The S&P 500: Just Say No

GMO White Paper – The S&P 500: Just Say No, August 2017

Valuation of the S&P 500

  • In the long term, the return is almost exclusively driven by dividends
  • Two other ways to make money from owning an equity asset class are from multiple or margin expansion – we can always decompose returns into these factors
  • Decomposition for the S&P 500 since 1970 based on these factors: margins and P/Es are basically flat over this long time period – over the long term, returns achieved have been delivered largely by dividends
  • Over the last 7 years, earnings and dividends have grown as one would expect, but P/E and margin expansion have significantly contributed to returns with multiple expansion actually providing the biggest boost
  • If earnings and dividends are remarkably stable, to believe that the S&P will continue delivering the wonderful returns we have experienced over the last 7 years is to believe that P/Es and margins will continue to expand just as they have over the last 7 years
  • It is remarkably easy to assume that the recent past should continue indefinitely but it is an extremely dangerous assumption when it comes to asset markets (particularly excessive ones)

GMO’s S&P 500 Forecast

  • Our forecasts are similar in spirit to a cyclically-adjusted P/E but we try to account for the cyclicality of earnings a bit differently
    • We look at trailing P/Es and make an adjustment to margins where we look at multiple proxies for returns on economic capital
    • Assume that at the end of seven years, P/Es and margins will revert to equilibrium levels
    • We then factor in earnings growth and income that we receive as equity owners
  • From our perspective, one has to make some fairly heroic assumptions to believe that the S&P is even remotely close to fair value. Holding all else constant, an equilibrium P/E of 31 would make the S&P look fairly valued today
    • To believe that a “normal” market valuation is 28x earnings brings us back to the logic provided in the dot com bubble
    • We are just off the highs of the highest profit margins we have seen in the post WWII era
    • Equilibrium levels for profit margins would have to be almost doubled to make today’s elevated levels look fairly valued

Other Lenses

  • A simple but useful perspective is a Shiller P/E – this represents a straightforward way of normalizing earnings from their current value to something that approximates trend by using a 10-year moving average of earnings
    • This is the 3rd most expensive market in history – the only times were 1929 and 1999
    • This measure has its detractors – from those who worry about distorted earnings from 2008 to those that argue that shifts in payouts have invalidated the measure
      • Correcting for the shift in payouts does little to alter the conclusion
    • For those who worry about the inclusion of a bad year for earnings like 2008 in the decade average, another measure paints a very similar picture
    • Hussman P/E – it is spiritually similar to the Shiller P/E but rather than normalizing to the 10-year average earnings, it normalizes to peak earnings
      • Using this methodology indicates that this isn’t the 3rd most expensive US stock market in history: it is the 2nd most expensive US stock market in history (only the period of the TMT bubble surpasses the expensiveness of the current market)
    • One could argue that we should forget all this top-down valuation nonsense and look at the situation through the lens of a stock picker
      • Valuation of the median/average firm: median price to sales data reveal something extraordinary – average US stock has never been more expensive than it is currently, even at the height of the insanity that was the TMT bubble of the late 1990s
      • Median P/E also shows the median stock is about as expensive as it was prior to the TMT bubble and the GFC
      • Either way, we are facing an exceptionally expensive stock market
    • Scale of the opportunity set by using a screen developed by Ben Graham – deep value screen based on four criteria: 1) stock’s earnings yield should be at least twice the AAA bond yield; 2) stock’s dividend yield should be at least 2/3 of the AAA bond yield; 3) issue should have total debt of less than 2/3 of tangible book value; 4) stock should have a Graham and Dodd P/E of less than 16x
      • In late 2008, the screen was finding lots of cheap stocks – 20% of Japan and the Asian markets were passing the screen; 10% of stocks in the UK and Europe were “deep value” cheap; and even in the US, 5% of stocks were being thrown up as deep value
      • Today, in Japan and Asia only around 5% of stocks are showing up as extremely cheap; in Europe and the UK the number drops to 1% to 2%; in the US, not a single stock passes the screen

Going Passive is an Active Decision

  • Decision to be passive is still an active decision – and we would suggest one with important risks that investors are not paying adequate attention to today
  • As more and more investors turn to passively-managed mandates, the opportunity set for active management increases
  • Decision to allocate to passive S&P 500 index is to say that you are ignoring most important determinant of long-term returns: valuation
  • Going passive eliminates the ability of an active investor to underweight the most egregiously overpriced securities in the index
  • When faced with the 3rd most expensive US 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
    • Yet, 30% of all assets in the US equity market in the hands of passive indexers
  • Using our framework, you need to believe that growth in earnings and dividends are going to be significantly higher than what they have been historically
    • Earnings and dividends from earnings have their roots in the growth of the economy, and it certainly does not appear as though the US economy is going to be rocketing back to the type of growth that we saw in the 60s and mid-90s
  • If you believe that P/Es and margins are going to stay high, allowing for earnings and dividends to do their normal thing, thus generating a decent return, you again are making some extraordinary assumptions that are certainly not based in anything related to the historic record of P/Es and margins
  • If you believe that P/Es and margins are going to expand from today’s levels, it becomes difficult to argue with you, as at this point you are defying all reason and logic

The (Relative) Good News

  • Everything is expensive and you are reduced to trying to pick the least potent poison
  • This is fine if you have to invest relative to a benchmark or strategic objective- there are still some relative opportunities around
  • Let’s return again to valuation to make the case for non-US equities: as we look at our forecasts for international equities, we get a forecast of -0.6% real in local currency terms
    • International equities suffers from a similar fate as US equities – elevate P/Es and margins but just much less so than their US counterparts
  • If we go back to the early 1980s and look at the spread of international equities versus the US, the approximately 4% gap between these two major assets classes in the 89th percentile of observations means that 89% of the time the spread between these two assets is less than 4%
  • While US equity bulls can profit to stronger economic fundamentals in the US than in Europe and Japan, the issue for investors is not the relative health of the respective economies because we know that economic growth has little to do with subsequent equity returns
  • As we look at the US equity market, relative expectations seem quite high and an awful lot appears to be in the price – however, international equities, while not cheap in absolute terms, certainly suffer from poor expectations and much better pricing
    • Their currencies also seem a bit cheaper relative to the dollar
  • Story is similar within emerging market equities but the news is actually better – emerging equities have a forecast of 2.9% real and cheap currencies to boot
  • Though emerging equities are expensive in absolute terms, they provide very strong return relative to US equities – the spread between emerging and the US is in the 90th percentile of observations going back to the late 1980s
  • We all know the trouble emerging equities have had over the last several years – but again, the key question is “What’s in the price?”
    • To us, emerging market equities look poised to significantly outperform developed market equities. And if you look at the emerging value universe, the forecast looks even better, rising to 6.2% real
  • For a relative investor, we believe the choice is clear: own as much international and emerging market equity as you can, and as little US equity as you can
  • In absolute terms, the opportunity set is extremely challenging. However, when assets are priced for perfection as they currently are, it takes very little disappointment to lead to significant shifts in the pricing of assets – hence our advice is to hold significant amounts of dry powder
  • Markets appear to be governed by complacency at the current juncture – looking at the options market, it is possible to imply the expected probability of a significant decline in asset prices
    • According to Minneapolis Federal Reserve, probability of a 25% or greater decline in US equity prices occurring over the next 12 months implied in the options market is only around 10%
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