The latest quarterly asset class return forecast from Jeremy Grantham’s Boston-based fund management group GMO makes for interesting reading. For the first time in a long time, the seven year forecast envisages that equities will produce annualised real returns that are above their long term average. In the case of high quality stocks (those with strong balance sheets, positive cash flow and so on), GMO is projecting real returns of 11.4% per annum. For US stocks in general the figure is 7.4% and for emerging market equities 10.7%.
Since GMO is a value investor, it is no surprise to see that it sees little or no value in Government bonds at today’s very low yields. In fact it expects US Treasuries to produce negative returns over the next seven years. It is more positive on emerging market bonds, which it sees making a 4.5% real return over its seven-year forecast horizon.
Although he has been widely dismissed as a perma-bear, that is, someone who is always negative on the outlook for stocks, to my knowledge Jeremy Grantham is a more complex prognosticator than that description would suggest. His warnings that stocks were overvalued during the Greenspan bubble years, and that investors were becoming myopic about risk, have proved to be amply borne out. But in his last quarterly letter (strongly recommended for those who do not know it) he takes a very different stance. The greater risk facing most investors, in his view, is that they will miss out on the market recovery when it comes.
At the same time however, historical analysis tells him that most bull markets over-correct on the downside before they are done. So while stocks are now back to somewhat better than fair value, in the short term they could get worse before they get better. Grantham says his worry is that he will get back in too early, as he has done many times before. This seems to me a good summary of where we stand today. Equities have certainly started to look good long term value, and comfort lies in the fact that, while it is possible they could fall another 20%-30% from here, those losses will be recoverable quickly whereas the 30%-50% losses experienced from extreme 2007 levels might not be recouped for many many years. Investors will need to be selective however.
There is the customary common sense in these comments from Neil Woodford, Invesco Perpetual’s star fund manager, yesterday.
On the outlook for the UK
“I think the outlook for the UK and indeed the entire world economy deteriorated in the final months of 2008. There is significant further downside in the three interconnected factors of consumer spending, the housing market and economic growth. Taking house prices first, we have already seen a drop in average UK house prices of 20% from the peak level in August 2007. But house prices are still high in relation to average earnings, especially for first time buyers. In the early 1990s, the house/price earnings ratio fell very markedly, from almost five to just over three. Even if the fall is not as marked in the current phase of adjustment, it is quite possible that we will see another15%-20% drop in house prices nationally”.
“The rise in house prices in the early part of this decade was fuelled by, and also facilitated, an increase in consumer borrowing. It too has risen to very high levels relative to earnings. Household balance sheets now need to be rebuilt, notably by reducing debt levels. But this is, by its very nature, likely to be a slow process. Lower house prices have already meant that home equity withdrawal (the process whereby households borrow against the equity in their homes), a previously strong support for consumer spending, has evaporated. As consumer spending is such a large component of UK GDP (60% in 2008) weaker consumer spending will inevitably impact GDP growth. The latest Treasury forecast of a 1% fall in UK GDP in 2009 looks far too optimistic. Furthermore, the recovery from that is unlikely to be a sharp, ‘V’ shaped one. With consumers and banks deleveraging and with the prospect of a very large government fiscal deficit, the recovery after 2009 is likely to be pretty anaemic”.
On the prospects for equities
“With the sharp falls in the UK and global stockmarket in late 2008, the UK market seems to be discounting an outlook which is at least as bad as that which I foresee. Overall UK equity market indices are now lower than ten years ago and I think there are good grounds for thinking the overall market has bottomed. But, as always, it is important to look at individual stocks and sectors and at that level there is some very good value indeed. The best value lies in companies that will be able to get through this difficult period for the economy with rising earnings, cashflow and dividends, and where this prospect is not appropriately valued by the market. I would highlight sectors such as pharmaceuticals, utilities and tobacco”.
I have nothing to add, as Charlies Munger likes to say.
Jonathan Davis 