Tuesday, August 6, 2013

US Equity Markets Over-Valued, Outlook Poor

We have long voiced concerns about the risks to the US equity market. From the market’s lows in March 2009, equity prices and earnings largely rebounded together through 2011. However, earnings growth stalled in 2012 while stock prices continued to climb. Moreover, while earnings growth remains modest, prices have already risen more year-to-date than they did in all of 2012. Moreover, using more robust valuation methodologies such as the Shiller Cyclically Adjusted Price/Earnings multiple (or CAPE) or Tobin’s Q, which compares a firm’s stock market capitalization to the replacement cost of its assets, suggest that the market is more significantly overvalued than basic trailing and forward P/E multiples.
 Along with our own research, we monitor the research of several firms with robust asset valuation research, among them Grantham, Mayo, and Van Otterloo (GMO), which manages in excess of $100 billion. One of the firm’s founders, Jeremy Grantham, has spent much of his career studying and defining asset bubbles and the firm has a long and very successful history of modeling asset class performance and managing asset allocation strategies. The firm models real, i.e. inflation adjusted, returns for multiple asset classes, which it updates on a monthly basis, over a seven-year time horizon. As of the end of June, the firm expected US large and small cap stocks to produce negative annualized returns after inflation over the subsequent seven years. Given the firm’s expectation of an average inflation rate of 2.2% annually over the period, the returns below translate into expected annualized returns of 1% for large cap US stocks and -0.50% for small cap US stocks.

 Many of our readers likely find this unfathomable given recent stock market performance. However, recent performance is largely responsible for poor expected future returns. Stock prices have risen very rapidly over the last 21 months and this has left them significantly overvalued. High valuations (i.e. when stocks are expensive) yield low future returns while low valuations (when you can buy stocks inexpensively) yield high future returns. Notice that GMO indicates that the long-term real return on US equities is 6.5% annually. Adjusting that for the 2.2% expected annual inflation rate yields an average nominal return of 8.7% annually. Large cap stocks would have to fall approximately 40% from their current levels to offer the long-term average return while small cap stocks would need to decline about 48% to do so.
Again, such a prospect is very hard for most readers to come to terms with and some might think that GMO’s outlook is unreasonable. Yet the firm’s current expectations for US equity performance are similar to what they have been prior to previous periods in which US equities have produced weak returns. The table below is from Jeremy Grantham’s quarterly letter produced in January 2009. As you can see, as of December 2001, GMO has a very similar expectation for US large cap stocks, represented by the S&P 500, and a significantly higher expected return for US small cap stocks relative to their current expectations.

Similarly, in September 2007, very near the market’s pre-crisis peak, they had real return expectations nearly identical to those that they carried as of the end of this year’s second quarter. At the time, GMO was using a long-term inflation expectation of 2.5%, translating the figures below into annualized gains of 0.70% for US large cap stocks and -0.10% for US small cap stocks. From September 2007 through June of this year, the S&P 500 (a proxy for US large cap stocks) has produced an annualized return of 3.14% while the Russell 2000 (a proxy for US small cap stocks) has produced a gain of 4.90%. While it would be easy to suggest than GMO has gotten it wrong this time around, we would note that their seven-year outlook as of December 2001 outlook appeared overly pessimistic years later at the end of 2007. Over that six-year period, the S&P 500 gained 6.07% annually while the Russell 2000 gained 9.12% annually. However, in 2008, the S&P 500 declined 37% while the Russell 2000 fell nearly 34%. Additionally, US equities continued to fall precipitously through the first 10 weeks of 2009. While we do not have the firm’s return expectations from the period, Jeremy Grantham has written extensively that the firm lost a significant portion of its asset allocation business from 1998 through 1999 as the technology bubble crescendoed and the firm side-stepped this bubble. Clients that left GMO, believing the firm to be too conservative or not it did not understand the supposed “new era” of technology-led investing, likely paid a horrible price for their decision. In short, experience suggests that when it comes to forecasting asset class performance, GMO’s challenges are more related to timing than to the quality of its forecasts. That is, their determinations that asset classes are cheap or expensive are likely to be accurate. 

After a more than 5% rise in US equity markets in July, GMO’s expectations as of the end of July, which will be published in the next week or two, will in all likelihood be lower still. Could GMO be wrong? Absolutely. But the process behind their expectations is robust and their track record strong. Those that are bullish on the stock market have little on which to stake their claim other than the Fed’s ability and willingness to orchestrate yet another asset bubble and reasonably attractive trailing and forward earnings. Yet trailing P/Es represent the past and the “E”, or earnings, of the past have had an enormous assist from Federal budget deficits, which are now declining. Additionally, analysts’ track record at predicting future earnings is only slightly more reliable than sightings of the Loch Ness Monster. We like to manage client assets with the odds in our favor and the risk of loss low. Today, that demands a significant underweight to US equities. While that is uncomfortable with the market reaching record highs, the probability is high that it be become far more comfortable in the near future as high valuations, high returns, and low volatility beget low returns, lower valuations, and high volatility.