GMO fourth quarter letter titled, “Ditch The Good, Buy The Bad And The Ugly” by Ben Inker.
Also see A Farmland Investment Primer By GMO
There has seldom seemed to be a much starker choice facing equity investors than there is today. On the one hand you have U.S. stocks, where profits1 have compounded at 11% for the past four years, real GDP has grown at 2.2%, accelerating to an annualized 4.8% over the past six months, and neither inflation nor deflation seems a credible threat. Or you can invest in the eurozone, where profits have compounded at -6% over the last four years in U.S. dollars, real GDP has grown at an annualized 0.3%, “accelerating” to 0.4% over the past six months, and consumer prices have been falling since April – months before oil prices began to fall. Or Japan, where profits have compounded at 6% over the past four years in U.S. dollars, the economy has grown at 0.3% over the same period, falling at a 4.3% annualized rate over the past six months, and a recent burst of inflation associated with a consumption tax hike has brought the level of consumer prices all the way back up to where they were in 1999. Or you could pick emerging markets, where earnings have compounded at 1.3% for the past four years, economic growth is decelerating in fast growers like China and economies are shrinking in commodity producers like Russia, and some combination of inflation (Russia, India, Brazil, Turkey) and deflation (Korea, China) threatens many countries.
And the problems for the non-U.S. options don’t stop there. The new Greek government is heading for a showdown with its paymasters, which may put it on a path to exit the eurozone, and far left and right parties are on the rise in much of Europe, which is not a shock given that the German-inspired austerity path to prosperity seems to be failing. Japan is facing some of the worst demographics in the world, has government debt of over 250% of GDP, and the only obvious cure for its wretched return on capital – investing less – would only worsen its economic plight in the medium term.
The problems for the emerging world are truly legion, from an epic credit bubble in China, to an economic crisis in Russia, to the plundering of state-owned enterprises from Argentina to Venezuela. (I wanted to throw in Zimbabwe for a true A to Z listing, but at this point, Zimbabwe would have to crane its neck pretty far to even see its way to being a frontier market, let alone an emerging one.) Given the backdrop, it is no wonder that the U.S. stock market has been the envy of the world, and with P/Es far from the nosebleed territory of the 2000 bubble, it seems awfully tempting to just follow the advice of the venerable Jack Bogle and avoid non-U.S. stocks entirely.2 And yet, as the New Year begins, we in Asset Allocation find ourselves slowly selling down even our beloved U.S. quality stocks in favor of the various problem children of the investing world. We are riding away from the Good and into the arms of the Bad and the Ugly. You might chalk it up to sadomasochist tendencies on our part. However, there is a method to our madness.
The short explanation is that markets don’t work quite the way people assume they do. A slightly longer answer is that things that “everybody knows” are generally priced into markets, despite the fact that most of the time what “everybody knows” turns out to be pretty wrong. If you could accurately forecast the surprises, it would be quite helpful, but in the absence of that ability, buying the cheap countries has generally been the right strategy. And the U.S. is about as far from cheap as any country in the world right now. To use one of the better single valuation measures out there, the cyclically adjusted P/E for the U.S. stock market is 26, versus just under 16 for the U.K. and Europe and a little under 14 for emerging. It will take a lot of good economic news to justify that kind of valuation premium in the medium term.
GMO: If You’re Going To Be a Jerk, at Least Be a Contrarian Jerk
Investors are probably ill-advised to be a knee-jerk anything. It may pain me to say it, but things are always at least a little different this time. We have never seen an economic environment quite like the one the eurozone is facing, with demographic headwinds, a seriously flawed monetary union, high debt loads, and falling household incomes. Certainly Japan is in uncharted territory as well, and if you can find a really good historical comparison for China, Russia, India, or any of the other major emerging markets, you probably are not paying enough attention. On the other hand, history tells us that if you are going to be a knee-jerk anything, at least be a knee-jerk contrarian. The 20% of developed stock markets that outperformed most over a three-year period underperformed on average by 1.3% in the following year and by 2.4% annualized over the next three years. The worst 20% of prior performers outperform by 1.6% and 0.8% annualized.3 The pattern is similar, if weaker, with regard to GDP growth. The fastest GDP growers over the prior three years underperform over the next one and three years by 1.2% and 0.4%, while the worst growers outperform by 0.9% over the next year and marginally underperform by 0.1% over the next three. The performance is summarized in Exhibit 1.
GMO: But GDP Growth Doesn’t Matter, Right?
Investing in the best performers over the past few years is clearly a pretty bad idea, as is investing in the fastest GDP growers. This is not because GDP growth doesn’t matter for stock market investors. GDP growth really doesn’t seem to matter for equity investors in the long run, and while that is a topic I covered in “The Death of Equities Has Been Greatly Exaggerated,” it’s worth covering the point again. Investing in a country because you expect it to have strong GDP growth in the long term is a bad idea, and this is true even if your prediction is an accurate one. Exhibit 2 shows the findings for the developed markets.
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