Pension Trustee Smith: I recommend to the committee that we liquidate our International equity assets and index our equity exposure to the S&P 500. US stocks have outperformed for the last 20 years, and I see no reason why that should not continue. Everyone knows that the US is the strongest economy and market in the world.
This is a somewhat fictionalized version of a comment or conversation that has gone on in many committee discussions over the last several years in one form or another. And why wouldn’t it? Being a US equity investor over the past several years has felt glorious. The S&P 500 has trounced the competition provided by other major developed and emerging equity markets. Over the last 7 years, the S&P is up 173% (15% annualized in nominal terms) versus MSCI EAFE (in USD terms), which is up 71% (8% annualized), and poor MSCI Emerging, which is up only 30% (4% annualized). Every dollar invested in the S&P has compounded into $2.72 versus MSCI EAFE’s $1.70 and MSCI Emerging’s $1.30. Diversification theoretically sounds good, but as Yogi Berra said, “In theory there is no difference between theory and practice, in practice there is.” Diversification in this particular instance seems good in theory but not so much in practice.
So, shouldn’t we agree with Trustee Smith and throw in the towel, index all of our equity exposure to the S&P 500, and call it a day? If our goal is compounding capital for the long term, which it is, we would not just say “No,” but something akin to “Hell no!”
Valuation of the S&P 500
The bedrock of everything we do is valuation, so let’s begin addressing Trustee Smith’s concerns with a look at the current valuation of the S&P 500. We will start our tour of valuation by examining our own framework. This in turn starts by understanding the drivers of return.
For any equity market, the return achieved can be broken down into four component parts. In the long term, the return is almost exclusively driven by dividends (growth and yield). Equity owners need to be compensated for providing capital to companies to help fund their long-term investments. That compensation comes from the cash flows the companies generate from their risky investments via earnings and dividends.
The two other ways to make money from owning an equity asset class are from multiple (P/E) or margin expansion (collectively we call these elements the valuation components). Together these four components make an identity – we can (ex post) always decompose returns into these factors. In Exhibit 1, we show a return decomposition for the S&P 500 since 1970 based on these four factors (earnings, dividends, margins, and P/Es). Margins and P/Es are basically flat over this very long time period. As we stated above, over the long term, the returns achieved have been delivered largely by dividends.
Using this same decomposition over the last seven years, we see quite a different story in Exhibit 2. Earnings and dividends have grown as one would expect, but P/E and margin expansion have significantly contributed to returns with multiple expansion actually providing the biggest boost of the four. This is typical of short-term periods, where the volatility of returns is dominated by shifts in the valuation components.
If earnings and dividends are remarkably stable (and they are), to believe that the S&P will continue delivering the wonderful returns we have experienced over the last seven years is to believe that P/Es and margins will continue to expand just as they have over the last seven years. The historical record for this assumption is quite thin, to put it kindly. It is remarkably easy to assume that the recent past should continue indefinitely but it is an extremely dangerous assumption when it comes to asset markets. Particularly expensive ones, as the S&P 500 appears to be.
GMO’s S&P 500 forecast
To go from the above accounting identity to a framework for forecasting returns requires some statement about the way the four elements will evolve over time. Our forecasts are similar in spirit to a cyclically-adjusted P/E1 but we try to account for the cyclicality of earnings a bit differently. We look at trailing P/Es and then make an adjustment to margins where we look at multiple proxies for returns on economic capital. We assume that whatever level P/Es and margins are trading at today, that at the end of seven years they will mean revert to equilibrium levels. This isn’t to say that in exactly seven years’ time we expect everything to be back to normal; rather, given how difficult it is to see seven years into the future, assuming a return to normal is a pretty good starting point. We then factor in earnings growth and income (dividends and buybacks) that we receive as equity owners.
Of course, there is some art and judgment associated with this model (unfortunately, social systems like markets are not beholden to such things as physical laws of nature). This framework is a great starting point for a conversation (at least it is if you find conversations about the likely returns to investments stimulating). If someone comes to you and says, “I think US equities will deliver 10% real per year from now on” you can ask them how. Does he think P/Es and margins will continue to expand? Does he have some rampantly bullish view on growth? Or perhaps an odd view on yield? Likewise, if you think our assumptions are daft, you can insert your own. We update this model every month and you can see the current dilemma in Exhibit 3.
The (relative) good news
The cruel reality of today’s investment opportunity set is that we believe there are no good choices from an absolute viewpoint – that is, everything is expensive (see Exhibit 10). You are reduced to trying to pick the least potent poison.
This is fine if you have to invest relative to a benchmark or strategic objective. There are still some relative opportunities around – if you are willing to break Trustee Smith’s parochial frame. The last thing you should want to do is concentrate your portfolio in the world’s most expensive assets…which is, of course, what Trustee Smith is urging you to do.
Let’s return once again to valuation to make the case for non-US equities. As we look at our forecasts for international (EAFE) equities, we get a forecast of -0.6% real in local currency terms.8 EAFE Value is a bit better at 0.3%. EAFE suffers from a similar fate as US equities – elevated P/Es and profit margins but just much less so than their US counterparts. In absolute terms, EAFE is ugly, but just not as ugly as the US.
However, in relative terms EAFE stocks look much cheaper than US equities. In fact, if we go back to the early 1980s and look at the spread of EAFE versus the US (see Exhibit 11), the approximately 4% gap between these two major asset classes in the 89th percentile of observations means that 89% of the time the spread between these two assets is less than 4%. Basically, on only a couple of occasions in the late 1990s and during the European crisis of several years ago have EAFE stocks been as cheap as they are relative to US equities.
While US equity bulls can point to stronger economic fundamentals in the US than those we see in Europe and Japan, the issue for investors is not the relative health of the respective economies because we know that economic growth has little to do with subsequent equity returns. Plus, anybody that can pick up a newspaper can see the headlines and make that facile determination. The question for investors is “What’s in the price?” And as we look at the US equity market, relative expectations seem quite high and an awful lot appears to be in the price. However, international equities, while not cheap in absolute terms, certainly suffer from poor expectations and much better pricing. Their currencies also seem a bit cheaper relative to the dollar. Combine all this with significantly cheaper relative valuations and we believe international equities look a damn sight better than their US counterparts.
The story is similar within emerging market equities, but the news is actually better. Emerging equities have a forecast of 2.9% real (local terms) and cheap currencies to boot. Though emerging equities are expensive in absolute terms (slightly expensive on P/E), they provide a very strong return relative to US equities. The spread between emerging and the US is in the 90th percentile of observations going back to the late 1980s. We would think the currencies should add another tailwind (approximately 1%) to the asset class as well. That represents a significant premium to US equities. We all know the trouble emerging equities have had over the last several years – concerns for an economic slowdown in China, a depression and never-ending political turmoil in Brazil, Russia’s recent significant recession after the price of oil collapsed to name a few. There are numerous reasons to be worried about emerging. But again, the key question is “What’s in the price?” And to us, emerging market equities look poised to significantly outperform developed market equities. And if you look at the emerging value universe, the forecast looks even better, rising to 6.2% real. Now, Trustee Smith is going to be even less enamored of emerging stocks than international stocks because they have underperformed even more significantly over the last seven years. But he is completely missing one of the most crucial points in investing – starting valuations are going to cover the vast bulk of portfolio outcomes over any reasonable length of time.
For a relative investor (following the edicts of value investing), we believe the choice is clear: Own as much international and emerging market equity as you can, and as little US equity as you can. If you must own US equities, we believe Quality is very attractive relative to the market. While Quality has done well versus the US market, long international and emerging versus the US has been a painful position for the last few years, but it couldn’t be any other way. Valuation attractiveness is generally created by underperformance (in absolute and/or relative terms). As Keynes long ago noted, a valuation-driven investor is likely seen as “eccentric, unconventional, and rash in the eyes of average opinion.”
In absolute terms, the opportunity set is extremely challenging. However, when assets are priced for perfection as they currently are, it takes very little disappointment to lead to significant shifts in the pricing of assets. Hence our advice (and positioning) is to hold significant amounts of dry powder, recalling the immortal advice of Winnie-the-Pooh, “Never underestimate the value of doing nothing” or, if you prefer, remember – when there is nothing to do, do nothing.
Markets appear to be governed by complacency at the current juncture. Indeed, looking at the options market, it is possible to imply the expected probability of a significant decline in asset prices. According to the Minneapolis Federal Reserve, the probability of a 25% or greater decline in US equity prices occurring over the next 12 months implied in the options market is only around 10% (see Exhibit 12). Now we have no idea what the true likelihood of such an event is, but when faced with the third most expensive US market in history, we would suggest that 10% seems very low.
But, one thing we have a high degree of confidence in is that Trustee Smith’s recommendation to concentrate his portfolio into indexed US equites, shun diversification, and sell international equities will ultimately increase the real risk in his portfolio, i.e., losing money, and make it even more difficult to meet the required rate of return. Good luck to you, Trustee Smith. It seems you are going to need it.
1 There will be more on this measure a little later in this paper.
2 As Graham and Dodd (1934) wrote, “Using a 5-, 7-, or preferably 10-year”average of earnings is a way of smoothing out the business cycle. Right now, 10-year average earnings are above their trend so this is actually a generous measure. As we have shown elsewhere (see “A CAPE Crusader: A Defense Against the Dark Arts,” a white paper by Montier, February 2014) a measure based on the trend 10-year earnings does even better at forecasting returns.
3 One of the authors (Montier) has regularly run this screen over time to assess the potential opportunity set from a bottom-up perspective.
4 Recall that the S&P was up more than 50% from the end of February 2009 to December 31, 2009. If a market is up 50%, holding fundamentals (earnings and dividends) constant, one would expect the forecast for the market to fall by approximately 7%. This is essentially what happened to our forecasts.
5 See Ben Inker, “Hellish Choices: What’s An Asset Owner To Do?” The April 2016 GMO Quarterly Letter is available at www.gmo.com.
6 An all-time favorite quote from Jeremy Grantham’s April 2001 Quarterly Letter: “The market gets increasingly inefficient as investors become more reluctant to bet against the benchmark…As the opportunities to add value increase, so does the personal risk, the career risk, and the business risk, until finally there will be incredible opportunities to make money and reduce risk that no one will dare take advantage of. We would like at least to be the last ones trying...”
7 See James Montier, “Six Impossible Things Before Breakfast” (March 2017). For instance, to believe that the US market offers fair value, you need to believe that it is capable of growing nearly three times faster in real terms than it has historically managed to do.
8 To get a total US dollar return for US investors, you need to add a forecast for the EAFE currencies to the forecast for EAFE. We have currency forecasts based on valuation and real interest rates, and developed currencies provide a very mild (less than 0.5% expected return) tailwind for EAFE equities.
Matt Kadnar. Mr. Kadnar is a member of GMO’s Asset Allocation team. Prior to joining GMO in 2004, he was an investment specialist and consultant relations manager at Putnam Investments. Previously, he served as in-house counsel for LPL Financial Services and as a senior associate at Melick & Porter, LLP. Mr. Kadnar has a B.S. from Boston College majoring in Finance and Philosophy and a J.D. from St. Louis University School of Law. He is a CFA charterholder.
James Montier. Mr. Montier is a member of GMO’s Asset Allocation team. Prior to joining GMO in 2009, he was co-head of Global Strategy at Société Générale. Mr. Montier is the author of several books including “Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance”; “Value Investing: Tools and Techniques for Intelligent Investment”; and “The Little Book of Behavioural Investing.” Mr. Montier is a visiting fellow at the University of Durham and a fellow of the Royal Society of Arts. He holds a B.A. in Economics from Portsmouth University and an M.Sc. in Economics from Warwick University.
Disclaimer: The views expressed are the views of Matt Kadnar and James Montier through the period ending August 2017, and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
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