My view of the economy’s future is boringly unchanged: “Seven Lean Years.” I still believe that after the initial kick of the stimulus, we will move into a multi-year headwind as we sort out our extreme imbalances. This is likely to give us below-average GDP growth over seven years and more than our share of below-average profit margins and P/E ratios, so that it would feel more like the bumpy (bumpy, but not so disastrous) 1970s than the economically lucky 1990s and early 2000s.
In contrast to predicting the impossibly difficult real world, predicting market outcomes is relatively straightforward. Profit margins and P/E ratios always seem to pass through fair value if, and it’s a big if, you can just be patient enough.
(…) But the bigger danger is that once again the Fed is playing with fire!
Whenever the Fed attempts to stimulate the economy by facilitating low rates and rapid money growth, the economy responds. But it does so reluctantly, whereas asset prices respond with enthusiasm. In our studies of the Presidential Cycle we have shown that, historically, where
modest Fed stimulus and some moral hazard hardly move the dial on the economy in the third year of the cycle, they push stocks up almost 15% a year above normal and risky stocks even more. (…)
Now, though, after our massive stimulus efforts, the Fed’s balance sheet is unrecognizably bad, and the government debt literally looks as if we have had a replay of World War II. The consumer, meanwhile, is approximately as badly leveraged as ever, which is to say the worst in history. Given this, we would be well advised to avoid a third go around in the bubble forming and breaking business.
Up until the last few months, I was counting on the Fed and the Administration to begin to get the point that low rates held too long promote asset bubbles, which are extremely dangerous to the economy and financial system. Now, however, the penny is dropping, and I realize the Fed is unwittingly willing to risk a third speculative phase, which is supremely dangerous this time because its arsenal now is almost empty.
I do not regret the bailout, although half as much to bankers and more to people with hammers insulating roofs would have been better. With ships lining up by the hundreds outside Singapore harbor, unloaded for want of letters of credit and other basic financial services, our financial leaders had better have acted fast. And they did. Not efficiently. Not fairly. And certainly not frugally. But they thawed the global real world, which was freezing rapidly.
I thought in return for the pain we had all learned some lessons. I was naïve. Congress will probably stay in the pocket of the financial world, and few useful changes will be made. Investors, traditionally reluctant to burn their fingers badly twice in a generation, line up to buy risk and bid down spreads as if eager to suffer for a third time in a decade. (…) Normally, investors appear to have longer memories than rabbits, but not this time! And the Fed, having learned nothing, still worships at the Greenspan altar. Overstimulus was painful in the 2000 break and extremely painful in 2008, but the Fed soldiers on with its failed strategy like Field Marshal Haig in World War I (“The machine gun is a much over-rated weapon.”).
So all investors should brace for the chance that speculation will continue for longer than would have seemed remotely possible six months ago. I thought last April that the market (S&P; 500) would scoot up to 1000 to 1100 on a typical relief rally. Now it seems likely to go through 1200 and possibly higher. The market, however, is worth only 850 or so; thus, any advance from here will make it once again seriously overpriced, although the high quality component is still relatively cheap. EAFE equities seem a little overpriced, emerging markets more so, and fixed income seems badly overpriced, especially cash, which is awful. Exhibit 2 shows our current 7-year forecasts.
The real trap here, and a very old one at that, is to be seduced into buying equities because cash is so painful. Equity markets almost always peak when rates are low, so moving in desperation away from low rates into substantially overpriced equities always ends badly. So this is a dilemma. In 2010, value purists will have to struggle increasingly with the Fed’s continued juicing of the markets. In order to control real risk – the risk of losing money – they will be forced to take the increasing career and business risk of lagging a rising market. Our choice – by no means a “solution” – is to only very slightly underweight global equities on the grounds that, when tilted to quality, they are still adequate in terms of
return potential. We also have to swallow our distaste for parking the rest in unattractive fixed income. And if the equity markets are indeed driven higher in the next six months, which, unlike my view of last summer, now looks to be at least 50/50, we will very slowly withdraw
equities: eight times bitten, once shy, so to speak, for in these situations we typically beat a much too rapid and enthusiastic retreat. If we do see a substantially higher market in the next few months, we will probably underperform, but likely not by much.
There is perhaps, though, one saving grace: the risky stocks have already been driven to extreme overpricing. Further attempts to drive the market higher (they may not be deliberate attempts, but does it matter?) will probably result in a much broader advance in which high quality stocks should hold their own or even outperform. Believe it or not, they can outperform on the upside, and these times tend to be: later in bull markets, or when they are relatively cheaper than the rest of the market, or both. (More quantitatively, high quality stocks have outperformed in more than 40% of up months and approximately 60% of
the time when they were relatively very cheap, as they are now.) For the record, they also outperformed in 1929 and 1972, at the end of the first two great bull markets of the 20th century, and held level in 1999. In a continuing rally, even level pegging for quality would be a great
improvement over 2009. And, if the market surprises me and goes into an early setback in 2010, then quality stocks should outperform by a lot.
What could cause an early setback would be some random bunching up of
unpleasant seven-lean-years data: two or three bad news items in a week or two might do the trick. This would suit me – cheaper is always better – but given the Fed’s intractability, it seems less likely than some further gains. For the longer term, the outperformance of high quality
U.S. blue chips compared with the rest of U.S. stocks is, in my opinion, “nearly certain” (which phrase we at GMO traditionally define as more than a 90% probability).