Grantham on the Markets: '860 Is Fair Value for S&P'

Jeremy Grantham has become a familiar and very popular face on this site. For those treasuring his insight, wisdom and prescient calls, the co-founder and soon to be retired chairman of Boston-based GMO has just published the October edition of his quarterly newsletter entitled “Just desserts and markets being silly again”.

Before quoting from the report, Grantham recently put matters into perspective in a Kiplinger article, saying:

The recent rally has been very speculative, favoring risky assets over the past few months. I’m sorry if you missed investing at the market’s March lows, but don’t compound the damage to your portfolio by chasing gains in risky assets. We’re at the beginning of a seven-year period of lean returns. You should only be buying the highest-quality blue-chip com­panies, where valuations are most attractive.

Here are a few excerpts from Grantham’s newsletter.

Corporate ex-financials profit margins remain above average and, if I am right about the coming seven lean years, we will soon enough look back nostalgically at such high profits. Price/earnings ratios, adjusted for even normal margins, are also significantly above fair value after the rally. Fair value on the S&P is now about 860 (fair value has declined steadily as the accounting smoke clears from the wreckage and there are still, perhaps, some smoldering embers). This places today’s market (October 19) at almost 25% overpriced, and on a seven-year horizon would move our normal forecast of 5.7% real down by more than 3% a year. Doesn’t it seem odd that we would be measurably overpriced once again, given that we face a seven-year future that almost everyone agrees will be tougher than normal?

Price … does matter eventually, and what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors. First, the disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems, particularly pressure on profit margins as the quick fix of short-term labor cuts fades away. Second, the slow gravitational pull of value as US stocks reach +30-35% overpricing in the face of an extended difficult environment.

It is hard for me to see what will stop the charge to risk-taking this year. With the near universality of the feeling of being left behind in reinvesting, it is nerve-wracking for us prudent investors to contemplate the odds of the market rushing past my earlier prediction of 1,100. It can certainly happen. Conversely, I have some modest hopes for a collective sensible resistance to the current Fed plot to have us all borrow and speculate again. I would still guess (a well-informed guess, I hope) that before next year is out, the market will drop painfully from current levels. ‘Painfully’ is arbitrarily deemed by me to start at -15%. My guess, though, is that the US market will drop below fair value, which is a 22% decline (from the S&P 500 level of 1,098 on October 19).

Unlike the really tough bears, though, I see no need for a new low. I think the history books will be happy enough with the 666 of last February.

Click here for the full report on Grantham’s reasoning for his cautious stance.

Source: Jeremy Grantham, GMO, October 2009.

Comments

[bbro:]

An S&P 500 at 860 would take it below a 1:1 ratio to NIPA corporate
profits....anytime that has happened it has been a tremendous buy...
with the GDP figures on we get new corporate profits figures.....would
love a selloff but proably not going to get that magnitude.....

Oct 27 06:55 AM

[SeekingTruth:]

I have believed for months that the S&P 500 should be in the 820 to 860 range "at best".
Without the stealth manipulation and control props in place, that's where it would be and it would be a much healthier climate for the small retail investor.
The Most Stealthy Corporate Insiders, Golden Sharks, and Joint Propaganda Magnum Class guys , with the help of their inside Government cohorts have the power now to game the market for max profit no matter what happens , and extreme distortions now also work in their favor more now than ever before.
And , they have the added advantage of taxpayer money to help them accomplish it as well as FED money at zero interest rates.
How Sweet It Is! ------------ for some.

Oct 27 10:18 AM

[CES:]

No comment about predicting the market's value and going on out SEVEN years ahead-what a crystal ball !!!!

Oct 27 01:23 PM

[Adonis:]

I have to agree with CES, seven years is a little too long for me to agree with a market outlook. I do agree that the next 2 to 3 years will be lean. In 2002 how could you ever be able to forsee the events that led up to 2009? Far too long, too many variables.

Oct 27 04:41 PM

[John Mylant:]

Wow, he hit it right on the head when he talks about the earnings the first quarter next year. That is when we won't be hiding behind reduced spending but hit the reality of the slow pace we are in. I am in full agreement. Correction here we come.

John Mylant
mylantsmoneyblog.typep.../

Oct 27 07:19 PM

[gabe borens...:]

As late as mid 2007 ,most of the experts and investors could not accept the notion of potential economic implosion.
In March of 2007 consensus was for a bearish correction.
The market rallied .
Now we are told that the market is over priced by the experts who have missed some key market adjustments
There is no way to quantify the relative value of the market at this stage of the business cycle.
The stock market is a leading economic indicator and as such it reflects an above average expansion in the period ahead.
As such barometer it confirms what is obvious -the catalytic measures in place will create above average business conditions.
All of the bearish nonsense about the U.S economy we have heard long enough.
For myself I can say the following : I was bearish early enough and I certainly was bullish in March.
My opinions were reflected in various interviews with the Bloomberg reporters.

Oct 27 08:02 PM

[megatrend:]

grantham understands the basics. The simple priciples that govern the market. Anytime the markets divert too far from these principles it creates tremendous opportunities for profit. megatrend2010.webs.com

Oct 27 09:06 PM

[Peter Mycro...:]

“Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.” – Sir John Templeton

Oct 27 09:35 PM

[ebworthen:]

New low, gold $2,000, stagflation or hyperinflation.

We've played a good game for the past 25 years.

Where will we get 9 trillion dollars and pay for SS, Medicare, etc., etc.?

Answer me that and I might believe no new low (say, S & P 200) and believe that we really don't understand what we have done to ourselves.

Oct 27 10:17 PM

[sequoiab:]

825

Oct 27 10:25 PM

[optionsgirl:]

LOL,it is printed for us. Thanks to Uncle Ben.


On Oct 27 10:17 PM ebworthen wrote:

> New low, gold $2,000, stagflation or hyperinflation.
>
> We've played a good game for the past 25 years.
>
> Where will we get 9 trillion dollars and pay for SS, Medicare, etc.,
> etc.?
>
> Answer me that and I might believe no new low (say, S & P 200)
> and believe that we really don't understand what we have done to
> ourselves.

Oct 27 10:34 PM

[jse17:]

Bingo!

There is always a second component to these wild predictions even if unreported. Something on the order of but I will show you the way is casually implied. Jeremy has no more of a valid idea of what the market will price out in 7-years than the price of postage stamps assuming they continue to exist!

Clark Gable's famous quote from Gone With The Wind many years back remains valid and applicable even today, "Frankly, I do not give a damn!"


On Oct 27 01:23 PM CES wrote:

> No comment about predicting the market's value and going on out SEVEN
> years ahead-what a crystal ball !!!!

Oct 27 10:46 PM

[Yamaka:]

As per WSJ Market Data, the 12-month forward looking p/e is 17 based on the expected "reported earnings" for the SP500 Index although the 12-month trailing p/e is very high 77.

This tells me that the Market is NOT overly valued, as it looks 6-12 moths ahead of what could happen.

When the short interest rate is near zero and plenty of fiscal and monetary stimuli are in the pipeline, a p/e of 18-20 is easily acceptable valuation.

Therefore, the SP500 Index could very well settle around 1150 before the end of 2010. Afterwards, it depends on where the interest rate would go AND the growth of earnings.

Oct 27 11:36 PM

[bbro:]

825/14151 = 5.82% that's a buy !!!!


On Oct 27 10:25 PM sequoiab wrote:

> 825

Oct 28 03:14 AM

[rick12345:]

Hmm... According to his quarterly report this time last year he predicted the S&P would fall another 50% fom the fair value at the time. The S&P 500 was trading at around 950 then so a 50% fall would have seen a bottom of around 450 - 475. As we all know the bottom was 666 or 800 if we choose to ignore the V shaped anomoly of Feb & March.

"seven-year period of lean returns" . What, are we using the bible to make predictions now ?

Oct 28 05:08 AM

[bbro:]

I want to know what he thinks GDP will be in 7 years.....

Oct 28 05:49 AM

[Michael Clark:]

2009 + 7 = 2016. I'm looking for an economic bottom in 2019. So we're not really that far off.

Oct 28 11:17 AM

[Michael Clark:]

Technical picture of the current indexes:

seekingalpha.com/insta...

We're heading into some more selling.

Oct 28 11:18 AM

[PompanoFrog:]

While I was not able to use the link quoted in this article I feel compelled to comment on this. He offers not one quantitative fact to support a 7 year bear market thesis.

On the other hand, does it make a difference to an investor whether earnings grow at a 5%, 6% or 8% rate. It means little. Investing is about understanding the business/liquidity cycle. All bull markets begin in recessions where the central bank floods the financial system with deposit growth. Money is a real economic factor in a capitalistic system.

During a recession there is little true investment demand for these funds and they leak into the financial markets. Stock markets make enormous moves during this phase. See for yourself. Create a spreadsheet of the S&P 500. Create a column to show 6 month rates of return. Now sort from top to bottom. It doesn't take brain surgery to peruse this list and see what is happening.

The missing link is understanding the money supply transmission mechanism. Money supply not only creates economic activity through bank lending, but also through appreciation of financial assets such as stocks, real estate and bonds.

Especially, stocks. The new wealth created by a stock market move doesn't have to be paid back. Can you imagine what is going on in China where there is little or no taxation on capital.

This is why it is so difficult for a central bank to control a bubble. If the stock market continues to rise due to momentum and/or sentiment it is creating credit and wealth faster than changes in money supply can counter.

I am going to play golf. Good Luck.

Oct 28 12:40 PM