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.