GMO Market Commentary: Ignore The "Common Sense"

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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