It has been a while since we heard from the rational folks over at GMO. Which is why we are happy that as every possible form of bubble in the capital markets rages, Jeremy Grantham lieutenant Ben Inkster was kind enough to put the raging Fed-induced euphoria in its proper context. To wit “the U.S. stock market is trading at levels that do not seem capable of supporting the type of returns that investors have gotten used to receiving from equities. Our additional work does nothing but confi rm our prior beliefs about the current attractiveness – or rather lack of attractiveness – of the U.S. stock market…. On the old model, fair value for the S&P 500 was about 1020 and the expected return for the next 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. Combining the current P/E of over 19 for the S&P 500 and a return on sales about 42% over the historical average, we would get an estimate that the S&P 500 is approximately 75% overvalued.”
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 the next 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.
With that assumption, “true” ROE has been 6.5%, against a real return of 5.7% for the S&P 500 since 1970, which is certainly in the ballpark, if not quite spot on. You could simply stop there and declare that the S&P 500, which is currently trading at about 2.5 times book value, must therefore be overvalued by 25%. The problem is, even if book value has been half of economic capital on average over the last 40 years, how do we know it is still half of economic capital today?
One way to get around the problem of accounting changes on book value is to look instead at return on sales. Sales have the nice feature that accounting changes have relatively little impact on them. Sales figures from 1970 were calculated on basically the same basis as sales figures today, and probably the same as they will be in 2050. Return on sales has looked fairly stable historically, and as you can see in Exhibit 3, we are significantly further above normal profit margin on sales than we are above normal ROEs.
Combining the current P/E of over 19 for the S&P 500 and a return on sales about 42% over the historical average, we would get an estimate that the S&P 500 is approximately 75% overvalued. But the assumption of stable return on sales is problematic for a different reason than ROE. Book value is at least an accounting estimate of equity capital, and as imperfect as it is, return on equity capital is what is supposed to mean revert in a capitalistic system. There is not such a strong argument for reversion when it comes to return on sales. Historically it has been mean reverting, but a high return on sales for a given company does not necessarily mean that competition will follow. Intel has a high return on sales on its microprocessors, but being in a position to sell those microprocessors requires huge amounts of investment and intellectual capital. An economy driven by Intels could easily support higher profit margins than one of supermarkets. So there is a chance that this return on sales framework overstates the degree of overvaluation in the U.S.
But enough about the details. The basic point for us remains the same – the U.S. stock market is trading at levels that do not seem capable of supporting the type of returns that investors have gotten used to receiving from equities. Our additional work does nothing but confirm our prior beliefs about the current attractiveness – or rather lack of attractiveness – of the U.S. stock market. To answer the question we get most often about our forecast – “How could you be wrong?” – there are a couple of ways we could be wrong. One of them is pleasant and implausible, the other is more plausible, but far less pleasant.
The less pleasant way we could be wrong is if 5.7% real is no longer a reasonable guess at an equilibrium return for U.S. equities. If equity returns for the next hundred years were only going to be 3.5% real or so, today’s prices are about right. We would be wrong about how overvalued the U.S. stock market is, but every pension fund, foundation, and endowment – not to mention every individual saving for retirement – would be in dire straits, as every investors’ portfolio return assumptions build in far more return. Over the standard course of a 40-year working life, a savings rate that is currently assumed to lead to an accumulation of 10 times final salary would wind up 40% short of that goal if today’s valuations are the new equilibrium. Every endowment and foundation will find itself wasting away instead of maintaining itself for future generations. And the plight of public pension funds is probably not even worth calculating, as we would simply fi nd ourselves in a world where retirement as we now know it is fundamentally unaffordable, however we pretend we may have funded it so far. William Bernstein wrote a piece in the September issue of the Financial Analysts Journal, entitled “The Paradox of Wealth,” which explains far too plausibly why generally increasing levels of wealth might drive down the return on capital across the global economy. It’s well worth a read, although perhaps not on a full stomach, as it is one of the most quietly depressing pieces I have ever come across (and this is coming from someone who has spent the last 21 years reading Jeremy Grantham’s letters!).
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