Equities getting cheap in a sea of troubles

Published December 7, 2011


It pays to go for quality companies and tilt to safety where possible


By TEH HOOI LING
SENIOR CORRESPONDENT


THE world is in a terrifying situation but investors should still have a near normal weight in global equities, said one of Wall Street's most well-respected strategist, Jeremy Grantham of GMO, in his latest quarterly letter.


But go for quality companies, tilt to safety where possible, and avoid lower-quality US stocks.

Also try to avoid duration risks in bonds. For the long term, they are desperately unattractive, he said. 'Don't be too proud (or short-term greedy) to have substantial cash reserves.'

And for him personally, he likes resources in the ground on a 10-year horizon. Now, he is only nibbling slowly because he still fears a further short-term decline in commodities as a result of less bad weather and economic weakness, especially in China.

So what's terrifying about the world now? The problems plaguing the eurozone is one thing. Secondly, the United States, and to some extent the world, will not easily recover from the current level of debt overhang, the loss of perceived asset values and the gross financial incompetence on a scale hitherto undreamed of.

Third, the US and the developed world have permanently slowed in their GDP growth. This is mostly due to slowing population growth, an ageing profile and an over-commitment to the old which leaves inadequate resources for growth.

Also contributing to the slowdown, particularly in the US and the UK, are inadequate long-term savings. Latest numbers showed that the US personal savings rate has fallen once again below 4 per cent.

In the US, its notably depleted infrastructure, marked fall-off in the effectiveness of education and training and its much-decreased effectiveness of government, particularly in its ability or even willingness to concern itself with long-term issues, will threaten its competitiveness.

Also of concern is the drastic decline in US income equality, and the stickiness of economic position from one generation to another.

The net result of these factors is a growing feeling of social injustice, a weakening of social cohesiveness and, possibly, a decrease in work ethic. In such an environment, it is difficult to achieve a healthy growth rate.

Furthermore, economic balance will slowly be eroded in an economy in which the average worker makes little or no economic progress.

Sales of ordinary goods will be weak and erratic, resulting in weaker and more unstable growth. Sales are erratic because, with little or no income progress, buying surges by the 'middle class' depend increasingly on shifts in confidence and a willingness to go into debt.

'Sitting on planes over the last several weeks with nothing to do but read and think, I found myself worrying increasingly about the one per cent and 99 per cent . . .' he wrote.

Meanwhile, the equity markets have been bombarded by bad news in the last few months. The news is complicated and inter-related. 'How one factor, say, 'Greek default', or 'China stumbles' interacts with others such as double-dipping economies and generalised financial crisis are impossible to know,' he said. 'One can only make more or less blind guesses.'

Looking out a year, the overall picture seems so much worse than the generally benign forecast of 4 per cent global growth from the International Monetary Fund.

'The probabilities of bad outcomes are not as high for us today as they were in early 2008. But the possibility of extremely bad and long-lasting problems looks as bad to me now as it ever has,' he said.

Record margins

Curiously, the S&P 500 - unlike other global equities - has hung in there and staged rallies whenever the bad news eased. A model developed by Mr Grantham and his colleague showed that the US market's performance can be explained by three factors: general good news, profit margins and inflation.

Inflation is benign now, and profit margins in corporate America are 'weirdly' at record levels. This explains why the US markets would rally whenever the negative news cools.

'But the longer you look at these record and still-rising margins and compare them to the miserable unemployment and substantial spare capacity, the stranger these high margins look.'

The margins will come down to more normal levels eventually. Probably by then, the negatives would have resolved themselves. If not, the US market could decline a lot, and test his 'No Market for Young People' thesis.

The thesis is this. All major equity bubbles broke way below trend line values and stayed there for years. But ex-chairman of US Federal Reserve Alan Greenspan and his successor Ben Bernanke introduced an era of effective overstimulation of markets which has resulted in 20 years of overpriced stocks and abnormally high profit margins.

Therefore, the markets didn't even reach their trend line in 2002, and took only three months to recover to trend in 2009. But now, with wounded balance sheets and perhaps an empty arsenal, the next bust may well be like the old days.

GMO looked at the 10 biggest bubbles of the pre-2000 era and calculated that it typically takes 14 long years to recover to the old trend. It will not be a pretty picture if that happens.

All the negatives out there notwithstanding, the fact is global equities are getting cheap.

The average growth estimate for Europe, Australasia and the Far East, emerging and US high-quality stocks was almost 7 per cent per annum real on GMO's seven-year forecast.

Good showing

This explained his recommendation of maintaining a near normal weight in global equities. In fact, GMO has adopted this position since July and it has a good report card to show for it. Preliminary numbers indicated that its largest equity strategy, GMO Quality, outperformed the flat S&P 500 Index by 9.1 per cent year-to-date net of fees yet.

Its GMO Global Balanced Asset Allocation Strategy, meanwhile, is 4.2 per cent ahead of its benchmark.