The following is excerpted from a white paper by Ben Inker, head of GMO's Asset Allocation group. To read the full paper, click here.
We have written and spoken in the past about why we believe recent profit margins are unsustainable, so I will not repeat the arguments in detail here. Our basic view is that corporations have been the perhaps unintentional beneficiaries of the recent large deficits run by the U.S. and other governments. These deficits have allowed aggregate demand to hold up in a period in which corporations have been lowering wages and shedding jobs. The deficits are not sustainable, and we believe the profit margins they enable are not either. If we adjust profit margins down to a more normal level, our estimate is that the S&P 500 is priced to deliver not 5.5-6.0% real, but about 3.5%. This could possibly be the “new normal.” The TIPS market shows that investors are prepared to lend money at 0.4% real for the next 30 years, and real cash rates today are around -2%, so it isn't an utterly absurd supposition that 3.5% is fair for equities. But we believe that the current economic environment, characterized by a strong desire for safety, a scramble for duration by pension funds and insurance companies, and, not least, a Federal Reserve actively working to supress long-term fixed income yields in the explicit hopes of pushing up equity prices, will not persist indefinitely. If we're right, equity investors will be in line for some capital loss as required returns wend their way back to 5.5-6.0%.
From current levels, we believe that this loss would be around 30% – enough to reduce the returns from the S&P 500 to around 0% real if we get back to fair value in 7 years.
The internet bubble of 2000 was the worst point of overvaluation for the S&P 500 in its history. Having averaged 16 times cyclically adjusted earnings since 1881, the market soared to 44 times, well over twice normal levels. The losses and forgone returns since then have caused many investors to question whether the long-term history of equity returns is relevant any more. While this is an understandable reaction, it is the wrong one. The last 12 years have been part of an essential healing process for U.S. equities, and have brought valuations down from 44 times normal earnings to 21 times. As we analyze equity returns, this means the healing process is not yet done, and the U.S. equity market is likely to continue disappointing investors for a few years longer.
But there is a difference between expecting low returns due to reversion to long-term normal valuations and expecting low returns because something has fundamentally changed about the return-generating process for equities. Whether GDP growth in the U.S. and other developed economies is going to be slower in the future is not, in and of itself, a reason to expect a lower return to equities. Likewise, the fact that historic equity returns have been higher than GDP does not mean that the equity market has been some sort of long-term Ponzi scheme. Equities are an ugly asset class – one that is more likely than almost any other to lose investors a significant amount of money at those times when they can least afford it. That is, in a way, their charm. It is why equity is such an appealing form of capital for companies. It is the reason why equities have been priced to deliver good returns historically. And it is the reason why we believe equities are very likely to be priced to deliver strong returns into the indefinite future.
