Tuesday, March 29, 2011

GMO’s Market Outlook: "Disappointingly Overvalued"

Opportunities across US and foreign assets classes are unattractive, according to Ben Inker, the head of asset allocation at the Boston-based global money manager Grantham, Mayo, van Otterloo & Co. (GMO). Neither the equity nor fixed income markets hold the potential for investors to earn acceptable inflation-adjusted returns, Inker said.

Inker delivered the keynote address at a conference on the global outlook and investment strategies held at Babson College on March 25.

Markets were “desperately overvalued” in mid-2007, prior to the financial crisis, Inker said. Since then, they have gone from “very interestingly cheap” in March of 2009 to today’s level, which he called “disappointingly overvalued.”

“This is where the life of an asset allocator gets very difficult,” he said. “Unfortunately right now we are not exactly sure what the right thing to do with our clients’ money is.”

Normalized P/E ratios are not extraordinarily rich, Inker said. He said the market is typically valued at 15 times earnings, and today it is priced at a ratio of 18.

A bigger issue, though, is that corporate profits are “unsustainably high and are going to come down,” Inker said. He said that we have just witnessed the fastest recovery of corporate profits in history, and they are already well above the average for other post-recession periods.

Analysts have forecast that profit margins are going to get to a level never seen before in history, Inker said. One reason is that capacity utilization in the economy is very low, and when it has been low in the past margins have expanded.

Inker doesn’t believe increased utilization will drive profits higher in this environment. Profits are defined in economic terms as the sum of net investments and dividends, less savings by the rest of the economy. The latter two terms tend to be fairly stable over time, and changes in net investments are what have caused profits to rise and fall, he said.

In the last 20 years, though, higher profits have been more a result of the government running a 9% deficit, Inker said, than of higher investment. Inker said that from 1952-1986 profits and capacity utilization had a positive correlation of 0.57; since 1987, however, that correlation was -0.17.

Even if net investment were to triple – which Inker said isn’t actually that hard to do – and if the government went to a “sustainable level of deficits, there just isn’t enough money out there for corporations.”

Bonds offer disappointing prospects for other reasons. Government yields are now at 60-year lows, Inker said. The last time yields were this low was in the 1940s, and bonds then were a “spectacularly bad investment for length of time longer than most professional careers,” he said. Indeed, for the next 40 years, bond investors suffered worse returns than cash investors.