Seven lean years

Followers of Jeremy Grantham know his consistently accurate long-term forecasts well, as well as his ability to identify and avoid asset bubbles and steer clients into high-performing asset classes.  His January 2010 letter to investors attests to his record and offers his latest forecast for the next seven years – his standard prediction time horizon.

Grantham’s prescience is remarkable but not irreplicable.  My own Monte Carlo simulations at the end of 2008 produced projections nearly identical to his at the time, and my simulations today nearly match Grantham’s current forecasts.

Given the commonalities between Grantham’s outlook and my own, I used Monte Carlo simulations to examine his forecast for a critical component of his asset allocation – US “high-quality” stocks – and to show how incorporate them into one’s own allocation.  Moreover, I show that “dividend aristocrats” and low-beta stocks are an attractive universe from which to select high-quality stocks.

Increasing allocations to those high-quality stocks should lead to improved performance without sacrificing additional risk.

Grantham’s current prediction, which he discusses at length in his most recent letter, is for “seven lean years” – a period of depressed returns across nearly all asset classes.  He projects large-cap U.S. equities to return just 1.3% per year.  Worse still are small-cap U.S. equities, from which he expects only 0.5% annual returns.  International developed market equities fare better (4.7%) in this scenario, but emerging markets equities look relatively anemic (3.9%). 

Fixed income looks equally daunting.  US government bonds are projected to return about 1.1%, and TIPS are projected to return only 0.8% per year. 

The only equity asset class that looks attractive to Grantham is US high-quality stocks, for which he projects a return of 6.8%. 

Grantham’s forecasts are real returns; they do not include his projected 2.5% annual inflation rate.

Grantham by way of Monte Carlo

Using my Quantext Portfolio Planner (QPP) software, I analyzed the asset class projections Grantham made at the end of 2008.  To compare QPP and Grantham, I converted Grantham’s compounded annual growth rate (CAGR) returns into arithmetic average annual returns.  I obtained the following, using QPP’s baseline settings (3% inflation, 8.3% per year arithmetic annual return and 15.1% annualized volatility for the S&P 500):

Projections from December 2008 Comparison (table taken from original article)Projections Dec 2008