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GMO’s Inker: Ditch U.S. Stocks Now

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In the latest quarterly update from Grantham, Mayo, Van Otterloo & Co., the co-head of its asset-allocation team says the firm’s love affair with U.S. equities is waning.

There is “a method to our madness,” said Ben Inker in GMO’s newsletter, released Thursday. While U.S. equities and the underlining economic strength of the country do indeed look good, the markets “don’t work quite the way people assume they do,” he explained.

As many market experts and economists like to remind investors, “things that ‘everybody knows’ are generally priced into markets,” he adds, and often “what ‘everybody knows’ turns out to be pretty wrong.”

Since investors and portfolio managers alike can’t accurately forecast surprises, the best strategy is to buy “the cheap countries,” Inker says. “And the U.S. is about as far from cheap as any country in the world right now.”

In terms of the cyclically adjusted price-to-earnings ratio, the U.S. stock market stands at 26 vs. just under 16 for the United Kingdom and Europe and a bit under 14 for emerging markets.

“It will take a lot of good economic news to justify that kind of valuation premium in the medium term,” cautioned Inker.

The portfolio expert admits there is strong support in the U.S. for equities: Profits have compounded at 11% for the past four years, real GDP has grown at 2.2% and accelerated to an annualized 4.8% over the past six months, “and neither inflation nor deflation seems a credible threat.”

In contrast, the E.U. has seen profits drop at compounded rate of 6% over the last four years in U.S. dollars, and real GDP has grown at just 0.3% on an annualized basis, “‘accelerating’ to 0.4% over the past six months,” notes Inker.

Looking ahead, issues in the Eurozone and Japan cannot be minimalized, he adds.

“Given the backdrop, it is no wonder that the U.S. stock market has been the envy of the world …,” Inker said. “And yet, as the New Year begins, we in Asset Allocation find ourselves slowly selling down even our beloved U.S. quality stocks in favor of the various problem children of the investing world.”

He compares this strategy to a famous movie title, with a twist: “We are riding away from the Good and into the arms of the Bad and the Ugly,” Inker explained. Still, history says that if an investor is going to act in a knee-jerk way, he or she should “at least be a knee-jerk contrarian.”

The thinking behind this is that “the 20% of developed stock markets that outperformed most over a three-year period underperformed on average by 1.3% in the following year and by 2.4% annualized over the next three years,” he explained.

In contrast, “The worst 20% of prior performers outperform by 1.6% and 0.8% annualized,” stated Inker. Plus, there’s a similar, though weaker, pattern for GDP growth.

Investing in the best performers over the past few years is clearly a pretty bad idea, as is investing in the fastest GDP growers, he stresses. Between 1980 and 2010, the countries with the fastest GDP growth slightly underperformed those with the slowest growth.

“The biggest reason for this non-intuitive result is that the relationship between GDP growth and earnings per share (EPS) growth that most people assume must be there does not exist in the long run,” Inker explained.

A big reason for this conundrum is dilution, he says.

Plus, the GDP growth that really matters “is almost certainly not the growth that ‘everybody knows’ is going to happen, but the growth that is going to come as a surprise. And predicting surprises is a notoriously tricky problem,” Inker explained.

“Value, on the other hand, only takes information that is freely available to all market participants,” stressed the expert.

In fact, investors who can find cheap countries poised for a big positive GDP surprise over the next three years will outperform “by a whopping 14.1% per year for the next three years,” he says. Furthermore, expensive countries with the worst GDP surprise lose by an annualized rate of 6.1% annualized.

“GDP surprise certainly matters, but our strongest takeaway at GMO is that even the cheap countries with the worst GDP surprise still outperform, and even the expensive countries with the best GDP surprise still lose,” Inker concluded.

That’s why the GMO asset allocation specialist says “investing in the various bad and ugly places in the world is going to wind up far more rewarding than the admittedly good-looking U.S.”

Grantham: Saudis Short-Sighted on Oil

When it comes to oil prices, GMO Chief Investment Strategist Jeremy Grantham says U.S. fracking has overtaken the modest growth in global oil demand.

The Saudis decided not to pull back on production, “and the oil market entered into glut mode, in which storage is full and production continues above demand,” Grantham notes in the latest GMO newsletter.

“The Saudis are obviously expecting that these low prices will turn off U.S. fracking, and I’m sure they are right,” he explained. “Almost no new drilling programs will be initiated at current prices except by the financially desperate and the irrationally impatient, and in three years over 80% of all production from current wells will be gone!”

This situation, he says, is likely to push oil to a new equilibrium level of $30-$50 per barrel.

“For the following few years, U.S. fracking costs will determine the global oil balance. At each level, as prices rise more, fracking production will gear up,” he added.

Longer term, in about five to eight years, it’s possible that U.S. fracking production could begin “to peak out and the full cost of an incremental barrel of traditional oil will become, once again, the main input into price,” the investment guru says.

“This is believed to be about $80 today and rising. In five to eight years it is likely to be $100 to $150 in my opinion,” he stressed.

Grantham says the Saudis have erred in their decision-making.

First, the big price decline has generated a real increase in global risk. An oil-producing country under extreme financial pressure – like Russia or Venezuela – could act rashly, Grantham says. Also, oil company bankruptcy could destabilize the financial world.

Longer term, the environmentally minded expert believes, electric cars and alternative energy may “eat into potential oil demand, threatening longer-term oil prices.”

The latest quick drop in oil prices is unusual. Except for the crash of 2008, oil hadn’t dropped at such a fast pace since 1900.

Grantham says the reason is straightforward: It was “relentlessly increasing U.S. oil supply that broke the market,” he states.

And, of course local and global politics has a significantly greater role in commodities, especially oil, than for stocks, the expert notes.

“Major shocks like this to the status quo are just plain dangerous, and Saudi Arabia, which loves stability much more than most, may come to regret not having sucked up the pain of selling less for a few years,” Grantham said.

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