Beware US Stocks: The Negatives Have Fallen Into Place

by: Jeremy Grantham

Jeremy GranthamGMO's letters to clients are important reading for money managers: Jeremy Grantham's focus on long term investing, asset allocation and valuation gives him broad perspective, and his track record is outstanding.

Mr Grantham admits that his biggest fault is being too early. With that caveat, here's what he had to say about US equities in his April letter to clients:

To a degree I have never seen before, today’s U.S. equity market appears completely unimpressed with the growing list of negatives. There have been plenty of overpriced markets where everything appears to be just fine and you can just about sympathize with that main group of bulls – “The Extrapolaters!” – saying everything is great and therefore the market should keep going up. But, this time, one by one, the negatives have fallen into place...

Let Us Count the Negatives

Interest rates have steadily risen at the short end, and the conundrum of low longer rates is disappearing as they also rise steadily, now to within 0.5% or so of long-term fair value on consensus inflation estimates. And for inflation fearers, the TIPS look even better. It is already easy to hold some cash, and it is becoming easier all the time to overweight bonds over stocks.

Oil and commodities prices have surged under the pressure of global demand. Recently they have also felt some effect from the increasingly socialist and nationalistic policies in South America and from terrorists in Nigeria. These rising prices must put pressure on inflation, consumption, and profits.

Global liquidity, without too much fanfare, has moved slowly and steadily from massive, and seemingly excessive, to increasingly moderate. This decreasing liquidity is an arrow aimed at what had become a global liquidity bubble that was driving global asset prices higher.

Anglo-Saxon housing markets are apparently topping out after having played a strong role in over stimulating consumption. Yet the U.K. market, particularly London, has made a teasing several-month recovery partly under the impetus in London of a large ‘city’ financial bonus year. But market declines, just like rallies, do not run smoothly. What is remarkable, though, is the complete faith expressed in the press that the tiny little weakness is over and a new bull market rules. Importantly, though, it is noted that last year had the lowest percentage of first time buyers for 25 years. That is what breaks all housing markets. The idle rich can keep markets going for a while on second homes and buying to ‘let,’ or rent, but in the end, you need new buyers. Inventories of unsold houses in general have been rising in the U.S., and sales in general have been declining. Prices in bubble cities are off a little. If it is not the beginning of the end, then at least we can see it from here.

The dollar looks increasingly suspect as the future for rate increases looks stronger abroad than here. Given the past rise in rates here, and the average U.S. rate advantage last year, indeed, the 10% to 15% dollar rally does not seem that impressive in hindsight. As relative rates look less attractive here, the dollar might well fall and make investing in the U.S. market less attractive. (Not to mention – almost – the trade deficit going on $900 billion a year and, what is really shocking, that our total imports are almost 60% bigger than our total exports.)

The Epic 23-Year Credit Cycle from 1982 is still the backdrop. Inflation and rates cannot decline much; increases in debt, especially mortgage debt, cannot continue at the recent rates; credit cannot stay so available; and risk premiums cannot narrow much further, unless you want Brazilian debt trading through U.S. governments. But the long, favorable cycle has done a great job in producing a state of permanent confidence in which risk is barely seen to exist.

Very, very high profit margins around the world, but particularly in the U.S., absolutely cannot continue. Exhibit 1 shows the U.S. picture. If global high profit margins cannot produce offsetting increased investment and competition, something very odd must have happened to capitalism. Look at Exhibit 1 and make your own guess about the timing of a decline, but now looks good to me.

Chinese labor, cheap and plentiful, has been said to be a reason for high profit margins, but surely Econ 101 would say that any resource equally available to everybody will pass through the usual competitive system that ends with a fair return on capital and no more. Only if cheap Chinese labor helped us and no one else could it be a permanent contributor to our high profit margins.

The Presidential Cycle effect ain’t what it used to be, at least not recently: last year’s market was not strong, but unexpectedly up a little rather than down, helped perhaps by Greenspan’s retirement. Now, though, Bernanke has an opportunity to behave in a Presidential Cycle way. If I were he, and wanted to stay in good standing with the administration, I would go for one or two extra quarter points this year so I could cut rates more next year. Remember, only increases in employment in the last 2 years move the vote. If he does this, it will help the infamous year 2 market to be weak, and year 3 to recover a bit, as nature intended.

The savings rate has declined year by year for a decade, often unexpectedly. This has created an equally unexpected series of strong consumer years that are in turn so good for profit margins. Under the influence of some of the factors discussed above, and particularly rising rates and stalling house prices, surely savings will rise a little, causing consumption and profits to be a little less than expected.