Many economists, including President Donald Trump’s own economic advisor, say 2019 will be a good year for the economy. GMO’s James Montier disagrees — strongly.
The U.S. markets and economy are in trouble, at least according to Montier, strategist and member of Grantham Mayo Van Otterloo‘s asset allocation team, in his recent white paper. He sees the U.S. market “increasingly as the hapless Wile E. Coyote … running in thin air only to eventually look down, realize his error, and plunge earthbound.”
Will this also be U.S. investors and advisors in 2019?
Excess optimism and overconfidence are two key problems, Montier says in the paper, “The Late Cycle Lament: The Dual Economy, Minsky Moments, and Other Concerns.”
“They are particularly dangerous in the late stages of an economic cycle where these terrible twins result in investors overestimating return and underestimating risk — a potentially lethal combination of errors,” he states. He notes that his research shows the U.S. economy is in its slowest and weakest recovery in postwar history.
He cites several reasons, including poor GDP growth, labor productivity and real wage growth. A “dual economy” is rising, in which productivity growth is “reasonable” in some sectors and nonexistent in others. Even those sectors with decent growth show lagging real wages. In fact, the only employment growth seen is from low-productivity sectors. Further, “the paltry gains in income that are being made are all going to the top 10%. This is not what a booming economy should feel like,” he says.
Montier points out that those who believe U.S. equities will generate “normal” returns “have to believe some quite extraordinary things,” he says. GMO does not see these highly unlikely things coming to pass, thus the firm owns “essentially zero [U.S. stocks] in our unconstrained portfolios, but then again we are used to career risk and would rather run it than allocate to such an expensive and risky asset.”
Inside the Numbers
The excess optimism — especially from analysts — has caused long-term earnings expectations to rise to levels not seen since the late 1990s tech bubble, Montier notes. He instead reverse-engineered the numbers to arrive at “today’s fair market value.” Historical growth with inflation has been 6% per annum for the S&P 500, while the market today is closer to 9%.
He states, “The market believes inflation is going to be around 2% annually (based on the difference in yields between 10-year nominal bonds and 10-year inflation-protected bonds). Thus, the implied real growth rate is a jaw-dropping 7% [per annum] … more than three times the historical average,” he states. This means investors would need to generate 5.7% in real returns.
Price-to-earnings ratios historically has averaged 14.5x, he presses on. Today’s P/E on the S&P 500 is 24x. To achieve that 5.7% per year growth over the next seven years means P/E will have to rise to 32x. “This is a higher P/E than recorded at the height of the tech bubble, and represents a 3-standard-deviation event.”
And for return on capital to reach that 5.7% real return, it would have to rise to 11% from its current 8%. “The historical average ROC is 6%,” he notes. “Incidentally, the FAANG stocks have an ROC of roughly 11%. Holding this view is akin to believing that we will have a nation of FAANGs. Getting to 11% represents a 5-standard-deviation event.”
He also points out that yield and growth, which historically have delivered a combined 6% real per annum (4% yield and 2% real growth), would need to generate 16% to hit that 5.7% real return. “Starting with a yield of around 1.4%, this implies a 14.6% real growth. This would be a 6-standard-deviation occurrence.”
Montier shows that manufacturing was the largest driver of productivity growth, followed by information and real estate. However, other sectors have shown little or no growth, such as utilities, transportation, education and health care and construction.
“In fact, we appear to have witnessed the birth of what has been described as a dual economy. In essence, we have one group of sectors with reasonable productivity (both levels and growth) and a laggard group with no productivity at all.” Even in the high-productivity sectors, wages have grown “significantly slower than productivity,” while there has been zero real wage growth in the laggards sector.
Montier adds that whereas the low-productivity sectors made up 46% of private-sector employment in 1990, today they account for over 60%. “The employment growth we have seen has been largely concentrated in zero real wage growth areas,” he states.
Further, the economic growth gains largely went to the top 10%. He says the economy has become “characterized starkly by growing differences between the haves and have nots.”
- When digging into the market, “a staggering 25% to 30% of firms are actually making a loss!” Montier states. The bottom line, he says, is it doesn’t matter “which version of earnings you use, the conclusion you reach is still the same: One in four companies is making a loss.”
- The individual investor has returned as a net buyer of U.S. equities for the first time since the late 1990s.
- Leverage is increasingly ominous, he notes, as companies are issuing bonds and buying back their own equity. “Rising leverage creates a systemic fragility,” he states. He notes the market is ripe for a Minsky moment, in which stability begets instability. During quiet periods, firms are most tempted “to take on ‘risk’ because extrapolation says there is no risk, and hence a free lunch exists. By taking on this risk, people sow the seeds of their own destruction.” Using a ratio of debt to gross value measurement, he show levels last were seen in 2007.
Montier believes there will be a serious market drop, but “I have no idea what the catalyst will be. Indeed, think back to the tech bubble of the late 1990s (or any other previous bubble for that matter.) Can anyone tell me the catalyst for the market having a Wile E. Coyote realization? I can’t, even with the benefit of 18 years of 20/20 hindsight.”
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