Monday, November 18, 2013

GMO's 3Q 2013 Letter


Inker excerpt:
But enough about the details. The basic point for us remains the same – the U.S. stock market is trading at levels that do not seem capable of supporting the type of returns that investors have gotten used to receiving from equities. Our additional work does nothing but confirm our prior beliefs about the current attractiveness – or rather lack of attractiveness – of the U.S. stock market. To answer the question we get most often about our forecast – “How could you be wrong?” – there are a couple of ways we could be wrong. One of them is pleasant and implausible, the other is more plausible, but far less pleasant. 
The pleasant way we could be wrong is if the U.S. is about to embark on a golden age of corporate investment and economic growth that will gradually compete down the current return on capital such that overall profits manage to grow decently as the P/E of the stock market wafts slowly down. This would solve lots of problems, including the federal deficit and unemployment and, quite possibly, health care costs as well, but there is sadly no evidence whatsoever that it is occurring, as can be seen in Exhibit 4.

The investment boom to drive such strong growth would almost certainly have to be at least as large as what we saw in the 1950s and 1960s, but as you can see, not only is corporate investment down significantly in the post-GFC years, it had been on a downward trend for 40 years prior to that. That doesn’t mean it absolutely cannot change, but investing on the basis that it will occur makes only slightly more sense than basing your retirement plans on winning the lottery.
The less pleasant way we could be wrong is if 5.7% real is no longer a reasonable guess at an equilibrium return for U.S. equities. If equity returns for the next hundred years were only going to be 3.5% real or so, today’s prices are about right. We would be wrong about how overvalued the U.S. stock market is, but every pension fund, foundation, and endowment – not to mention every individual saving for retirement – would be in dire straits, as every investors’ portfolio return assumptions build in far more return. Over the standard course of a 40-year working life, a savings rate that is currently assumed to lead to an accumulation of 10 times final salary would wind up 40% short of that goal if today’s valuations are the new equilibrium. Every endowment and foundation will find itself wasting away instead of maintaining itself for future generations. And the plight of public pension funds is probably not even worth calculating, as we would simply find ourselves in a world where retirement as we now know it is fundamentally unaffordable, however we pretend we may have funded it so far. William Bernstein wrote a piece in the September issue of the Financial Analysts Journal, entitled “The Paradox of Wealth,” which explains far too plausibly why generally increasing levels of wealth might drive down the return on capital across the global economy. It’s well worth a read, although perhaps not on a full stomach, as it is one of the most quietly depressing pieces I have ever come across (and this is coming from someone who has spent the last 21 years reading Jeremy Grantham’s letters!)

Grantham excerpt:
In equities there are few signs yet of a traditional bubble. In the U.S. individuals are not yet consistent buyers of mutual funds. Over lunch I am still looking at Patriots’ highlights and not the CNBC talking heads recommending Pumatech or whatever they were in 1999. There are no wonderful and influential theories as to why the P/E structure should be much higher today as there were in Japan in 1989 or in the U.S. in 2000, with Greenspan’s theory of the internet driving away the dark clouds of ignorance and ushering in an era of permanently higher P/Es. (There is only Jeremy Siegel doing his usual, apparently inexhaustible thing of explaining why the market is actually cheap: in 2000 we tangled over the market’s P/E of 30 to 35, which, with arcane and ingenious adjustments, for him did not portend disaster. This time it is unprecedented margins, usually the most dependably mean reverting of all financial series, which are apparently now normal.) By June this year, markets felt relatively quiet and under the surface there was still a considerable undertow of risk aversion in the institutions. The Russell 2000 and the GMO High Quality universe were both just level with the S&P, all up 16%. Normally we would have expected the Russell to outperform handsomely. However, since then speculation has perked up so that today, the broad U.S. market is up 20% and the Russell 2000 is a more typical six points ahead while stocks in the GMO High Quality universe are several points behind. We have also had a sharp and unexpected uptick in parts of the IPO market in the U.S., so I would think that we are probably in the slow build-up to something interesting – a badly overpriced market and bubble conditions. My personal guess is that the U.S. market, especially the non-blue chips, will work its way higher, perhaps by 20% to 30% in the next year or, more likely, two years, with the rest of the world including emerging market equities covering even more ground in at least a partial catch-up. And then we will have the third in the series of serious market busts since 1999 and presumably Greenspan, Bernanke, Yellen, et al. will rest happy, for surely they must expect something like this outcome given their experience. And we the people, of course, will get what we deserve. We acclaimed the original perpetrator of this ill-fated plan – Greenspan – to be the great Maestro, in a general orgy of boot licking. His faithful acolyte, Bernanke, was reappointed by a democratic president and generally lauded for doing (I admit) a perfectly serviceable job of rallying the troops in a crash that absolutely would not have occurred without the dangerous experiments in deregulation and no regulation (of the subprime instruments, for example) of his and his predecessor’s policy. At this rate, one day we will praise Yellen (or a similar successor) for helping out adequately in the wreckage of the next utterly unnecessary financial and asset class failure. Deregulation was eventually a disappointment even to Greenspan, shocked at the bad behavior of financial leaders who, incomprehensibly to him, were not even attempting to maximize long-term risk-adjusted profits. Indeed, instead of the “price discovery” so central to modern economic theory we had “greed discovery.”

(Memo: “price discovery” is the process that happens in an open and competitive and unregulated market, where the interplay of supply, demand, and cost structures determines the efficient price. “Greed discovery” is the process by which a vastly and unnecessarily complicated financial system is exploited by expert insiders. These insiders have far more knowledge than the lambs – formerly known as clients – and without adequate regulations the lambs are defleeced in a surge of “rent seeking.”) 
In the meantime investors should be aware that the U.S. market is already badly overpriced – indeed, we believe it is priced to deliver negative real returns over seven years – and that most foreign markets having moved up rapidly this summer are also overpriced but less so. In our view, prudent investors should already be reducing their equity bets and their risk level in general. One of the more painful lessons in investing is that the prudent investor (or “value investor” if you prefer) almost invariably must forego plenty of fun at the top end of markets. This market is already no exception, but speculation can hurt prudence much more and probably will. Ah, that’s life. And with a Fed like ours it’s probably what we deserve.

Inconvenient Conclusion

Be prudent and you’ll probably forego gains. Be risky and you’ll probably make some more money, but you may be bushwhacked and, if you are, your excuses will look thin. Your call. We of course are making our call. 
Postscript 1 
What can go wrong for the market? There is a slow and for me rather sinister slowing down of economic growth, most obviously in Europe but also globally, that could at worst overwhelm even the Fed. The general lack of fiscal stimulus globally and the almost precipitous decline in the U.S. Federal deficit in particular do not help. What are the odds in the next two years? Perhaps one in four.
Postscript 2
Hot off the press, for a less serious moment at our client conference comes the latest update (or data mining, if you prefer) of the… ta da…Presidential Cycle. Since October 1977 when GMO started, 36 years have passed. In that time – when logic and experience say you stimulate to help the next election – the third year has been over 1½ times the other three added together and years one and two, when you should be tightening, have been commensurately weak. For the weakest five cycles, the average of years one and two was negative but for three cycles it was strong, even very strong. These three cannot be blamed totally on the Greenspan-Bernanke regime’s tendency to overstimulate, but mostly they can. Bearing in mind that for us Presidential years run October 1-September 30, these three two-year returns were 1996, +48%; 1984, +43%; and 2004, +19%. Now, this is the scary part. 1996 ended in the 2000 crash, 1984 in the crash of 1987, and 2004 in the financial crash of 2008. In the current cycle we are already up 19% with a year to run! Of course, it may turn out to be a very strong two years and all will be well. Who knows?