Wednesday, October 2, 2013

7 Year Asset Class Forecast

The bar graph below has been seen many times across the online world of finance since its release. It comes from Jeremy Grantham's GMO, and it is their forecast of how asset classes will perform over the next 7 years. The graph is so widely followed because of GMO's track record in correctly predicting future gains and losses.

The following shows GMO's previous forecasts vs. their actual outcome. You are unlikely to find another source in the market place anywhere near to this precision.


Here is their current forecast, which provides a follow up to my discussion earlier in the week on U.S. vs. emerging stock market valuations. GMO believes that emerging market stocks will provide an average return of 6.9% while U.S. stocks will lose an average of 1.1% (3 green bars averaged). Click for larger image:

More important than the difference between emerging markets and U.S. stocks is the return expected even if you choose the best parts of the world. This should be considered when a pension fund or financial advisor speaks about a guaranteed 8% plus return per year as long as you invest for the long run.

The U.S. Will Not Default On Government Debt

I know we go through this on what seems like a semi-annual basis now, but for those that are watching the news and are concerned about "the coming U.S. debt default" let me remind you: don't! Turn off the news and go read a book, spend time with your family, or watch a movie. As David Stockman explains briefly and succinctly in the Bloomberg discussion below, the United States will never default on its debt.

For a short period of time will they have to cut back on specific areas of wasteful and unneeded government spending? Maybe. And the response to that? Great!!

The U.S. at some point will face its day of reckoning, but I assure you it will not come because politicians are trying to do the right thing and cut spending. It will come the day the bond market decides it will no longer fund a bankrupt country. The bond market will decide the day the U.S. no longer can live this fairy tale. That is the real concern, and it is very real, not the current charade you see taking place on the news networks 24 hours a day.


Looking to the past and the mixed performance of stocks during shut downs, you can see that the market does not really care.


If U.S. stocks fall from here it is because they are extremely over priced.

Monday, September 30, 2013

U.S. Stock Market Moves Further Away From Reality

The following provides a historical look at secular bull and bear markets in the U.S. stock market. It shows the historical trend line for inflation adjusted stock prices going back to 1871. Stocks have been above this trend line, other than a few brief moments in early 2009, since 1996 when Alan Greenspan gave his famous "Irrational Exuberance" speech. Stocks tend to put in secular bottoms and begin new secular bull markets at points well below the historical trend line.


In order to find a true bottom the leverage in the market must be removed, which unfortunately will come in a very violent manner. The following (red line) shows inflation adjusted margin debt at the NYSE, which is now closing in on the 2008 pre-crash highs. The blue line provides a close up of the graph above, beginning at the 1996 Irrational Exuberance moment through today.


In addition to margin debt, which represent confidence or euphoria in the market, you can look at pure valuation to determine whether stocks are over priced. The next chart shows the 2 year change in P/E multiples, which is the largest two year expansion of P/E ratios since the dot com bubble and the expansion just before the 1987 crash. In simple terms, a rising P/E ratio means investors are raising the price they are paying for stocks faster than the underlying earnings are rising. The rise in stock prices over the last two years has come almost exclusively through P/E multiple expansion.


The much anticipated bond sell off which occurred earlier this year was supposed to "rotate" money into stocks and provide the next catalyst for higher prices. As you can see in the chart below, while bonds have sold off stocks have flat lined and tracked sideways. The money leaving the bond market has moved to cash, which I believe is only a preview of what is coming.


While other parts of the world will face problems of their own, using their markets as a gauge helps to show how far from reality the U.S. stock market has diverged. For example, while the U.S. P/E ratio has moved back up to 23.6x earnings (a level where previous secular bull markets throughout history have peaked), in emerging markets the price to earnings ratio stands at just 13.4x. In simple terms, while earnings may be down (and may continue to fall) in these emerging markets their price compared to the actual earnings the companies generate are much more in line with reality.


It is my estimate the the P/E graph above will converge again at some point over the next few years. I believe the U.S. multiple will meet the emerging market multiple at a far lower point. What does this mean for U.S. stock prices? They will decline significantly.

h/t StreetTalkLive, dshort, Zero Hedge, Barclays Research, Research Affiliates