According to James Montier, now is the time to allocate away from U.S. equities and into emerging markets.
Montier is a member of the asset-allocation team at Boston-based Grantham, Mayo, Van Otterloo & Co (GMO). Before joining GMO in 2009, he was co-head of global strategy at Societe Generale. He's a regular contributor to GMO's library of white papers and research studies on topics ranging from productivity to strategic asset allocation to contrarianism, and more.
But Montier’s message is not new for those who have followed GMO. For the last decade, GMO has consistently forecast poor performance for U.S. large-cap equities.
And it has been wrong.
Its widely followed seven-year forecast has predicted annual returns at or below zero for large-cap U.S. equities, but the actual returns were approximately 250% over the last decade.
Montier was a keynote speaker at the Inside ETF conference in Hollywood, FL, on January 28. His talk was titled, “Late Cycle Lament.” Here is a link to the slides from his presentation.
As of December 31, 2019, GMO’s seven-year forecast was for real annual returns of -4.9% for large-cap U.S. equities and 8.2% for emerging market equities.
Montier said that one of the most common behavioral biases is over optimism, and it is, “pervasive and dangerous” late in the business cycle. It causes investors to overestimate returns and underestimate risk. He warned that investors are doing just that by allocating toward U.S. equities.
He acknowledged that 2019 was a banner year for equities, but was peculiar because growth outperformed value, as it has done for the last decade. The same was the case with U.S. versus non-U.S. and large-cap versus small-cap equities.
“That upended many deeply held investment beliefs,” Montier said.
Why did this happen and will it continue?
Montier acknowledged that GMO has not been fans of the U.S. equity market for a while, and that it has been painful. U.S. real annual returns were 7% while the rest of the world returned 2% over the last decade.
For the next decade, that is likely to reverse, he said.
He showed data that the current business expansion is the weakest, slowest and longest post-war expansion. Productivity has been slower than GDP growth and real wages have barely grown. The gains in the post-Reagan era have been captured by a relatively small number of people, he said – mostly the top 10% of income earners.
That inequality is not a good foundation for a repeat of strong equity performance, according to Montier.
But can earnings come to the rescue? He said they have grown slightly slower than GDP, so stock market performance hasn’t been about GDP or earnings growth.
“It’s about stocks and multiple expansion,” Montier said.
Montier cited a commentary by John Hussman, who quoted Robert Rhea that, in the last phase of a bull market, “speculation is rampant – a period when stocks are advanced on hopes and expectations.” You don’t want to buy when speculation is rampant and the market is rising due to multiple expansion, Montier said.
Comparing the US to the rest of the world, Montier said the difference is not due to sales growth, although margins in the U.S. were slightly higher. Buybacks have been a significant part of the U.S. outperformance (outside the U.S., corporations have been net-issuers), making them the biggest fundamental contributor to market performance.
The US outperformance was due to buybacks and multiples, Montier said. Can that continue? Looking at valuations, the U.S. has a Shiller P/E of approximately 27, while the rest of the world ex-U.S. is 15 and the emerging markets are at 13.
“You don’t want to bet on multiple expansion,” Montier said.
To get a reasonable return from U.S. equities, you must believe that multiples will expand. To get to 5.7% real returns on U.S. equities, U.S. equities would need to go to a spot P/E of 32, which he said would be three standard deviations higher than peak spot P/Es.
“We are in a bubble,” Montier said, which he defined as a, “suspension of beliefs.”
How much must you suspend beliefs? To get reasonable returns from profitability growth, our profitability would need to increase from 7.1% to 10.2%, which is a four standard deviation event, Montier said. That would require every company to achieve the profitability of the FAANG stocks.
If it is about profitability growth and yield, he said we need a six standard deviation event.
“We are in the realm of extreme disbelief,” Montier said.
Could buybacks drive the market higher? The problem, he said, is that every company cannot pursue buybacks simultaneously. That creates a systemic vulnerability, through excessive leverage. Corporate debt-to-GDP has risen steadily since World War II. It is not a catalyst of a bear market, he said, “just a vulnerability.”
Montier said he doesn’t know what will cause this trend in leverage to end, just like he can’t say in hindsight why the dot-com bubble or the Japanese bubble peaked when they did. “All you know is that there are risks out there that are not worth paying a premium multiple for,” Montier said.
But that is exactly what investors are doing.
Investors are underwriting those risks at nearly 30-times earnings. A quarter of U.S. firms are not profitable, according to Montier, regardless of what measure of accounting one uses (GAAP or something else).
A “stunning” 82% of IPOs had negative EPS in 2019, Montier said, which is higher than at the peak of the dot-com bubble. “It is the same appetite for insanity.”
The key threat to U.S. firms is impaired cash flow, according to Montier, which could come from a cyclical downturn.
Cash flow closely tracks NIPA profitability, he said. But NIPA profits are at nearly their highest level since 1980.
How investors should allocate
A 60/40 portfolio will generate very low returns – between 0 and 3% – not enough to finance anyone’s investment expectations, he said.
“You have to be different, which is hard,” he said.
Two hurdles prevent us from being contrarian: human nature is social and we like a safer, warmer environment that breeds conformity; our brains feel social pain the same way we feel physical pain. The second reason is career risk, which Jeremy Grantham has frequently cited. That leads to momentum in stock prices and movement away from fair value.
“The challenge is to dare to be different,” Montier said.
That means emerging market equities, and the perception that they are riskier is not as true as it was in the past. He cited data showing that multiple and GDP growth in those markets needs to be much more modest than in the U.S. to achieve reasonable investment returns.
Montier said that GMO owns essentially no U.S. equities in its asset allocation strategies. It has 30% in emerging-market value equities, plus a “big allocation” to alternatives and 22% in fixed income, including 10% in U.S. TIPS.
More ETF Topics >
According to James Montier, now is the time to allocate away from U.S. equities and into emerging markets.