This Bear Is Buying (Certain) Stocks
When you look at what's going on in Europe and Japan, and the massive problems that we still face in the U.S., it's hard to be bullish these days. And Jeremy Grantham isn't.
But, surprisingly given his gloomy views, he finds some stock groups attractive. What he likes: large-capitalization foreign stocks, emerging-markets stocks and high-quality U.S. stocks. I think his bearish views, as well as his stock picks, are right on the money.
Primarily because of the European debt crisis, Grantham, chief investment strategist for GMO, a Boston institutional money manager, is more bearish than usual. He finds the euro zone's seemingly never-ending inability to put its problems behind it a "terrifying situation." As a result, Grantham advises clients to "be more cautious than usual."
Apart from the crisis, economic growth in the developed world is slowing as populations age and nations devote an inexorably rising amount of their budgets on the elderly, Grantham says. Those headwinds are only likely to worsen.
The U.S. faces special problems, Grantham says. Its infrastructure badly needs rebuilding. The quality of education and training has declined markedly, and government seems unable to even try to grapple with long-term issues, such as the debt overhang and climate change.
Sounding a bit like a member of the Occupy movement, Grantham bemoans rising income inequality in the U.S. He says it has become much more difficult for poor people to advance economically than it was a generation ago. American society, he says, is less upwardly mobile than even England's.
One result of this trend is the erosion of economic balance. Luxury products sell well because the wealthy can afford to pay for them, he says. But middle- and working-class people have trouble paying for moderately priced goods. This leads to "weaker and more unstable growth." The U.S., Grantham says, "looks like a plutocracy, and a rather mean-spirited one at that."
When the economic news brightens, however briefly, stocks rally because inflation remains benign and corporations continue to produce remarkably strong profits. But profit margins "will come down to more normal levels eventually, of course, and when they do they will bring the market down with them," Grantham says.
If Grantham is right, U.S. stocks face rocky times ahead. Grantham says that "fair value" for Standard & Poor's 500-stock index is about 975 to 1000. If the S&P dropped to fair value, prices would tumble roughly 20% from the S&P's December 13 close of 1226.
Grantham lays the blame for our current mess on Alan Greenspan. The former Federal Reserve chairman, says Grantham, "introduced an era of effective overstimulation of markets that resulted in 20 years of overpriced markets and abnormally high profit margins."
If the past serves as a good guide for the future, we may be in for a few more bad years. GMO has studied the ten biggest financial bubbles of the pre-2000 era and has calculated that it typically takes 14 years to recover once they burst. Grantham doesn't argue this, but I will: Our stock-market woes began in 2000, suggesting that we face only a couple more lousy years.
Grantham is a savvy market watcher, and he's been more right than wrong over the years. So what's an investor to do with his depressing stew of opinions and information?
My strategy is always to watch closely what a money manager does and to pay less attention to what he says. And here Grantham and his firm are surprisingly upbeat on some types of stocks.
While avoiding low-quality U.S. stocks, GMO has a "near-normal" weighting in foreign stocks and high-quality U.S. stocks. Grantham has been flogging shares of superior companies for years, and I think he's 100% right. By high quality, he means companies that carry relatively little debt, have high and sustainable profit margins, are well suited to fend off competition and pay dividends. Most of the companies that meet these qualifications are large, often huge.
In its latest forecast of seven-year returns for various investments, GMO says high-quality U.S. stocks should return 7.9% annualized. The firm predicts that emerging-markets stocks will return 8.1% annualized and that stocks of large companies in developed foreign lands will return 8.3% annualized. Returns of that magnitude may seem modest, but they'd be quite enough to make me happy.
The reason for GMO's optimism on these types of stocks: price. Foreign stocks, including emerging-markets stocks, are trading at roughly ten times anticipated earnings for the coming year. Even if earnings disappoint, these stocks may not have far to fall. High-quality U.S. stocks are also unusually cheap.
Long-term bonds, Grantham warns, "are desperately unattractive." I couldn't agree more. The bond bull market has lasted far longer than most analysts, including me, thought it would. But it will end, and it will end badly for many investors.
The bottom line: The headlines probably won't turn cheery anytime soon, so don't expect volatility to subside. But if you invest in the right corners of the markets -- blue chips, in the U.S. and abroad, and emerging markets -- you'll probably make decent money in the coming years.
Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C. area.