Just Say No to the S&P 500, GMO Warns Investors

Despite the fact that being a U.S. equity investor over the past several years has felt glorious, investors should not concentrate their portfolios into indexed U.S. equites, shun diversification and sell international equities.

Such is the focus of a new Grantham Mayo Van Otterloo white paper titled “The S&P 500: Just Say No,” which was written by two members of GMO’s asset allocation team, Matt Kadnar and James Montier.

The paper points out how the S&P 500 has trounced the competition provided by other major developed and emerging equity markets.

“It is easy to see, given the strong performance of U.S. equities in both absolute and relative terms, why many are suggesting they are the only asset you need to own,” the pair write.

Over the last seven years, the S&P is up 173% (15% annualized in nominal terms) versus MSCI’s index for Europe, Australia and the Far East (in USD terms), which is up 71% (8% annualized), and MSCI Emerging, which is up only 30% (4% annualized). Every dollar invested in the S&P has compounded into $2.72 versus MSCI EAFE’s $1.70 and MSCI Emerging’s $1.30, according to the paper.

“So, shouldn’t we … throw in the towel, index all of our equity exposure to the S&P 500, and call it a day? If our goal is compounding capital for the long term, which it is, we would not just say ‘No,’ but something akin to ‘Hell no!’” Montier and Kadnar write.

The pair then take a look at the current valuation of the S&P 500 and at the four components that drive returns – dividends, earnings, price-to-earnings multiple expansion and margin expansion.

The pair find that 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 of the four.