A record number of fund managers believe global equities to be overvalued, with an overwhelming majority seeing the US market as the most overvalued in the world. Is it time to “just say no” to the S&P 500?
The “just say no” message refers to the title of a new white paper co-authored by high-profile GMO strategist James Montier. GMO, headed by iconic investor Jeremy Grantham, has $77 billion in assets under management and is famous for having predicted past market crises, such as the Japanese bubble that burst in 1989 as well as the 2000-02 dotcom implosion and the 2008 global financial crisis. The title of Montier’s latest paper sounds like an anti-drugs warning, and the content of the paper is similarly stark.
The S&P 500, Montier notes, has “trounced the competition” over the last seven years. It has risen 173 per cent, compared to just 71 per cent (in dollar terms) for the MSCI EAFE, the most widely-followed index tracking non-US developed markets. Emerging markets lag even further behind, rising just 30 per cent over the same period.
Those US gains have been largely driven by an expansion in profit margins and valuation multiples to historically lofty levels. Future gains, says Montier, require either that dividends and earnings start growing at a much faster pace – unlikely, as both are “remarkably stable” over time – or that valuation multiples and margins continue to expand.
“The historical record for this assumption is quite thin, to put it kindly,” says Montier. Margins and multiples tend to revert to the mean over time, so buying US stocks “now requires a belief that ‘it’s different this time’ with respect to the valuations that people will put on stocks, and the margins that companies can command”.
Montier points to stocks’ cyclically-adjusted price-earnings ratio (Cape), which has only ever been exceeded in 1929 and 2000 – both prior to major crashes. Cape, popularised by Nobel economist Robert Shiller, has its detractors. However, Montier argues that if one uses a modified Cape to account for potential shortcomings, stocks look even more expensive, exceeding 1929 levels to become the second-most expensive market in history.
Nor, he says, are the figures distorted by a handful of overvalued large-cap technology stocks. The median stock, as measured by its Cape and price-sales ratios, is even more expensive than it was at the peak of the dotcom bubble in 2000. Then, overvaluation was concentrated in the technology sector, says Montier, whereas everything looks pricey today.
The global hunt for yield means bargains have vanished. In late 2008, 20 per cent of Asian stocks could be categorised as “deep value”, or dirt-cheap; 10 per cent of UK and European stocks satisfied this criteria, as did 5 per cent of US stocks. Today, 5 per cent of Asian stocks fit the bill, and just 1–2 per cent of UK and European stocks. In the US, says Montier, “not a single stock” can be called deep value.
The message is clear, says Montier; this is an “exceptionally expensive stock market”. Montier denies being a perma-bear, pointing out that GMO was pounding the table for stocks at the market bottom in 2009.
However, sceptics might retort that GMO has been on the wrong side of the market for a long time now. As for back as March 2011, Montier was complaining that US stocks were overvalued by 40 per cent and “priced for perfection”. Similarly, in his latest letter, he cites value investing legend Benjamin Graham, who warned that an absence of deep value stocks was a strong indicator that it was time to get out of stocks. However, that same 2011 letter noted that not one US stock could be termed deep value. Anyone who heeded Montier’s advice went on to miss out on six years of big market gains.
Indeed, stocks’ stubborn refusal to heed the GMO message appears to have led to a softening in the position of Montier’s boss, Jeremy Grantham. Though still wary of US equities, Grantham recently admitted that this time may well be different and that valuation multiples and profit margins could remain elevated for many more years.
No lone voice
Still, while Montier’s bearish message may be an especially blunt one, he is far from being a lone voice on the subject of US valuations. Out of 20 valuation metrics tracked by Ned Davis Research, 16 suggest US stocks are extremely overvalued. As noted earlier, Merrill Lynch’s latest fund manager survey shows a record number see global equities as overvalued, with concerns largely centred on the US investment universe.
The last time fund managers were nearly as concerned was back in the late 1990s. Goldman Sachs recently cautioned that 10-year returns have been negative or below historical norms 99 per cent of the time when valuations were as high as they are today. Vanguard founder John Bogle, who has spent his life preaching the buy-and-hold message, estimates the US market will be hard-pressed to deliver annualised returns of more than 2 per cent over the next decade.
Billionaire hedge fund manager Paul Tudor Jones said earlier this year that US valuations were “terrifying”, while fellow billionaires Bill Gross and Howard Marks have also expressed alarm regarding today’s multiples. Even Prof Jeremy Siegel, long known as a market bull who has sparred with Robert Shiller on the apparent shortcomings of the Cape indicator, recently agreed that long-term returns are going to be lower than historical norms.
While there is broad agreement that US stocks are overvalued relative to history and that low future returns are likely, most observers agree valuation cannot be used as a timing tool. An expensive market is not necessarily ripe for a fall; it simply means future long-term returns are likely to be disappointing. Rather than selling, concerned commentators like Robert Shiller suggest investors rotate into non-US markets or underweight the US in their portfolio.
The problem, says Montier, is that international equities are also expensive, “but just not as ugly as the US”. Although unattractive in absolute terms, international markets do look good compared to the US.
The current valuation differential between US and non-US markets has only been exceeded on a couple of occasions since the 1980s, according to GMO’s data (in the late 1990s and during the European sovereign debt crisis a few years ago). Their currencies, too, seem cheaper than the dollar. Combined, it all means international stocks – especially emerging markets – “look a damn sight better than their US counterparts”.
GMO’s recipe, then, is to own “as much international and emerging market equity as you can, and as little US equity as you can”, while holding a fair bit of cash in the event stocks suffer a sell-off. For now, however, investors should lower their expectations and accept that in a world where nothing is cheap, “you are reduced to trying to pick the least potent poison”.