GMO Market Commentary: Ignore The "Common Sense"

Tyler Durden's picture

From GMO via Wells Fargo

"I've got plenty of common sense ... I just choose to ignore it."

      - Calvin, from Calvin and Hobbes

By the time the Times Square ball landed, U.S. equity markets had closed the books on one of the best years in recent history. Oecember's further rise of 2.5% put the capstone on an amazing year for the S&P 500 Index, which finished 2013 up 32.4%. New historic highs on this index were reached routinely throughout the month. Small-cap stocks, as represented by the Russell 2000® Index, added 2% in Oecember to finish the calendar year up a remarkable 38.8%. Yes, you read that correctly: Small-cap stocks rose almost 40% in a single year.

The "common sense" justifications for these dramatic moves are now well documented. The Federal Reserve (Fed) model, which compares earnings yields on the S&P 500 Index (the inverse of price/earnings) with the Treasury yield, clearly signals to load up on stocks. Common sense also tells us that profit margins are at an all-time high, so clearly it's a good time to be buying stocks. Yellen's dovish background, common sense tells us, is yet further reason to expect continued loose monetary policy and accommodation. And, finally, common sense dictates that recent upward gross domestic product (GOP) revisions, lower unemployment numbers, and a successful holiday retail season, means that of course it's time to load up on stocks.

Here's the problem: We don't buy the common sense. And so, like the philosopher boy above, we choose to ignore it. We suggest you do the same, but for good reason.

First, the Fed model, while intuitively appealing, is a relative measure. Yes, bond yields are ridiculously and artificially low, so of course earnings yields are going to look attractive on a relative basis. But we're trying to make money in an absolute sense, not a relative one. What if bonds and stocks are BOTH overpriced? Then what? Oh, and one more inconvenient truth-the Fed Model's track record of forecasting future returns is actually quite abysmal.

Second, yes, we'll concede that profit margins are at all-time highs-an undeniable fact. Here's the problem: Profit margins are reliably mean-reverting, which means that hitting an all-time high is not a cause for celebration but just the opposite-a reason to be afraid.

Third, yes, quantitative easing can continue for some time, maybe even decades. But that isn't a reason to get excited about stocks. In fact, we believe quite the opposite. What it means is that if that is true (and we don't believe that it will be), then we've got much bigger problems on our hands because stock returns going forward are going to be dismally below what they've delivered for the past 150 years of our modern industrial society.

And finally, ah, yes, GOP growth! Too bad GOP growth has historically had zero to mildly negative correlation with stock market returns. In other words, even if GOP growth is resuscitated, even if 2014 turns out better than we thought, so what! Economic growth-across developed countries, across emerging countries, across time-has told us absolutely nothing  about future stock market returns. Sorry to deliver the bad news.

So, we ignore common sense and instead rely upon the unconventional wisdom of, you guessed it, valuation. Rather than load up on stocks, we remain cautious and nervous because, from a valuation perspective, U.S. stocks look downright frothy. And, if the global markets continue to rally into 2014 and beyond, it is more likely that we'll trim. By the end of November, our official seven-year forecast for the S&P 500 Index was -1.3 (real) and our forecast for small-cap stocks, at 4.5%, is worse than it was during most of 2007. Quality, a large position in the fund, has also seen its forecast come down as it, too, has had quite a nice run. Forecasts for quality are still quite positive, so we're happy to continue owning these stocks but becoming less happy by day. Outside of the U.S., the only groups that we are somewhat optimistic about are value stocks, particularly in Europe, and emerging equities, which we think are priced to deliver 3.4% annually over the next seven years.

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Dr. Engali's picture

So buy stawks then?  Based on this nonsense we should do the opposite of what they say, because none of this has made any sense over the last few years. 

Toolshed's picture

Dr. Engali, I could not have given a better reason to buy and personally hold precious metals, than you just gave, if I tried.

Clint Liquor's picture

"Common sense, is not very common"  Mark Twain

0b1knob's picture

Confucius says:  Never take stock market advise from one who does not know the difference between GDP and GOP. 

insanelysane's picture

I think it may make sense, which worries me.

The FED is expanding the balance sheet to buy stocks and bonds (paper) which keeps the "market" going.

Hypothesis: The FED can manipulate the market higher for a long long time.

Point 1.  They are not buying tangible goods that physically depreciate.  So there is no depreciation of their balance sheet.

Point 2.  Stocks and bonds can be created with very few physical materials and energy so there really isn't a limit to how many there can be.  Virtually infinite.

Point 3.  The FED is an all powerful institution that can print money so they never need to unwind the balance sheet to raise money.

The FED can prop the market for a long time.

illyia's picture

Oddly, I agree with you. Which worries me on every level...

wisehiney's picture

It bothers me when they agree with me.

saveandsound's picture

I love "Calvin and Hobbes"

CrimsonAvenger's picture

Then you'll love this, if you haven't seen it - life advice from Bill Watterson, drawn in C&H style. Probably the best damn thing I read all last year.

tvdog's picture

An unfunny, mean-minded comic from an evil time. Throw Calvin in the trash.

Colonel Klink's picture

I stopped working, listening, and banking with Wells Fraudco many years ago.  Only way to fix the problem is to stop doing business with those companies who are stealing from you.

My advice:  Stop doing business with the top 10 banks, withdraw your funds and go to a community bank or credit union.

Check the banks soundness:

Yen Cross's picture

    Banks are fiat roach motels. Switched to a C.U. back  in '07.

Colonel Klink's picture

Yep, the KEY is to kill those large TBTF banks.  If enough people moved their money, and stopped taking loans from them, the game would be up.

Same goes for buying any modest amount of PMs and taking physical delivery.  There's just not enough to go around if everyone wants some.  If there were enough people acting in concert, the system would sieze up and fail.

buzzsaw99's picture

the fed will buy twitter and all the worthless crap eventually. buy and hold bitchez.

Dewey Cheatum Howe's picture

Ignore gravity also. Things keep levitating upwards when less energy is expended to keep them levitating too......

JustObserving's picture
Ignore The "Common Sense"

Why are you applying reason and rationality to fraudulent, manipulated markets?  The US is broke.  The only way to keep the economy going is to keep stock markets elevated by any means necessary.

The Fed will take any measures necessary.  It is virtually certain that the US government intervenes in the US stock markets to support them.  Does the US intervene to attack gold and silver, probably using big banks like JP Morgan? All the evidence seems to support that thesis.

Everything is fake now in the US - your freedoms, your rights, your privacy and your markets.  Bad economic news has been banished and short sellers and precious metals buyers have been decimated.  

How long can this illusion of a good economy and ever-rising markets can be sustained, no one knows.  But you can easily go bankrupt applying reason and rationality to fraudulent, manipulated markets.




kito's picture

The US is broke


are they? by what measuring stick? the same one that has trounced jeremy grantham since he uttered several years ago that nobody in this life would see a new high in the s&P?

we saw the chart today by tyler, and the one by hambone a few days ago that seem to demonstrate the worlds central banks have plenty of room to run with this. it seems the new normal is working out fine for the worlds leaders and cbs. look at the 10yr on the piigs. no issues. no major country is broke anymore. 

so is the u.s. broke? i am going to say no, so long as long as the entire world continues to backstop the current system. and that, to me, now, is how its going to roll for evah.........BTFD. 

btw, the bag is over my head again. its my shame for being so fucking stupid the past 3-4 years. i shouldve just continued to graze in the pastures of the dow and s&p. my retirement portfolio wouldve been alot better off..........

gjp's picture

I feel your pain and frustration, Kito, every bit of it.  Never took the bag off of my head to begin with.

madbraz's picture

Fact - GDP growth has close to 90% correlation to stock market returns for periods of 10 years or more.

slightlyskeptical's picture

Large caps funds are returning near 20% a year over last 5 years, small cap funds over 20% a year in that same timeframe. Every time I have ever bought equity funds with that type of past performance advertised, I got my ass handed to me. I expect the same to occur shortly. Start buying back in when the trailing 5 year returns are about 6-8%.

Clint Liquor's picture

Some time ago I had to decide whether I wanted to be a 'Stocksucker' or a 'Gold Bug'. While being a 'Bug' is not very appealing, 'Stocksucker' left a bad taste in my mouth.

Fuh Querada's picture

"GOP growth" - the Repugnicans taking both houses?

Missiondweller's picture

I love ZH but I sure wish they would hire a proofreader.

adr's picture

Common sense says that if something is too good to be true, it probably is.

Everything good is a seasonally adjusted mirage of good times. The fantastic rebound is housing is hard to see when there are six vacant homes on my street without for sale signs.

Record corporate profits? Based on what, record accounting fraud.

MrSteve's picture

Those homes will sell like hotcakes, once it "greens up". no doubt!