The latest GMO Quarterly Report, released yesterday as a 26-page PDF, has some interesting charts and commentary on valuations, PEs, and a premium on US equities.
Let's put a spotlight on a chart and commentary starting on page 10.
Questions
When we began building our forecasts, this series had a wonderfully mean-reverting look to it. There had been no obvious trend for the close to 50 years of data, despite plenty of good times and bad in the interim. And the appearance of long-term stability still seemed strong as late as the early 2000s. At the time we excused the new highs of profitability as the consequence of the housing boom and bubble in risk assets. Afterwards profits were good enough to fall through the old average in the financial crisis, although not to the lows we saw in prior recessions. And since then, after the fastest and sharpest recovery on record, we saw them rise well beyond anything the U.S. has ever seen. On this measure, while profitability is off of its recent highs, it is higher than any point in history before 2010.
And this leads to the quandary for thinking about the U.S. stock market. We cannot find any convincing evidence that the U.S. is deserving of trading at a premium P/E to the rest of the world. This profitability, however, could be read either of two ways. Either the U.S. has somehow unlocked a secret to permanently higher profitability or this is an extremely dangerous time to be investing in the U.S. U.S. profitability has never looked materially better relative to the rest of the world than it does today. The bull case would be that, for whatever reason, this profitability gap is sustainable and U.S. stocks are only mildly more expensive than the rest of the developed world given U.S. P/Es are only about a point higher.
But, frankly, we have a hard time believing this bull case. U.S. outperformance in recent years can be readily explained by the better trends in profitability, but that is a long way from saying that outperformance was truly justified. From a macroeconomic perspective, maintaining such high levels of profitability in the face of low investment rates implies ever-increasing wealth inequality in this country, unless taxes were to be raised in a way that seems highly implausible. Generating sufficient end demand in the economy given the inequality would call on either the rich to start spending their wealth at significantly greater rates than we have seen historically or the rest of households to spend more than 100% of their income, as they did in the housing bubble. It is hard to envision that an economy that relies on those foundations to be a sustainable one.
Conclusion
The clearest evidence for the U.S. being special today is inextricably tied to its recent performance. In the long run, the U.S. clearly had the good fortune of not having its capital stock destroyed, but otherwise doesn’t look that special. In the shorter term, we have seen an impressive expansion of American profitability that has not been mirrored in the rest of the world, and U.S. stocks have duly outperformed. This has, not surprisingly, led investors to try to convince themselves of the inherent superiority of U.S. stocks to justify continuing to hold them. We cannot completely reject the possibility that those arguments are correct, but the evidence seems pretty thin. Certainly there is no strong evidence that would cause us to believe the U.S. is truly deserving of trading at a higher P/E than the rest of the world. On the profitability front, there seems little doubt U.S. corporate profitability is better than normal, but the question is how much better? Our best estimate is that profit margins are about 24% better than normal, but there is a wider than normal range of possibilities here, with the plausible figures anywhere from 5% to 40% above normal. The impact on our forecast is a range as high as +2% real to a disastrous -4% real for the next seven years, depending on which measure of profitability was the “true” one.
Disclaimer: The views expressed are the views of Ben Inker through the period ending December 2015, and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
- How Sustainable is Corporate Profit Trend?
- Do US Equities Deserve a PE Premium?
1A. I side with Ben Inker that US equities do not deserve much of a PE premium.
2A. As far as profitability goes, ignoring another massive war such as WWII, the US cannot hold an edge in profitability for long. Aside from labor issues and tax consequences, whatever US companies are doing better productivity-wise, other companies will eventually figure out.
But that statement does not really answer the question of trend. Even if the US deserves a premium, the trend itself will mean revert.
Simply put, corporate profits as a percentage of GDP are not going to stay in the 9% to 10% range, and 10-year smoothed PEs will not stay at a level they are now, only exceeded in 1929, 2000, and 2007.
There is no reason to believe "this time is different" for either PEs or corporate profits.
Here's the critical question: If the trends mean revert, what will US equities return?
7-Year Asset Class Real Return Forecasts
The above from latest GMO Forecast.
GMO Disclaimer
The chart represents real return forecasts for several asset classes and not for any GMO fund or strategy. These forecasts are forward‐looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Forward‐looking statements speak only as of the date they are made, and GMO assumes no duty to and does not undertake to update forward‐looking statements. Forward‐looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results may differ materially from those anticipated in forward‐looking statements. U.S. inflation is assumed to mean revert to long‐term inflation of 2.2% over 15 years.How Good or Bad Can Returns Get?
I like Inker's approach of putting a range on things. Here is the key paragraph from above:
Our best estimate is that profit margins are about 24% better than normal, but there is a wider than normal range of possibilities here, with the plausible figures anywhere from 5% to 40% above normal. The impact on our forecast is a range as high as +2% real to a disastrous -4% real for the next seven years, depending on which measure of profitability was the “true” one.Disastrous Discussion
Inker labeled -4% real returns as "disastrous". Actually, 0% for seven years would be disastrous for pension funds expecting 8% returns or better for the same timeframe.
States like Illinois would likely be wiped out. And if 0% is disastrous, I am not sure what the correct word for -2% or -4% should be.
Even 2% real returns (3%-4% nominal) vs. expected nominal returns of 8% or better would be an outright disaster to many pension plans. Yet, 2% is likely as good as it gets.
Looking back on today, seven years from now, Inker may very well look like an optimist.
Mike "Mish" Shedlock
