The Great Paradox of the U.S. Market!

1: The U.S. Market

Well, the U.S. is really enjoying itself if you go by stock prices. A Shiller P/E of 34 (as of March 1st) is in the top 1% of history. Total profits (as a percent of almost anything) are at near-record levels as well. Remember, if margins and multiples are both at record levels at the same time, it really is double counting and double jeopardy – for waiting somewhere in the future is another July 1982 or March 2009 with simultaneous record low multiples and badly depressed margins.

But for those who must own U.S. stocks (most institutions) even when they are generally very overpriced, there is a reasonable choice of relatively attractive investments – relative, that is, to the broad U.S. market.

  • Quality: Although not spectacularly cheap today, U.S. quality stocks 1 have a long history of slightly underperforming in bull markets and substantially outperforming in bear markets (although they did unusually well in the recent run-up). In addition, their long-term performance is remarkable. AAA bonds return about 1% a year less than low-grade bonds – everybody gets it, and always has. In bizarre contrast, the equivalent AAA stocks, with their lower bankruptcy risk, lower volatility, and just plain less risk, historically have delivered an extra 0.5% to 1.0% a year over the S&P 500 (to be precise, an extra 1.0% a year for the past 63 years, with the gains concentrated in the period since 2008). What on earth is that? Even holding their own should be inconceivable. It is the greatest aberration of all time in the market, and one I’m happy to say we at GMO realized 45 years ago, when Fama and French were still obsessing about returns to risky small cap and price to book. 2 And while I’m bragging, I should say that GMO has added a decent long-term increment to that generic 1%, totaling 1.3% a year above the S&P 500 in our Quality Strategy for the last 10 years. 3
  • Resource equities: Not only are raw materials finite – believe it or not! – getting scarcer, and therefore certain to rise in price, but at longer horizons (10 years) resources are the only sector of the stock market to be negatively correlated with the broad stock market. They are far and away the most diversifying sector (see Exhibit 1). They are also particularly cheap today having been whacked recently.