Jeremy Grantham’s asset class projections are worth paying attention to. Grantham has demonstrated a fairly remarkable ability to predict returns on major asset classes. The Economist published an article in August of 2008 that shows just how good Grantham’s asset class outlooks have been for the last ten years. Also to his credit, he specifically told investors to be in cash in January of 2008.
Grantham’s outlook for the next seven years (from October 31, 2008) looks good for major equity classes. For large-cap equities, Grantham is calling for annualized return of 8.4%. He projects that “high quality” domestic stocks will return 12.9% per year (annualized). His projection for U.S. government bonds is 3.8% per year. Grantham also provides projections for the additional value that active management can add, but we will ignore this component for the time being. [Note: Grantham’s projections in the link below are in terms of “real return,” which is return minus inflation. You can get the actual returns by adding 2.5% to the “real returns” because Grantham assumes that the long-term rate of inflation is 2.5%.]
Lowell Herr, at ITA Wealth Management, got my attention when he posted:
Jeremy Grantham’s market calls have been well above average and we can only hope he is right as he peers into his 2009 crystal ball…One might conclude he is using Quantext Portfolio Planning software to come up with his projections as there is a high correlation between Grantham’s projections and what I am seeing with QPP.
I decided to investigate. Quantext Portfolio Planner (QPP) has a baseline setting for the expected return and risk of the S&P 500, as well as for the future inflation rate. QPP’s baseline assumption is for an average annual return of 8.3% per year for the S&P 500, with a standard deviation of 15.07%. The default setting for inflation is 3%. Using these default settings for the S&P 500, QPP projects risk and return for other asset classes. I have used QPP to generate projections for broad asset classes that Grantham provides his forecasts for, using representative ETFs. I have used all default settings and three years of trailing data (through November 30, 2008) to initialize QPP.
To compare Grantham’s projections to QPP’s projections, we must convert Grantham’s annualized returns (compounded or geometric annual return) to average annual returns. There is a simple formula for converting between average annual returns and compounded annual returns (CAGR):
(1 + Average Annual Return)2 - (Standard Deviation)2 = (1 + CAGR)2
The key to converting between average annual return and compounded (or annualized) return (CAGR) is that you must know the Standard Deviation of the asset class. We have used the projected standard deviations from QPP, but the historical standard deviations are essentially identical in this case.
Once we do the conversion, we see a high level of consistency between Grantham’s projections and QPP:
click to enlarge
The Grantham data come from the article footnoted above. We have added Grantham’s projected real return for each asset class to Grantham’s assumption for inflation (2.5%). We then convert from annualized returns to average annual returns using the equation above.
In general, there is a remarkable level of agreement between QPP and Grantham. Grantham’s projections have a projected average return of 9.4% per year vs. QPP’s 8.3% per year. QPP is projecting a substantially higher spread between small-cap stocks and large-cap stocks (the size effect) than Grantham. QPP is projecting a lower return for EAFE (EFA) than Grantham—to the tune of 2.3% per year.
If we simply increase QPP’s baseline assumption for the expected return of the S&P 500 from 8.3% per year to 9.3% per year (to more closely match Grantham) and run QPP, we obtain the following projections:
Grantham’s assumption of a higher return for the S&P 500 impacts QPP’s projections for the other asset classes. The QPP projection for emerging markets now almost perfectly matches Grantham’s, and the projection for EAFE differs by only 1.3% per year.
Grantham’s projection for REITs is 3% per year lower than QPP’s, once we have adjusted the projected return for the S&P 500 upwards. I would hazard to guess that Grantham is handicapping REITs based on assumptions about the duration of the credit crisis. Conversely, QPP’s very high projection for REITs is largely a result of the collapse of the real estate market over the past couple of years. While it is reasonable to assume that this asset class is now more in the high risk/high return category, the projected 16.4% per year seems pretty high.
Grantham’s projections for these core asset classes are consistent with a fairly reasonable long view. Grantham is making a fairly optimistic assessment of the expected returns, of course. From the perspective of QPP, his projections are consistent with raising the long-term expected return of the S&P 500 by about 1% per year. This increase in the equity risk premium propagates through the other core asset classes. I have not delved deeply enough to understand Grantham’s projection that the size effect has largely disappeared. Grantham’s model for projecting asset class returns is based on fundamental variables and this result will require some further sleuthing.
Perhaps Grantham’s most interesting contention is that “high quality” stocks will return an annualized 12.9% (10.4% in real return). This is far above the projection for the S&P 500. What are high quality stocks? Grantham provided a representative list in a recent interview with Fortune, including Coke (KO), Wal-Mart (WMT), Procter and Gamble (PG), Microsoft (MSFT) and Johnson and Johnson (JNJ). If you combined these five stocks in equal proportions in a portfolio, how would they look? QPP (using Grantham’s 9.3% assumption for the S&P 500) projects that this portfolio will return an average of 10.3% per year. That’s 1% per year more than the S&P 500, but it doesn’t get us to 12.9% on an annualized basis.
All of the discussion of QPP so far focuses on long-term strategic asset allocation projections: the fair long-term rates of return. There is another element that drives returns: the tactical component of returns. Asset classes that have out-performed fair value for some period of time are likely to revert downwards, and vice versa. QPP estimates that most major asset classes were over-valued in November of 2007 and now projects that most major asset classes are under-valued. This “tactical” component of projected returns makes QPP more “bullish.” The tactical part of returns is challenging simply because it requires timing of rates of mean reversion.
Previous analyses suggest that investors have become indiscriminately risk averse, and have been attributing risks to a range of high quality firms that are unjustified. My list of representative “high quality” stocks in this category includes JNJ, KO, and PG. At some point, investors will recognize this out-of-balance assumption of risk. At that point, it would make sense for investors to prefer high quality stocks. When retail investors start to send money back into equities, it would be reasonable to assume that they will enter cautiously, and prefer less volatile, high quality firms. This effect could drive higher returns in these stocks.
Frankly, I see the case for high quality stocks in much simpler terms. If you bought the S&P 500 at the start of 2008, you bought a substantial amount of companies with high risks of failure—such as Washington Mutual, Lehman Brothers, AIG, Ford (F), GM, and a host of others. If you could screen out some meaningful fraction of these stocks, you could generate performance that beats the S&P 500. This is why a screen for “quality” makes sense to me. Fortunately, this is not a difficult thing to do.
What does all this mean? Grantham’s outlooks are quite optimistic—and this is quite a change from his perspective only a year ago. Grantham’s current projections look a lot like QPP’s long-term baseline projections. In essence, Grantham is saying that the global markets were massively over-priced before the decline and that they are somewhat below fairly priced now. Grantham’s outlook implies an increase in the baseline return of U.S. stocks (9.4% for the S&P 500) due to the massive sell-off in 2008. REITs are projected to be higher risk and higher return than they were prior to the real estate bubble. This result shows up consistently between QPP and Grantham’s outlooks and makes sense given all of the problems that real estate faces.
The high level of consistency between QPP and Grantham’s outlooks demonstrate that Grantham is mainly betting on reversion-to-the-mean, and that he believes that the capital markets will recover. Grantham’s projection that “high quality” stocks will out-perform is consistent with a range of quantitative analysis using QPP.
Note: Grantham’s new outlook has just come out (December 29, 2008). It is even more bullish on equities than the outlook used as the basis for this article. This is consistent with even greater relative under-pricing due to continued selling since the last update.