The US stock market is "hideously expensive," according to James Montier, an influential strategist with GMO, a global investment management firm based in Boston. He says investors should consider going to cash rather than running the risk of suffering precipitous equity declines.
Both Montier and GMO, which manages $120 billion (€96 billion) in assets and is headed by renowned investor Jeremy Grantham, have been sounding the warning bell on US valuations for some time, arguing value investors should stick to high-quality blue-chip stocks such as Microsoft and Johnson & Johnson. However, the continued advance of equities means GMO now sees almost no value in the US market and precious little elsewhere.
GMO has cut its equity allocation to 36 per cent of its portfolio, Montier told Swiss business magazine Finanz und Wirtschaft recently and is selling out of its large-cap holdings – "the Microsofts, J&Js, Pfizers and Procter & Gambles of this world".
Such stocks remain low risk, he said, they’re just not cheap. Globally, the situation is similar, Montier saying it is “getting harder and harder” to find cheap stocks. The value that was evident in the European periphery two years ago has faded. Montier describes the region as “okay, but not outright cheap”.
Low returns
GMO’s seven-year asset forecasts have been famously accurate over the past 15 years and are widely followed by institutional investors. Its latest forecast is very pessimistic: in real terms, US large- and small-cap stocks will be substantially lower in seven years’ time, with high-quality names eking out minor gains. International stocks will do better, with the best gains – real annual returns of 3.8 per cent – likely to come from emerging markets.
Even here, however, Montier is not enthusiastic. “Emerging markets are really bifurcated into stocks you don’t want to own at all, because they are really expensive, and stocks that are outright cheap, but they are also pretty damn scary,” he says.
Chinese banks, for example, are cheap, but not cheap enough to compensate for their outsized risk. Russian stocks are more tempting, although investors run the risk of expropriation. “Investing in Russia has option-like characteristics,” he says. “It’s either worth nothing or a lot more than what it is trading on now.”
Bonds are no better. Grantham described them as “absolutely, nerve-rackingly overpriced” earlier this year.
Lack of opportunities
The absence of value in global assets means the current environment appears worse than in 2000 and 2007. US and European stocks were much more overvalued in 2000, but you could sit on cash and get paid almost 3 per cent in real terms, says Montier, or opt for emerging market equities, old economy small-cap stocks, or other reasonably priced assets.
In 2007 bank deposits offered real returns to the patient value investor. In today’s world of zero interest rates, however, there is “nowhere to hide”, says Montier.
Other investors share this frustration. “In a world where more and more assets are being pushed up to uncomfortably high valuation multiples, finding assets cheap enough to buy is a serious challenge for investors,” Société Générale said earlier this year. The number of European stocks meeting its deep value criteria has collapsed in the past two years, it said, while scarcely any bargains at all exist in the US market.
Last year, the absence of opportunities led Seth Klarman, one of the most successful investors in history, to return $4 billion in funds to clients. Some 40 per cent of his portfolio is estimated to be in cash.
Another iconic investor, Warren Buffett's partner Charlie Munger, recently said it was two years since he had bought a stock for his personal account.
Blackrock's Russ Koesterich, too, has cautioned investors not to overpay for defensive sectors. Classic defensive sectors such as utilities and consumer staples, he says, seem "overpriced and risky", and no longer trade at their usual large discount to the market. The same could be said of dividend stocks, which have long traded at a discount to the broader stock market. In recent years, however, investors have grabbed yield wherever they can find it, causing dividend stocks to trade at a premium to the S&P 500.
No alternative?
Many investors agree that there is little value to be found in stock markets, but make the Tina argument: there is no alternative. Rock-bottom deposit rates mean savings are being eroded by inflation. Ten-year bond yields in Japan, Germany, France, Italy and three other European countries are below 1 per cent. Even high-risk junk bonds offer rates well below historical norms.
The alternatives to stocks, Montier admits, are “appalling”, creating a thirst for yield that has driven up global asset prices.
Additionally, while many institutional investors agree stock prices look rich, they can see that a “buy every dip” mentality has taken hold, with pullbacks almost invariably proving short and shallow. October’s market decline looked like it might prove to be a more serious affair, with the S&P 500 falling 9.8 per cent only to hit fresh all-time highs within weeks.
Abandoning caution
The perceived responsiveness of central banks to market declines has caused some bears, such as British hedge fund manager
Hugh Hendry
, to throw in the towel. In a
MoneyWeek
interview last month, Hendry related his journey from bear to bull, saying there was “less need” for “disaster insurance” in a world “where the central banks seem to have your back, seem to be underwriting risks and global asset prices”.
At a recent investment conference, added Hendry, he asked fellow hedge fund managers how they would respond to a 12 per cent market decline. “They’re all buying,” said Hendry. “The central banks have created a behavioural tic which is becoming self-reinforcing and I believe we saw another manifestation of that behaviour in October.”
The message, as the MoneyWeek interviewer quipped, appeared to be that in a market like this, never sell anything and you'll be fine.
This kind of mentality – where fear of losses is replaced with the fear of missing the upside – will likely lead to a bubble, cautions Montier. “The narrative is simple: we are all protected, underwritten by central banks. That’s a very tempting thought in the short term, but incredibly dangerous. The central banks will protect us up until they don’t anymore. And you don’t know when that will be.”
Advice
So what should an investor do? The first thing, perhaps, is to lower one’s expectations and, if possible, increase one’s savings rate to compensate for lower future returns. Over the last century, US stocks have delivered real annual returns of over 6 per cent. According to GMO’s latest seven-year forecast, no major asset class will match that return over the coming years.
The best returns will come from an unlikely source, says GMO, timber, which it predicts will generate real annual returns of 5.4 per cent. Emerging equities and high-quality US stocks are recommended, although returns are predicted to fall well shy of historical norms. There are also “some stocks in the cyclical and industrial field that still can be considered value in Europe”, says Montier.
Montier’s main piece of advice, however, is to be patient. “Hold a lot of dry powder now,” he says. “Fifty per cent of our portfolio today is in cash or some form of short-term bond holdings. If we do get a dislocation in equity markets, we will have the ability and deploy that dry powder. That’s the time to buy.”
