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The forecast from investment firm Grantham Mayo
Van Otterloo for projected asset-class returns is
widely anticipated within the investment industry,
even though it’s rarely sunny. At the Morningstar
Institutional Conference in early March, I sat down
with Ben Inker, co-head of the firm’s asset-allo-
cation team, to delve into the firm’s latest forecast.
Christine Benz:
Let’s start with
U.S.
equity today.
Generally speaking, it’s not a particularly optimistic
picture for
U.S.
equity.
Ben Inker:
We don’t much like
U.S.
stocks today, and
that’s because their valuations are trading at the
very high end of what we’ve seen historically.
U.S.
large-cap stocks don’t look as expensive as they
did in
2000
, but we’re trading at valuations today that
are higher than we saw at the market peak in
1929
or
1965
. We are trading at what we think of as upper-
20
s in terms of normalized earnings, which is really
quite expensive. If valuations are going to come back
to long-term averages
—
which is, let’s say,
16
or
17
times normalized earnings
—
that means, over the
next seven years, you’re unlikely to make money rela-
tive to inflation in
U.S.
stocks. So, we really don’t
much like them. They have been worse, but they’ve
spent most of their history much better.
Benz:
Are small caps particularly unattractive to
you today?
Inker:
Yeah, it’s one of the interesting things. Most of
the times in history when the S
&
P
500
has been at its
most expensive, it’s been a large-cap phenomenon.
2000
was an extreme example of that. It was only a
handful of stocks that were driving the very high valu-
ations in the S
&
P
500
, and so if you just looked at
the average stock in the
U.S.
, it was much less bad.
Today, we actually see something of the reverse.
U.S.
stocks look expensive to us, more or less across the
board. But if forced to own
U.S.
stocks, we’d rather
own the big ones. Smaller-cap stocks are trading
at higher valuations than we’ve really ever seen.
Again, they’re not as silly as the Internet stocks were
in
2000
, but we’ve seen a period of time where the
U.S.
economy has been outgrowing the rest of the
world by a significant margin.
U.S.
small caps tend to
be much more domestically focused. They tend to
be more leveraged than large-cap names, and they’ve
been big beneficiaries of very low interest rates. A
lot of things have gone their way. We don’t think that
things will continually go their way. And they’re
priced as if small caps are growth stocks, and the
reality is that the vast majority of small caps are
not growth.
Benz:
Again,
U.S.
stocks are not attractive overall
to you. But when you take a few different cuts of the
U.S.
market, a couple of pieces look slightly better.
Quality looks better to you. Let’s talk about how you
define quality.
Inker:
For us, quality stocks are companies that have
shown an ability to earn a high return on capital
across the economic cycle, where that return on
capital has been stable, and where the company has
been able to do that with low debt. Those are the
three key factors for us for quality. Now, those compa-
nies have some nice characteristics. They are much
less likely to go bust than the average company
because they are profitable and they don’t have debt.
They don’t outperform in the long run; there is no
particular reason why they should. They are probably
less risky; but today, in one of the few times in
history, they’re not trading at a premium. These guys
are actually trading at slightly lower P/Es than the
average stock, which is interesting because we think
they deserve a premium.
And particularly today, we think they would deserve
a premium because when we look at
U.S.
stocks
today, the most striking thing is that
U.S.
corporations
have almost never been more profitable. Profits, as
a percent of
GDP
, are near all-time highs. Returns on
invested capital look very good. We think they are
GMO Forecast Calls for Pain
Portfolio Matters
|
Christine Benz