Quantext, Inc.
March 2, 2010
Bringing the pieces together
A little over a year ago, Grantham projected annualized returns for equities and a range of other risky asset classes that looked very good indeed – which matched my Monte Carlo projections very closely. Today the outlook is far less rosy, largely because of the massive rally in equities in 2009. Grantham believes that the broad domestic stock indexes are simply too expensive on the basis of reasonable future earnings and earnings growth. At the same time, however, there remain some great opportunities in US high-quality companies.
“For the longer term, the outperformance of high quality U.S. blue chips compared with the rest of U.S. stocks is, in my opinion, ‘nearly certain,’” he wrote in his letter to investors, explaining that he defines ‘nearly certain’ as more than a 90% probability.
While Grantham‘s forecast for domestic stock indexes are notably worse than those of Monte Carlo’s long-term baseline, this difference affects little which asset classes qualify as attractive. US high-quality stocks look good. Emerging markets, unsurprisingly, are a high-return/high-risk proposition, and are even riskier today than at the time of Grantham’s writing because of high prices.
Grantham’s outlook is fairly consistent with PIMCO’s “New Normal” world view in its implications for equity exposure. High-quality stocks also tend to be consistent dividend payers, and dividends are likely to make up a larger fraction of total returns in a “New Normal” world. International stocks look more attractive than domestic equities – something reflected in the projections for EFA versus SPY.
Low-beta equities also look more attractive in a New Normal scenario, and the dividend aristocrats tend to have low betas. The beta for an equal-weighted portfolio of the top ten aristocrats by market cap is 0.87, which is fairly low for an all-equity portfolio. One piece of Grantham’s outlook that is inconsistent with the New Normal, which includes the possibility of substantial inflationary pressures, is his low expected inflation rate of 2.5%. In the event of higher inflation, inflation-indexed bonds will substantially outperform nominal bonds, and real assets, such as timber, will look more attractive.
A brief note on timber
Aside from high-quality stocks, Grantham’s projections identify one other possible source of outperformance: He projects 6% in real return (8.5% in nominal return) for managed timber. A portfolio allocated equally to each of two large timber REITs, PCL and RYN, has a projected average annual return of 12.7% in QPP. When I convert Grantham’s 8.5% CAGR to average annual return (using the projected volatility for my timber proxy), I get average annual return of 11.1%. Once again, the results are quite close.
Conclusions
When I first compared my Monte Carlo simulations to Grantham’s outlook in 2008, I was surprised and, frankly, gratified by their similarity. I had the same reaction this time around. Grantham has a remarkable track record, so I’d rather be betting with him than against him.
Our shared outlook calls for a substantial shift away from traditional asset allocation models. To demonstrate this, we will start with a reference case from QPP for a fairly generic 60/40 portfolio:
QPP projects an annual return of 7.7% for this portfolio, with annualized volatility (standard deviation in returns) of 12%. Recall that QPP has higher estimates than Grantham of the expected returns for domestic equities as a whole. If I adjust QPP’s projections for large-cap and small-cap domestic equity indexes downward to agree with Grantham, the projected total portfolio return drops to 6.7%.
If I alter the portfolio such that the bond allocations remain the same, but the equity allocation is 20% to EEM and 4% each to the top ten dividend aristocrats (listed previously), my new 60/40 portfolio will have expected average annual return of 9%, with annualized volatility of 11.9% (almost identical to the volatility of the original 60/40).
If we believe Grantham’s more dire projections for broad-based U.S. equities, focusing the equity portion of the portfolio on high-quality domestic equities and foreign equities adds 2.3% per year in expected return over a typical 60/40 allocation. If we use QPP’s baseline projections, this is a more modest 1.3% benefit. Either way, such a shift substantially boosts expected return without adding portfolio risk.
The conceptual implications of this kind of departure from standard asset allocations are huge. Can markets really be so inefficient that the market-cap-weighted equity indexes impose a substantial net drag on overall performance? Ten years ago, this would have seemed outlandishly unthinkable. Today, it seems a lot more plausible.
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