U.S. stocks have reached speculative levels, analysts at GMO warn.
“A decision to allocate to a passive S&P 500 index is to say that you are ignoring what we believe is the most important determinant of long-term returns: valuation. At this point, you are no longer entitled to refer to yourself as an investor. You may call yourself a speculator, but not an investor,” wrote Matt Kadnar and James Montier, members of GMO’s asset allocation team in a report this month.
The global investment firm predicts a negative 3.9 percent annualized real return on the S&P 500 over the next seven years.
In reaching that conclusion, GMO assumes profit margins and P/E ratios will revert to normal over the next seven years. It pegs the current P/E of the S&P 500 at 24.4, well above a normal 16.
“When faced with the third most expensive U.S. equity market of all time, maintaining a normal weight in a passive index seems to us to be a decision that will likely be very costly,” the analysts said. “Yet despite this, it remains a popular path, with around 30 percent of all assets in the U.S. equity market in the hands of passive indexers.”
To expect good returns from U.S. stocks to continue, investors must believe that growth in earnings and dividends are going to be “significantly higher than what they have been historically,” which is “an enormous stretch," they said.
Foreign and emerging stocks aren’t cheap either, but relative to their U.S. counterparts, are far better values.
“Own as much international and emerging market equity as you can, and as little U.S. equity as you can,” Kadnar and Montier said.
GMO, which has been bearish for a number of years and wrong on its forecasts, has suffered client outflows as a result.
Jeremy Grantham, one of the firm’s founders, recently questioned whether corporate profit margins might be permanently higher than in the past due to increased industry concentration. (In their report, Kadnar and Montier said the firm is researching whether increased industry concentration in the U.S. may affect profit margins.)