GMO 2013 Q3 Letter

GMO have belatedly published their third quarter letter (pdf). (For more information on GMO click the “Backgrounds” page on the blog site.)

Some quick highlights and my thoughts below (emphasis added). And, yes, this is much shorter than the 14 page letter(s).

Inker Title: Breaking News! U.S. Equity Market Overvalued!

During the past three years GMO built a completely new forecasting model from the bottom up. Major motivators for the new work were a) an steady increase in intangible assets as a percentage of book value and b) probable shifts in sustainable profit margins due to corporate economic power.

It results in a modest change to estimates of U.S. equity “fair value” and a meaningful but not large change to emerging market estimates. “On the old model, fair value for the S&P 500 was about 1020 and the expected return for the next seven years was -2.0% after inflation. On the new model, fair value for the S&P 500 is about 1100 and the expected return is -1.3% per year for the next seven years after inflation.”

Given the dividend yield of 1.9% and assuming inflation around 2% that means a nominal total return of about 5% or 0.7%/yr. This implies stock prices about 7% lower than today’s prices in seven years, a decline of 1%/yr.

GMO has an outstanding record with these 7-year forecasts.

Per GMO the only way current valuations could be near fair value would be if either a) the U.S. were about to enter a “golden age of corporate investment and economic growth” larger than the scale of the 1950s and 1960s or b) if the equilibrium return on U.S. equities were no longer 5.7% real but were about 3.5% over then next one hundred years. They see the former is highly improbable. They see the latter as extremely depressing, since it means that all retirement plans will be wrecked, pension plans will be woefully underfunded (“the plight of public pension funds is probably not even worth calculating”), and foundations would be unable to continue their work as their endowments shrunk.

U.S. “high quality” stocks and European and emerging market stocks are not a “screaming buy” but represent better value that the U.S. broad market.

Grantham Title: Ignoble Prizes and Appointments

In my opinion this piece is less interesting than many of his letters. He grills the efficient market theory as well as Greenspan and Benanke. He takes on the “career risk management” of the professional money management establishment which he thinks contributes to herd mentality, volatility, and bubbles. It’s somewhat old hat for long time Grantham readers, but still entertaining and educational. (He adds Janet Yellen to the mix.)

He does a fifth anniversary review of the key components of the financial crisis. In his view the two main factors were a) a massive increase in commodity prices plus b) the huge housing bubble not just in terms of price but construction.

But he does turn to today’s stock market with an eye on bubbles (one of GMO’s research specialties). And that’s where it gets interesting for investors. He does not see any of the anecdotal evidence of a bubble in full swing (“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.”)  Only quite recently have we seen small cap stocks meaningfully beating high quality stocks and “a sharp and unexpected uptick in parts of the IPO market”. So, he concludes “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…”

He cites the forecast for negative 7-year returns saying “investors should be aware that the U.S. market is already badly overpriced”. His “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.”

I’d like to make some quick comments and comparisons regarding Grantham’s “bubble prediction” for the next year or two:

It seems clear that Grantham is not using a fully defensible quantitative model to make this call. However, it is well-founded on decades of extensive research into bubbles. This work has necessarily taken him into the realm of behavioral finance and psychology even while he retains a grasp on the bottom up and top down rational, quantitative models of fair value. I would say that Grantham is a good candidate for “expert intuition” in terms of bubbles while still retaining “System 2” functions. It’s hard to match his track record and intellect.

However, Kahneman himself has singled out the stock market as an unlikely place for expert intuition noting the under-performance of a large majority of “professionals”. Still, I am encouraged to value Grantham’s perspectives. A high proportion of failed experts does not mean there are not some valuable experts. Furthermore, this involves the study of a particular feature, namely bubbles, rather than the market in general and it is supported by Grantham’s deep research and lengthy contemplation. Kahneman finds two necessary features for valid expert intuition: a) “the domain is inherently predictable” and b) “the expert has had sufficient experience to learn the regularities” I think GMO’s work on bubbles has found regularities and Grantham has deep experience in this domain. Thus, I maintain that Grantham has “expert intuition” here. Still, that does not mean his prediction is certain to be correct.

Further Thoughts

Back in February 2012 in the 2011 Q4 letter Grantham wrote “In the very short term, the Inker-Grantham “comfort” model for explaining P/E points out that the “normal” response (over response would be better) both to current high profit margins and to current low inflation would call for a substantially higher market than existed three months ago (the gap has been half closed in the intervening months). To me this suggests that just like last year, the U.S. market will fight bad news and try to go up and that it is unlikely to go down much until either the current, extremely high profit margins decline or some very big wheels fall off: Europe, China, or the U.S. That is to say, in the near term, periodic moderate bad news of any kind, except about profit margins and inflation, is unlikely to keep the market down.” That has turned out to be correct. Despite a “fair value” estimate below S&P500 1,100, Grantham implied a target “over response” that would take the S&P500 into the 1,500s. The S&P500 subsequently blew through that target over-valuation and today Grantham sees the possibility of a full throttled bubble rather than a generic “understandable” overvaluation.

Fellow value investor and quant, John Hussman, comes up with similar valuations and forecasts using ensemble methods. There is probably meaningful overlap between the approaches of Hussman and GMO. Still, Hussman recently wrote that we could feasibly see a Sornette style market blow off during the next couple months, pushing the S&P500 into the 1,900s – about an 8% gain – before crashing. This is less of a prediction than a modeled possibility. Hussman says we are well into a bubble currently.

My bottom line is that the responsible investor is screwed right here, right now. Avoiding much market exposure seems prudent, but the trick will be to avoid psychological pain if you sit out and watch the market grind higher for a couple years. My guess is that if you sit it out you’d better tune it out (is it possible to not know what the market is doing for most of us?) and/or find some alternative investment classes or direct investments.

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