made an air-tight case for the crash in 2000, with tons of charts to back him up. And in March 2009, he dramatically increased his position in stocks for his clients.

In Jeremy Grantham's most recent quarterly letter (available at www.gmo.com), he shares his secret.

That he believe the only things which really matter in investing are the bubbles and the busts...and that he unabashedly worships bubbles.

Grantham believes he always has opportunity somewhere. In some country or in some asset class, there is usually something interesting going on in the bubble business.

You're certainly familiar with two bubbles bursting – the Nasdaq in 2000 and US home prices six years later. Grantham thinks these two bubbles were typical bubbles. He says a typical bubble "goes up in three-and-a-half years, and down in three."

The Nasdaq went from 1,200 to 5,000 in about three years. And it returned to where it started less than three years later. In 2005, home prices soared to three standard deviations away from the norm (which is Grantham's definition of a bubble). The boom took about four years, and the bust about three.

Grantham has studied literally hundreds of investment bubbles over the centuries. The one striking feature to Grantham is that "all of them go back to the original trend... the trend that was in place before the bubble formed."

Grantham likes to "exploit" bubbles for profit. He says, "Their breaking is certain or very nearly certain, and that sort of prognosticating is much more appealing to me."

As usual, Grantham doesn't hold back: "To avoid exploiting bubbles is intellectual laziness or pure chickenry." He says that "saving your big bets" for the extremes is his favorite way of making money.

Right now, I believe we're in the midst of a bubble. We're in the Bernanke Asset Bubble. In this bubble, not just one thing goes up...EVERYTHING goes up.

To maximize your profits in a bubble, it's best to just stay on board as long as you can, and use a trailing stop to take you out of your position. (See TradeStops for the details on how trailing stops work.)

Want to beat buy-and-hold? Want to beat the average fund manager by managing your own money? Then get to know bubbles. Get to know Jeremy Grantham.

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