and Bonds are Disgusting
June 26, 2012
Jeremy Grantham, who has consistently identified overpricing in the US equity markets – he flagged both the Dot Com bubble and the irrational pricing that preceded the financial crisis, for instance – said last week that US stocks are “a little expensive” and bonds are “disgusting.” But his sternest warning to investors concerned the longer-term threat posed by global resource constraints.
Abnormally high corporate profits are the primary reason for Grantham’s contention that stocks are overvalued. Reversion to the mean is the core expectation that undergirds his firm’s investment philosophy, and when profit margins revert to their historical averages, he argued, investors will suffer weak returns.
Grantham is the co-founder and chief investment strategist of Grantham Mayo van Otterloo (GMO), the Boston-based asset manager. His was one of the keynote presentations at last week’s Morningstar Investment Conference, held in Chicago.
I’ll discuss Grantham’s concerns about natural resources – he devoted most of his talk to that subject – but first let’s look at his assessment of valuations in global capital markets.
I’ll conclude with some very specific advice from Grantham on how investors can make money.
The problems with stocks and bonds
Followers of Grantham – and our readers – are familiar with GMO’s investment process, which is based on a faithful reliance that certain key variables that drive stock prices – such as P/E ratios, revenue growth and profit margins – will reliably revert to their means.
GMO regularly publishes its forecast for market returns, which it projects over a seven-year time horizon. It “ruthlessly normalizes” earnings, Grantham said, assuming they will return to their historical averages by the time seven years have passed.
Abnormally high earnings will lead to disappointing US equity returns, Grantham said.
“The great majority think US equities are reasonably cheap,” he said, “but we don’t, because we want them to be priced to normal earnings.”
Mason Hawkins, the chairman and CEO of Memphis-based Southeastern Asset Management, spoke the previous day and articulated the opposing view: Margins and earnings are neither at peak or temporarily elevated levels. He said margins are higher in the US (but not globally) because we have exported lower returning businesses to other countries, such as those that are manufacturing-based, and have kept the higher returning ones, in industries such as technology and pharmaceuticals. Additionally, he said many US-based firms have significant overseas subsidiaries. Often they own less than 50% of them and account for them on an equity basis, where income but not sales is consolidated. That has artificially pushed up earnings, he said, but not temporarily.
Grantham conceded that high profit margins in the context of high unemployment is “truly weird” and has never occurred before. But he also said that GMO’s research has revealed that rising government debt is often accompanied by higher profit margins (although he did not say whether this was globally or just for the US, or over what time period).
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