Stop me if you've heard this before, but money manager GMO LLC is bearish on U.S. equities. The Boston-based firm and its noted co-founder, Jeremy Grantham, have long warned that U.S. stocks are overpriced and fixing to fall. And that hasn’t happened . . . yet.
But during a presentation by one of its investment team members at this week’s Inside ETFs conference, the firm made its case that investors are too optimistic—and thus, unrealistic—about U.S. equities.
James Montier, a member of GMO’s asset allocation team, presented his company’s doom-and-gloom message in a most disarming way, what with his British accent and engaging sense of humor. But make no mistake that his intent was pure GMO; namely, that the facts don’t support current valuations for U.S. equities and that investors should look elsewhere for opportunities.
First, he noted that GMO has not been a fan of U.S. equity markets for a while, which he admits has been an “extremely painful thing to go through” for his firm. Since 2007, he said, U.S. equities have registered annual real returns after inflation of 6.8% versus 1.85% for the rest of the world.
But Montier said this outperformance isn’t the result of a gangbuster U.S. economy. He pointed out the current U.S. economic recovery since the Great Recession is both the longest—and weakest—in the post-World War 2 era. And productivity has grown slower than GDP growth. In addition, he said, real wages have barely grown at all during this expansion.
“That’s a pretty terrifying thing to say,” he added. “And the gains have been captured by a very small minority of people. The top 10% have been gathering almost all of the gains of the economic expansion . . . What we have is huge inequality, which is a huge problem in any economic cycle. This doesn’t feel like a good foundation for the type of optimism that has generated enormous U.S. equity outperformance.”
Montier noted that overoptimism is one of the common behavioral traits in the late stages of a market cycle as investors overestimate expected returns and underestimate risks. “I think that’s what we’re currently going through,” he said. “That’s a pretty dangerous combination of traits.”
To GMO’s thinking, the two main sources for the outperformance of U.S. stocks versus the rest of the world have been buybacks and valuation. The former is a massive debt-for-equity swap that’s jacking up both stock prices and corporate leverage, Montier said, while the latter has resulted more from multiple expansion than from earnings growth.
“How likely are those two sources of return going forward?” he asked.
Regarding valuations, Montier said the Shiller P/E ratio, formally known as the cyclically adjusted price-to-earnings (CAPE) ratio, is currently more than 30 times, which is roughly double its historic median. Meanwhile, the Shiller P/E ratio for the developed world, ex-U.S. is around 15 and for emerging markets it’s roughly 13.