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«To get back to fair value, the S&P 500 would need to drop by 50%»

Sandro Rosa and Gregor Mast
James Montier, member of the asset allocation team at the Boston-based asset manager GMO, is convinced that the US stock market is in bubble territory. However, European equities aren’t particularly cheap, either. Only emerging markets value-stocks appear vaguely attractive to him. Investors should be patient and hold a lot of cash in their portfolios in order to be able to buy when markets are correcting.

James, markets have been very excited about the election of Donald Trump. How long will this honeymoon last?
You never know, because the trouble with Trump is his «policy-by-tweet»-approach. Today’s message is this and tomorrow’s is something entirely different. And between tweet and executive order you do not really know what is going to happen. I believe markets have priced in the best possible outcomes from a Trump victory without any evidence he can actually deliver on any of his promises. The health care bill failing was therefore interesting, because this was his first big legislation – and it failed. What fails next?

What would happen if Trump delivered on his promises?
If he succeeds, wages rise – assuming he will get through some big fiscal stimulus package through -, while inflation probably picks up and the Fed tightens interest rates. And none of these are particularly helpful from an equity market perspective. So there is pretty limited upside.

What is your take on US-equities?
US-stocks are in bubble territory. According to our definition that is the case when the S&P 500 (SP500 2438.3 0.16%) is more than two standard deviations above its fair value. At the moment, this bubble-threshold is at 2350 points.

When will the bubble burst?
Nobody knows. All you know is that when markets are exceedingly expensive it takes very little to disappoint them. Equities are currently the third highest in valuation terms we have ever seen. Only in 1929 and 1999 were they more expensive. And you do not hear many people telling you to buy because it’s like 1929 and 1999.

Are markets headed for a crash?
I think you never know what triggers a correction or even if there will be one. All you know is that if you buy at these prices, future returns will be low. My view is that at some stage a crash is quite likely.

Why do you think that?
We are seeing the typical bubble-like behavior of over-confidence and over-optimism. One retort is that there is no euphoria. For instance, we do not observe the kind of massive surge in IPOs that we witnessed during the dotcom bubble or hear arguments that «this time is truly different».

So why do you think this is bubble-like behavior?
Because I do not think people are rationally buying equities expecting very low future returns. I think they are buying them because they expect good returns. And when the returns do not materialize, that is probably when a correction or a crash will occur, because people will be disappointed.

Why do you think markets are over-confident? There are factors that do not support such a view.
When you look at the growth rates that would be needed to support today’s valuations, they are ludicrous compared to history. In the past, the average real earnings growth has been about 2% per annum. To justify today’s prices you would need earnings to grow over 6% per annum for a decade. That’s three times normal. To me, that sounds extremely over-optimistic.

Do you have other examples?
Analysts are behaving the same way. They are getting very, very bullish about earnings. You can see that in their forecasts. Now, given that everybody knows that they are too bullish anyway you would expect the market to correct for that and trade at a discount on the forward multiple. It does not. It is even trading at a premium! So we are putting expensive premiums on these delusional dreams of analysts.

Optimists draw a comparison to 1996, when stocks climbed for another three years – despite warnings about high valuations. Wouldn’t that be a possible scenario?
That is always the painful part. Being a value investor, you are cursed to be too early. You are too early to buy and too early to sell. That’s just the nature of the beast. It could indeed be that today is like 1996, when the market also looked expensive and still went up for another three years. Value is a very poor guide to reasonably short-time horizons but a very powerful guide for long-run horizons.

What is the consequence of that?
If you are using a value-approach, then you need to focus on something longer than three years. Because there is nothing that stops expensive assets from becoming even more expensive. We could easily see that this time around. We certainly cannot rule it out. I just do not think that we can call that investment, it is effectively speculation.

Why is that?
Because you are buying something knowing it is expensive and saying you are buying anyway because you think you can get out before anyone else. And we know it is really hard to do that. History is not kind to those who have tried.

You could make the argument that equities look attractive relative to bonds.
From where I look at asset classes there is nothing that is cheap. Investing today is a bit like picking the tallest dwarf – not great fun. And I think the central banks have encouraged this behavior. They have said: »Go out there and speculate.» Effectively pumping up the third bubble within twenty years.

Why do central banks not learn?
I am not sure that they do not learn. But from their point of view there is almost no alternative. Fiscal policy has not been allowed to be used and therefore everybody looks to monetary policy to carry the burden. It will not work, because monetary policy can only ever be about transferring assets from one party to another – from creditors to debtors. So there won’t ever be effective monetary policy for getting growth going.

And why is that?
Real corporate investment does not respond terribly much to interest rates, neither does people’s savings behavior. So there is no real transmission mechanism between monetary policy and the economy. But everybody expects the central banks to be able to do this and so they keep playing along. It is the confidence fairy.

What should an investor do in such an environment where nothing is cheap?
There are four paths you could follow, not all of them equally sensible. First, you could concentrate your portfolio. Just own the most attractive asset class. This is what we at GMO call the «Kamikaze»-portfolio, because it would be essentially investing all in emerging market value equities. If you had a sufficiently long time horizon – let us say 20, 25 years – that would probably be a reasonable strategy.

Which countries and sectors show up in emerging markets value?
The selection is actually very broad-based and does not have any particular country or sector biases. Of course, there are Russian energy stocks in there – they are always nice and cheap. But there are also Korean Chaebols and Taiwanese semiconductor firms, which are well-run businesses, as far as we can see. But people don’t seem to want them.

Many pundits argue European equities are the better alternative: they are much cheaper and growth is finally picking up.
Relative to US equities they do indeed appear attractive. However, European stocks are still not cheap. Based on our models, we would think a return of 6% in real terms would be fair. But for Europe – and also for Japan – we are getting numbers that are essentially 0%. For the US we forecast annual real returns of –3%.

What is the second path investors could take?
The second way would be to sidestep the problem and invest in alternative assets, such as hedge funds or private equity. However, I don’t believe that there are that many sources of uncorrelated returns. I think most of the so-called alternatives are not really alternatives but are simply different ways of owning standard risks. However, if you can find alternatives that are well-priced, great. But I don’t think there are that many of them around.

And the third option?
The third option would be to use leverage, which is basically the risk-parity approach. That works fine as long as rates stay really, really low and you don’t have any violent market moves. If rates rise or if there is a lot of volatility, leverage becomes a big problem. We have seen that throughout history.

What is the fourth approach?
Be patient and hold a lot of cash, which has a high option value. That option value being that you can rotate into assets that you don’t currently want to own, but if there is volatility, you get the chance to own them at much more attractive prices.

Which path do you follow at GMO?
In our portfolios we are taking elements of most of those approaches. So a fair share of the risky assets we hold are in emerging markets value stocks, where we get at least some return. We also invest in alternative assets. And then we hold nearly 30% in cash and short duration bonds. Another 7% is in treasury inflation protected securities. So we have nearly 40% of the portfolio in dry powder. This is not because we like cash, it is just that we think the alternatives carry the danger of seriously impairing capital significantly.

Many people don’t like holding lots of cash when interest rates are essentially zero and inflation is picking up.
Cash is like death by a thousand cuts: Inflation eats away a bit every year but at least it is not the kind of big 50% loss that you get when stock markets re-price. So we are trying to build a portfolio that can survive different outcomes and it is going to have a conservative bias because the one thing we know is most assets are expensive. This is not a time to be a hero. This is a time to sit there and do a Winnie the Pooh: When there is nothing to do, do nothing.

What would make the US equity market attractive again – how much would it have to correct?
To get back to our sense of fair value tomorrow, it would have to fall by more than 50%. Then we would be on average valuation, which again we estimate based on profitability going back to normal.

What about fixed income? Aren’t US-treasuries approaching fair value after the recent rise in yields and given the economy might not be that healthy after all?
They are certainly closer to fair value, but I am not sure they are close. The ten year yield is roughly 2,5%. My best guess for inflation over the next ten years is probably about 2%. So you are getting a real return of somewhere between zero and 0,5%. That is not going to pay many pension funds’ liabilities.