Tuesday, November 19, 2013

Grantham Mayo Quarterly Letter: "Breaking News! U.S. Equity Market Overvalued!" (and Jeremy Grantham slams EMH)

As I say every three months, apologies to Mr. Van Otterloo, no offence intended it's just that headline space is tight on the Blogger platform.
From GMO's Co-head of Asset Allocation, Ben Inker
Our recent client conference saw the unveiling of our new forecast methodology for the U.S. stock market, a methodology that we are extending to all of the other equity asset classes that we forecast. It is the result of a three-year research collaboration by our asset allocation and global equity teams, and involved work by a large number of people, although Martin Tarlie of our global equity team did a disproportionate amount of the heavy lifting. In a number of ways it is a “clean sheet of paper” look at forecasting equities, and we have broadened our valuation approach from looking at valuations through the lens of sales to incorporating several other methods. It results in about a 0.7%/year increase in our forecast for the S&P 500 relative to the old model. On the old model, fair value for the S&P 500 was about 1020 and the expected return for thenext seven years was -2.0% after inflation.  
On the new model, fair value for the S&P 500 is about 1100 and the expected return is -1.3% per year for the next seven years after inflation. For those interested in the broader U.S. stock market, our forecast for the Wilshire 5000 is a bit worse, at -2.0%, due to the fact that small cap valuations are even more elevated than those for large caps. 
So much for 36 months of work. One could say that we didn’t know that we would wind up with the same basic forecast we started with, and that is true, but on the other hand we didn’t have any particularly large concerns that our forecast was giving us the wrong answer in the first place. This makes the S&P 500 forecast significantly different from the emerging equity forecast, where, as we have been telling our clients for a while, we believed that our forecasting methodology overstated the attractiveness of the group. Our revised emerging forecast is noticeably lower than that generated by the old model, and clients are welcome to contact their relationship manager for more information about this change if they would like. 
What was the point of doing all of this work on the S&P 500 forecast if we were pretty confident that the old model was doing its job well? There were several reasons. First, we are always trying to improve our forecast methods, and this was merely a larger project than a number of others we’ve tackled over the past20 years in this area. Second, we want our process to adhere as closely as possible to our basic beliefs hat stocks should sell at replacement cost and that the return on capital and cost of capital need to be in equilibrium in the long run. And third, we want a process that makes it as straightforward as possible to slice the equity markets in a different way and still be confident in the resulting forecast. On both the second and third points, we believe the new methodology is superior to the old.The primary issue with turning our beliefs into forecasts is that the key input to valuing the market is an unobservable item: economic capital. Economic capital – aka replacement cost – is central because it is the “thing” that generates earnings. Book value of common equity is the accounting figure that is supposed to approximate this term, but it is subject to multiple distortions that make it a clearly inadequate proxy for true equity capital. One way of seeing this is to simply look at ROE – that is, return on book value of equity – over time. In the U.S., the average ROE for the S&P 500 has been 13% since 1970, as we can see in Exhibit 1....MORE
And, again as usual, Mr. Grantham has something to say:

Ignoble Prizes and Appointments
Jeremy Grantham
Part 1. The Nobel Prize
Economics is a very soft science but it has delusions of hardness or what has been called physics
One of my few economic heroes, Kenneth Boulding, said that while mathematics had indeed
introduced rigor into economics, it unfortunately also brought mortis. Later in his career he felt
that economics had lost sight of its job to be useful to society, having lost its way in a maze of
econometric formulas, which placed elegance over accuracy.

At the top of the list of economic theories based on clearly false assumptions is that of
Rational Expectations,in which humans are assumed to be machines programmed with
rational responses.

Although we all know – even economists – that this assumption does not fit the real
world, itdoes allow for relatively simple conclusions, whereas the assumption of complicated,
inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in
five, six, or seven decades of economic mainstream work being largely thrown away.
It did leave us, though, with perhaps the most laughable of all assumption-based theories,
the Efficient Market Hypothesis (EMH)....MORE