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.
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.