In GMO’s April 2010, Quarterly Letter, Playing with Fire (A Possible Race to the Old Highs), Jeremy Grantham makes two seemingly contradictory statements. First he reports that the line of least resistance is for the market to move to the 1500 to 1600 range over the next 18 months from a today’s range of 1200, and then he goes on to state that the market is “very overpriced”.
How is it that a well respected money manager can make such a statement and what led him to this conclusion? It’s our best guess that Grantham’s analysis is based, at least in part, on the P/E10 ratio, which could lead one to make a statement like Grantham’s.
The P/E10 ratio was invented by Robert J. Shiller, a distinguished professor of economics at Yale University, and is widely used by top money managers to determine market valuation. In 2001, Shiller published the paper “Valuation Ratios and the Long-Run Stock Market Outlook,” which put forth his view that stock market returns are hard to forecast in the short-run, but the simple theory of mean reversion is basically right and can be used to predict long-term real stock market returns. While the P/E10 ratio is a good predictor of long-term stock market returns, it can stay in overvalued or undervalued ranges for long periods of time and it is therefore not a short-term market timing tool.
We believe that Grantham’s statement is based on comparing today’s P/E10 ratio to both the average of the market’s history and the average of the past 20 years. As of April 15, 2010, today’s P/E10 ratio stands at 22.04, the market’s historic average is 16.3, and the average for the past 20 years is 26.09. Therefore, depending on how you believe the market will behave (i.e. like its 139 history or like the past 20 years) you can arrive at Grantham’s statement.
In our opinion, Grantham’s statement reflects a belief that the market should be viewed in context of its entire history (i.e. that it’s overvalued by 35.2 %), but that the majority of investors will exhibit behavior similar to what we’ve seen over the past 20 years (i.e. that the market is 18.4% underpriced and will move into the range of 1500-1600). Additionally, our analysis shows that the fair value P/E10 range is 15 to 20, or a market value of 825 to 1100. Therefore, the statement that the market is “very overpriced” is a bit hyperbolic, but one can still say that the market is moderately overvalued.
A copy of the letter can be found at www. GMO LLC.com
A comprehensive discussion of the P/E10 ratio can be found at element-alpha.com under the Market Valuation tab.
Disclosure: No positions