GMO: ‘Breaking News! U.S. Equity Market Overvalued!’

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Ben Inker of GMO from Q3 letter to shareholders

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 in flation. 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 in flation. 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 con fident 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 past 20 years in this area. Second, we want our process to adhere as closely as possible to our basic beliefs that 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 con fident 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 fi gure 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.

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