Saturday, January 30, 2010

Fundamental Valuations and Forecasts

GMO's 7-Year Forecast by Asset Class

Jeremy Grantham of GMO has long been one of my favorite asset managers and financial commentators because of his value-based approach, his long-term investment horizon, and his warnings about fads, national debt, and growing asset bubbles.  The GMO January Letter is interesting for its 7-year forecast of annualized returns by asset class.

Seven Lean Years

The forecast begins with the prospect that a continuing Fed policy of low interest rates will promote another speculative asset bubble, again endangering the economy and the financial system.  This bubble may boost stock prices in the near term but the bubble will eventually burst.

Grantham believes that the economy faces what he calls "Seven Lean Years", because "after the initial kick of the stimulus, we will move into a multi-year headwind as we sort out our extreme imbalances. This is likely to give us below-average GDP growth over seven years and more than our share of below-average profit margins and P/E ratios ..."

The US stock market is already overpriced, but it may continue advancing and become even more overpriced, Grantham believes.  He estimates that the Standard and Poors 500 index is worth only about 850 but becuse of Fed policy may go to around 1200 before declining.

Expected Returns by Asset Class 

He considers the "high quality" component of the US stock market to be "relatively cheap", however.  I don't know GMO's criteria for high quality, but investment strategists commonly use criteria such as a good balance sheet, cash flow, decent current valuation, and good business prospects, as is the case as with a subset of US consumer staples companies.  Except for managed timber, other assets are overpriced relative to history -- international equities a little so, fixed income very much, and cash extremely so.  I've included GMO's chart of forecast annualized 7-year real returns by asset class.

Note that the chart includes no other commodities than managed timber, nor any other real estate.  GMO's long run inflation assumption is 2.5% per year.  International equities are ex-Japan.  Note also that there is a wide band of uncertainty around the central estimates.

In case the chart above is not legible, here are the 7-Year Asset Class Return Forecasts: US equities: large cap 1.3%, small cap 0.5%, high quality 6.8%. International equities: large cap 4.7%, small cap 4.6%, emerging 3.9%. Bonds: US government 1.1%, international government 1.3%, emerging 2.1%, inflation indexed 0.8%, US Treasuries (30 days to 2 years) -0.6%. Managed timber 6.0%.

Risks in This Environment

The most salient feature of this chart for investment strategies is that expected returns are much lower overall than historical averages.  In this environment, GMO feels that professional managers, being more concerned with comparison to their peers than with absolute returns, will be "seduced into buying equities because cash is so painful."  The problem with that approach is that "Equity markets almost always peak when rates are low,so moving in desperation away from low rates into substantially overpriced equities always ends badly."

GMO Investment Strategy

GMO's solution to this dilemma, Grantham says, is to only slightly underweight international equities, but "tilted to quality", because the EAFE index is priced not far below historical norms.  The rest of their portfolio is in fixed income, despite the meager expected return, although they do not specify the composition within fixed income.  The equity allocation will be slowly reduced, however, if the equity markets continue to advance.

PIMCO's Ring of Fire

In contrast to GMO's expectations for asset classes, Bill Gross's recent PIMCO commentary discusses investment prospects across countries. As explained in "The Ring of Fire", Gross's approach seems to be based in part on fundamental valuation methods, as GMO's is, although he uses a different set of metrics more suited to fixed income.

Gross finds similarities between PIMCO's New Normal and a book that I have written of in earlier commentaries -- a study of eight centuries of financial crisis titled This Time Is Different by Carmen Reinhart and Kenneth Rogoff.  PIMCO's thesis is that financial crises are followed by a process of deleveraging (shifting debt from the private to the public sector) which reduces economic growth and lowers returns on investment for a protracted period.  PIMCO categorizes countries as red, yellow, or green based on public sector debt and the public sector budget deficit, both as percentages of GDP.

In PIMCO’s chart “The Ring of Fire”, the most vulnerable countries are shown in red.  "These red zone countries are ones with the potential for public debt to exceed 90% of GDP within a few years’ time, which would slow GDP by 1% or more. The yellow and green areas are considered to be the most conservative and potentially most solvent, with the potential for higher growth."

PIMCO Investment Strategy

The conclusion that Gross draws is the difference "between emerging and developed economic growth, forecasting a much better future for the former as opposed to the latter."  His investment strategy divides assets into growth, emerging markets fixed income, and developed markets fixed income:
  1. Growth assets (as well as currencies) should be allocated to developing countries that are less levered and less prone to asset bubbles. "Look, in other words, for a savings-oriented economy which should gradually evolve into a consumer-focused economy. China, India, Brazil and more miniature-sized examples of each would be excellent examples."
  2. Fixed income assets should be allocated to emerging countries when the opportunity occurs. However, reduced liquidity and less developed financial markets (e.g., property rights) make the emerging economies less appealing for fixed income, which means that "most bond money must still look to the “old” as opposed to the new world for returns."
  3. Most fixed income assets should be allocated to a carefully selected subset of the developed nations, but the large, traditional bond markets should be avoided -- Japan because of demographics and the need for external financing, the US because of deficits and entitlements, Europe because of  the debts of nations on the southern tier, and the UK because of its high debt.  His top preference is Canada because of its fiscal balance and conservative banks, which did not participate in the housing crisis.  His second choice is Germany "the safest, most liquid sovereign alternative, although its leadership and the EU’s potential stance toward bailouts of Greece and Ireland must be watched".
This is a much different strategy than GMO's, which does not give so much weight to emerging market equity and allocates to fixed income only grudgingly, but it is useful to see the investment world sliced and diced in different directions.

Woodcuts by Gustave Baumann (1881-1971), known for his work in Santa Fe, New Mexico and his depictions of the southwest