Jeremy Grantham's GMO: "The S&P Is Approximately 75% Overvalued; Its Fair Value Is 1100"

Tyler Durden's picture


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."

Key highlights:

  • 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!).

Full letter below (pdf):

Your rating: None

- advertisements -

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Mon, 11/18/2013 - 20:22 | 4167584 johngaltfla
johngaltfla's picture

More like 2xBitcoin closing price.

or 20% below gold's closing price.

Mon, 11/18/2013 - 20:31 | 4167616 bunzbunzbunz
bunzbunzbunz's picture

Stupid bitcoins need to slow down...I'm trying to get at . But they lowered the amount they pay per hour since bitcoin freakin doubled... WHERE CAN I GET MOAR!?

Mon, 11/18/2013 - 20:40 | 4167651 johngaltfla
johngaltfla's picture

Ask the Bernank to print you some. He took it to 666 on his own today.

Mon, 11/18/2013 - 20:43 | 4167661 bunzbunzbunz
bunzbunzbunz's picture

Man...I wish he would print me a few. I wish I would have printed myself a few 3 years ago when I thought, hey bitcoins a cool idea, but that's dumb - no one would ever pay money for them.

Mon, 11/18/2013 - 21:33 | 4167824 flacon
flacon's picture

Watch Bitcoin be destroyed (probably by .gov). DROPPED $250 IN FIFTEEN MINUTES!!!:

Mon, 11/18/2013 - 21:36 | 4167831 fonzannoon
fonzannoon's picture

Now it's only up 1,000% ytd.

Mon, 11/18/2013 - 21:42 | 4167849 BaBaBouy
BaBaBouy's picture

BTC Just Hit $900. Then Crashed Its $605Now.

Having Fun, Idiots ???

Mon, 11/18/2013 - 21:51 | 4167888 bunzbunzbunz
bunzbunzbunz's picture

....................................You realize that people take loans out to invest in any legitimate investment you can think of right? So..a leveraged gold investment may swing by -50% or +200% or greater in any given day. Hopefully you can also then realize that nearly all of the post-inflation gains in gold markets over the last 10 years were due to idiots leveraging into gold to try to increase their yields. So who exactly is an idiot? People that leverage or people that benefit from leverage, or people that get hurt by leverage?

Mon, 11/18/2013 - 21:56 | 4167923 bunzbunzbunz
bunzbunzbunz's picture

Annnnnnnd back to 760. Your emotions are the same kind that made those idiots nearing retirement throw away half their money in 2008. Oh look. If you had just left the account alone, your losses would have been recouped, and everything you put in from 2008 on would have grown at ~20% annually. Shocking! Buy diversified and HOLD!@#?!@<M?dsJAV:KHSf

Mon, 11/18/2013 - 21:40 | 4167841 bunzbunzbunz
bunzbunzbunz's picture

Roffle waffle. Yeah, it went up 500 in the last few days. I'm so shocked that it could drop 250!!!! Yes people with large amounts are going to cash out every now and then and buy a fucking Ferrari. Douche bags.

Mon, 11/18/2013 - 22:37 | 4168112 bubblemania
bubblemania's picture

Highly Bullish!

Mon, 11/18/2013 - 20:37 | 4167639 AlaricBalth
AlaricBalth's picture

Fundamental equity market analysis. Such a quaint, antiquated concept. Throw out all standard metrics as long as the Fed has the pedal to the metal. Market overvalued by historical norms? Yes.
Does anyone care? No.
Damn the torpedoes. Full speed ahead!!!

Mon, 11/18/2013 - 21:28 | 4167799 LetThemEatRand
LetThemEatRand's picture

East bound and down, loaded up and truckin'.  We're goin' do what they say can't be done. We've got a long way to go, and a short time to get there....

We have the Bernanke as the Bandit.  Snowden as the Snowman.  I guess Yellen is the faithful dog companion.  And of course Timmy is little Enos.

Mon, 11/18/2013 - 21:30 | 4167809 VD
VD's picture

fair value is 800; they omit many factors. also, the cascade effect of SP recoupling down past 1100 could amplify 'correction'.

Tue, 11/19/2013 - 00:27 | 4168481 DeadFred
DeadFred's picture

Correction down to fair value plus a 50% overshoot brings it right to hard support. It will turn at 750 for sure!!!

Mon, 11/18/2013 - 20:23 | 4167585 edb5s
edb5s's picture

At first I thought "Ben Inkster" was a new nickname for the Bernank.

Mon, 11/18/2013 - 20:24 | 4167589 OwnSilverPlayMusic
OwnSilverPlayMusic's picture

I agree wholeheartedly, but I'm not a fan of marshall law.  So... ya know, it's a crapshoot.  If city pensions fail nationwide would people wake up then??

Mon, 11/18/2013 - 20:25 | 4167593 johngaltfla
johngaltfla's picture

Nope. Bendyaoveryellen would just double down and print even more offering to buy all Munis from afflicted cities.

Mon, 11/18/2013 - 20:24 | 4167590 BlueStreet
BlueStreet's picture

I'd give my right nut to see 1100. 



Mon, 11/18/2013 - 20:27 | 4167602 johngaltfla
johngaltfla's picture

I'd give your right nut also. Then load up on SH. :)

Mon, 11/18/2013 - 20:57 | 4167712 Ol Man
Ol Man's picture

I see bitcoin at 1100 tomorrow...8>D

Mon, 11/18/2013 - 20:59 | 4167725 Ignatius
Mon, 11/18/2013 - 20:25 | 4167592 buzzsaw99
buzzsaw99's picture

interesting but irrelevant

Mon, 11/18/2013 - 20:26 | 4167599 Bay of Pigs
Bay of Pigs's picture

The BlowHorn won't like this call.

Hatchet job in 3,2,1.....


Mon, 11/18/2013 - 20:27 | 4167604 wisehiney
wisehiney's picture

Shiots gonna blow.

Mon, 11/18/2013 - 20:35 | 4167628 RaceToTheBottom
RaceToTheBottom's picture

Stop the QE, that will show how much the market is overvalued by.

75% sounds about right to me but stop QE, that will do it.

Mon, 11/18/2013 - 20:35 | 4167629 Al Huxley
Al Huxley's picture

Thank god they came out with this - there's noting better for putting the brakes on an incipient retail buying frenzy and preventing it from getting out of hand than a well-reasoned letter discussing market valuations. 


I would expect that now we'll see people moving calmly toward the exits, closing positions in a rational manner and booking modest but healthy profits, as the market takes a gentle pause for a couple of years before trending gradually up again.

Mon, 11/18/2013 - 20:37 | 4167638 carbonmutant
carbonmutant's picture


Mon, 11/18/2013 - 20:48 | 4167680 Rainman
Rainman's picture

I can see Japan from here.

Mon, 11/18/2013 - 20:43 | 4167659 NoDebt
NoDebt's picture

Look, it just sounds ridiculous when you put it that way.  Please try to be more serious about your posts in the future.

Mon, 11/18/2013 - 20:50 | 4167689 bunzbunzbunz
bunzbunzbunz's picture

Hope and fear bro. No room for rationality. That would mean less hope or fear.

Mon, 11/18/2013 - 21:11 | 4167764 w00dmann
w00dmann's picture

Thanks for the laugh!  Great post. 

Tue, 11/19/2013 - 02:52 | 4168690 Himins
Himins's picture

If a few things do fall through the cracks, qe Queen Janet, will be happy to clean up the steaming broom too small.

Mon, 11/18/2013 - 20:36 | 4167632 Whiner
Whiner's picture

Jeremy Baby, did your modeling factor $85 Bil plus moar per month into the trading desks of the Primary Dealers? What do underlying evaluation models have to do with bubbles enforced by Central Bankers? Just tell when the wheels will run off. Our sense is it won't be too long. 2014? 2015? 2016?

Mon, 11/18/2013 - 20:53 | 4167697 bunzbunzbunz
bunzbunzbunz's picture

Pfft. we're in the next 20 year expansionary fool. We're starting it a little early so the people that pay attention can get a little more this time.

Mon, 11/18/2013 - 20:36 | 4167633 carbonmutant
carbonmutant's picture

Sounds like Ben Inkster has been on the phone with Carl....

Mon, 11/18/2013 - 20:37 | 4167640 Super Broccoli
Super Broccoli's picture

wow the market operators are turning incredibly bearish, now if GS tells you they're bullish and you need to buy, HIT the damn SELL order and RUN

Mon, 11/18/2013 - 20:43 | 4167662 seek
seek's picture

Mildly OT: Bitcoin broke the $1000USD mark in China a few minutes ago, and the exchange-weighted price is approaching $1K as well. Doubling in price in under 24 hours.

Add it to the list of things to blow up.

Mon, 11/18/2013 - 21:00 | 4167723 seek
seek's picture

Update: Just broke $1,200 USD in China. This blow-off is going to be pretty epic at this rate.

Mon, 11/18/2013 - 21:08 | 4167753 Ignatius
Ignatius's picture

Well, China certainly has a lot of dollars and they gotta do something with 'em. 

Mon, 11/18/2013 - 21:08 | 4167754 Bay of Pigs
Bay of Pigs's picture

So it went up $200 in 17 minutes? Good grief...

Mon, 11/18/2013 - 21:33 | 4167793 seek
seek's picture

Yeah, it did! It's that insane, I'm watching the real time quotes out of several chinese exchanges and it's unreal.

There's a small ($100) pullback happening now, it's still over $1100 USD.

Update @2031: pullback is accelerating, now $1040.

@2032: $950, it's collapsing

Mon, 11/18/2013 - 21:35 | 4167826 Herd Redirectio...
Herd Redirection Committee's picture

I can only find bids of $625 on

The money that goes into Bitcoin for smuggling will come out...  Some of it will possibly be transacted directly for goods and services, but probably 85% are 'hot money' flows...

Mon, 11/18/2013 - 21:51 | 4167830 seek
seek's picture

@2035: $912

@2036: $898, just broke $900 on the downswing. So $1200 to $900 (25%) in 30 minutes. Wheeee!

@2041: $902, dipped then bounced a little, looks like it must have hit some buy limits at $900.

@2042: $840, the floor folds big time and Wheeee! again. I love roller coasters, don't you?

@2044: $820... how low do we go? Are there limits at $800? Wait 2 minutes and we'll find out!

@2046: $830... looks like limit orders triggered around 820 / 5000 CNY.

@2048: $868, maybe we've found the floor at 5000 and triggered a big bounce.

@2050: $902, boinnng! Is it a dead cat or a superball?

If you want to follow along: it's a weight avg of chinese exchanges.

Mon, 11/18/2013 - 22:29 | 4168077 Wahooo
Wahooo's picture

Nothing changes. Tulip farmers.

Mon, 11/18/2013 - 21:31 | 4167818 RaceToTheBottom
RaceToTheBottom's picture

So does this mean the Winklewankers could build something?  Or does throwing 10 million of FB funny money invoke the funny money clause?

Mon, 11/18/2013 - 20:46 | 4167672 NoDebt
NoDebt's picture

"If equity returns for the next hundred years were only going to be 3.5% real or so, today’s prices are about right."

There's another way, Jerry.  Imagine they're lying to you about inflation and it's actually a couple points higher than the reported number.  Do the numbers make more sense now?  I believe you will find they do.

Mon, 11/18/2013 - 21:39 | 4167767 AlaricBalth
AlaricBalth's picture

Imagine what would happen if the Fed were to report the actual inflation number. Interest on the national debt would skyrocket. Debt service would amount to over 70 cents+ of every tax dollar collected, as opposed to the current 43 cents+. Cost of living adjustments for Social Security, federal and military retirees would blow a Trillion dollar hole in the budget. The Fed would be forced to stop printing, due to economic as well as political pressure which would result in a market crash the likes we have never seen. In other words chaos.

Many years ago the Fed analyzed the future demographic trends and felt it prudent to begin "adjusting" the inflation calculations to account for an aging bulge in the demographic curve. The unintended consequences of this number fudging has created a compounding effect over time between the actual inflation rate and the reported rate. This has led to an extreme misallocation of capital which has caused the Fed to continue its various printing programs. It must print practically forever to fill the gap between what is real and what is reported.

The Fed will continue the lies until it dies.

Mon, 11/18/2013 - 21:13 | 4167769 Seal
Seal's picture

“…..In the meantime, an index of German share prices (1913 = 100) rose from 126 in January 1918 to 531,300,000 in September 1923, and to 23,680,000 million in November 1923 amidst extremely high volatility. (In dollar terms, because of the currency depreciation, the same index (1913 = 100) fell from 101.55 in January 1918 to 2.72 in October 1922, before recovering to 39.36 in November 1923.) The extremely high volatility of the stock market is a typical feature of hyperinflating economies.”


ISSN 1017-1371, The Financial Implications of Reflation, Dr. Marc Faber

Mon, 11/18/2013 - 20:47 | 4167676 Sechel
Sechel's picture

Nobody is worried because everyone is smart enough to sell before the market goes down.

Do NOT follow this link or you will be banned from the site!