Hi Guys,
Recently, MFO member Ted referenced a 7-year forecast generated by the honorable GMO investment advisory firm. Here is the Link to the GMO graphic that captured my attention:
http://www.ritholtz.com/blog/2013/08/gmo-7-year-asset-class-real-return-forecasts/print/Thank you Ted.
The bar chart certainly should focus your attention too. Just look at the disparity for the negative returns for both the US Large and Small Cap components, especially when contrasted against the more normative predictions for the Emerging Market sector. If you trust this forecast, you will surely consider a major asset allocation adjustment.
However, for the moment, please keep your powder dry. How accurate and reliable is the GMO forecast? That’s a particularly relevant question now given the popular excitement that usually accompanies Jeremy Grantham’s inspired releases. He is a genuinely respected expert in this arena. Here is an internal Link to a post that I contributed earlier on this matter that focuses on scoring market prognosticators:
http://www.mutualfundobserver.com/discussions-3/#/discussion/7332/time-to-look-again-at-emerging-markets-equityThe current July 2013 GMO report takes a dramatic negative position with regard to projected US equity returns. GMO forecasts that US Large Caps and Small Caps will deliver a -2.1 % and -3.5 % annual real return. respectively, in this upcoming 7-year cycle. The firm also projects a very positive outlook for the Emerging Market group.
I honestly do not know anything about the GMO methodology. Their criteria are a black box to me. I can not make any judgments about their Emerging Markets forecast since I don’t understand the mechanisms that govern its behavior or evaluations. In contrast, I do have some resources and perceptions with regard to the US marketplace. So I’ll limit my submittal to an assessment of GMO’s predictions in that area alone.
According to the CXO Advisory Group Guru scorecard, which was maintained and faithfully executed for a long time, Jeremy Grantham was correct 47.5 % of the time in 37 scored prediction instances. Not all that bad, but not great either. This is really only half the story since we don’t know the magnitudes of the gains or losses associated with each decision. However, it is a cautionary note; Grantham, is not omniscient.
Given these observations, I was motivated to do a few simple calculations. I’m sure the details of that analysis will bore you, so I’ll immediately summarize my basic conclusion: GMO is very likely wrong with respect to its US forecasts. I say “very likely” because nobody can forecast the future with precision. It’s uncertain and is best characterized in terms of probability odds.
Here’s why I disagree with the GMO projection.
Basically, GMO ignores Base-Rate considerations in their projections. The S&P 500 (Large Cap proxy) has produced 6.5 % annual real returns over its entire history. If you did no analysis whatsoever, a respectable zeroth order estimate for the upcoming 7-year stretch would be the same 6.5 % annual Base-Rate.
The GMO projection is a heroic departure from that baseline standard. Is it correct? I’ll not be dogmatic on this matter; I’ll allow my calculations to guide my likelihood decision.
My analysis exactly follows the modeling and procedures outlined in John Bogle’s “Common Sense on Mutual Funds” book. The methodology is reported in Chapter 2 of that classic tome. The analytical procedure accepts the Occam’s Razor simplicity analysis approach.
Annual Real Return is equal to Dividend Rate plus Earnings Growth Rate plus any annual speculative change in the Price-to Earnings (P/E) rate ratio. By focusing on Real Return, inflation is nicely removed from the equation.
I examined a bunch of scenarios using the WSJ’s reported current dividend rate (2.05 %) and an average of the past and forecasted P/E ratios (approximately 15). That P/E ratio is approximately in neutral territory; many experts believe that above that tipping point, markets are overvalued with downward pressures suggestive of a regression-to-the-mean likelihood, and below that threshold, the reverse is probable.
If investors have neutral feelings over market prospects ( P/E ratio remains near its current level), then over the 7-year upcoming period, earnings growth must be a -4.1 % annually to satisfy the GMO prediction. That is highly unlikely since historically earnings growth rate has been more like in the plus 3 % range. That 3 % target results from a roughly 1 % demographics growth and a 2 % productivity enhancement.
An alternate way to test the plausibility of the GMO forecast is to calculate what the change in the speculative component (the P/E ratio element) must be to satisfy the GMO real returns prediction. That balance is easily done again using the Bogle formulation.
If historically conservative earnings growth rates of 2 % and 1 % are introduced into the equation, a P/E ratio change range of -6.1 % and -5.1 % annually is required. That too is a highly unlikely outcome. It demands a consistently pessimistic cohort of market participants to make the GMO prediction work.
If the GMO forecasts prove to be in the ballpark, the accompanying P/E ratios would need to be in the 10 range. Unless attitudes and perspectives dramatically change, the US investors would never allow that to happen, at least for very long.
Based on the simple Bogle model and the historic Base-Rate market returns, I reject the GMO 7-year US equity forecasts. The probabilities of their forecast ever becoming a reality is remote. In this instance, commenting only on the US equity segment of their forecasts, I believe that GMO has missed the mark by a huge margin.
Making a few numbers and resorting to Base-Rate data are always useful tools when doing a sanity check. In this instance, the overly aggressive negative predictions for the US equity markets are exposed as very low probability events.
Given these poor likelihood odds, I’ll not act on the GMO US equity estimates. I’ll not abandon my US equity portfolio holdings, at least not based on the uninspired GMO forecasts that I consider flawed.
Regardless of my negative assessment of the current GMO forecast, I still consider that outfit a respected market analytical powerhouse. They do good work. In general, when GMO speaks we should always listen, but not always immediately accept their judgments. A little independent analysis helps to challenge outrageous,outlier predictions.
Please share your opinions on this crucial portfolio matter.
Best Regards.
Comments
◾His forecasts are generally long-term, but he occasionally comments about near-term expectations for the overall U.S. stock market. Evaluating long-term forecasts is problematic due to difficulty of constructing a large sample of reasonably independent forecasts.
◾He develops forecasts based mostly on fundamental valuation and macroeconomic/financial analyses, as modified by the effects of the Presidential term cycle.
◾Jeremy Grantham has been mostly negative about the prospects for U.S. equities (apparently since 1994), but not for international equities.
◾Jeremy Grantham’s forecast sample size is very small, so confidence in the measurement of his accuracy is very low.
His strong pessimism drives GMO managed funds toward the most stable (large capitalization) value stocks, and these funds have performed fairly well (reflecting perhaps a value premium rather than market timing).
Source: CXO Advisory
They have very good track record indeed, starting from predicting bull run in 1982.
He predicted the following, all the based on reversal to the mean
- In 1982, he said U.S. market was ripe for a "major rally."
- In 1989, he correctly called the top of the Japanese economy.
- In January 2000, he warned of an impending crash in tech stocks which took place two months later.
- In April 2007, Grantham said we are now seeing the first worldwide bubble in history covering all asset classes.
- They also predicted the outperformance of many of the asset classes that were cheap in 2001, REIT, Smallcap value, Emergin Market, etc.
GMO's predictions are based on the idea that profit margins and price-earnings ratios are mean-reverting over a period of years. Here is the link to Duke University professor Edward Tower' study on their predictions
http://public.econ.duke.edu/Papers//PDF/GMO_Predictions1.pdf
In fact, Mr. Tower participated in the discussions with Boglesheads in Diehard forum at M* after he published this research.
To me, their 7 year forecasts vs their actual investing is something that I can loosely co-relate to M* fund rating. One is quatitative/automated, based on risk adjusted returns at M* and based on the theory of reversion to the mean, other is qualitative (Fund ratings by their analysts at M*, and inidvidual fund Mgr/committees view, etc. at GMO.
I have seen numerous posts here as well as M* mixing-up these two.
Earnings are mean reverting. Inflation/deflation deviates from stability. What is "required" to fall back to "trend" (or below) is not as substantial as assumed, once these factors are given their appropriate ranges.
I have vivid memories of 2008-09, and of 2001-03, and of 1974-75 to know that falls in market value can be quite large.
I do not dismiss their prognostications lightly.
(Not invested in any GMO funds)
I really do appreciate your fine contributions that significantly enhanced the practical usefulness of my original posting. Truly independent, diverse opinions enlarge on the subject’s scope and make for better decisions, especially when presented in an honest, friendly manner. You guys did that.
Let me reiterate my respect for Jeremy Grantham and his fine organization. I definitely do not “dismiss their prognostications lightly”. That is the precise reason why I did my own meta-forecast (long-term, broadly overarching by design).
The marketplace is largely populated by smart folks whose informed actions neutralize each other with their fierce competition. Grantham and company are the elite among this smart cohort. I have had the good fortune of listening to three lectures given by Grantham, and exercised the opportunity to question him on one of those occasions. He is indeed an honest, dedicated, and ultra-smart market advisor.
But smart people do not always make smart choices or prescient decisions. Gary Belsky and Tom Gilovich’s book “Why Smart People Make Big Money Mistakes” partly provides an answer. Given the same data sets, we often interpret them differently, suffer behavioral biases, and choose opposite sides of the transaction. That’s why markets and capitalism works.
We’re all familiar with faulty assessments that lead to bad decisions. It has happened throughout history, even among the elitist segments of our population. At one point, China ruled the world with its inventions and outsized naval fleets until a single ruler disastrously decided to burn all his ocean-going ships. He isolated his country to foreigners and trade. On that one bad decision, China dropped from its number One slot as a world economic leader to almost a non-entity for centuries.
In the economics community John Maynard Keynes made and lost fortunes several times with his beauty contest approach to investing, He also said (1927) “We will not have anymore crashes in our time”. Remember Yale economist Irving Fisher’s infamous 1929 claim that “Stock prices have reached what looks like a permanently high plateau” immediately before the crash.
Scientists are also not immune to the bad decision disease. Isaac Newton lost a fortune in the South Sea bubble. By the way, he also incorrectly formulated his optics theory based on some data that later investigators discovered were fraudulently fudged to match his model. People are not perfect.
Apparently my initial posting was either not clear in some areas, or was misunderstood. Either way, it’s my fault so allow me to clarify.
Inflation was not a part of either my analysis or the GMO projections. We both completed our calculations based on real returns only, specifically excluding the need to forecast inflation dynamics. Inflation is a daunting challenge, especially highly uncertain worldwide. So we both chose to exclude the inflation dimensional complexity from our assessments. Both our analysis will fail if the world experiences some wild inflation excursions in the upcoming 7-year period.
Keep in mind that the Bogle model uses earnings growth rate on an annual basis in its formulation. There is a very tight correlation over many decades between corporate composite earnings growth rate and GDP growth rate.
As I mentioned earlier, the two dominant factors to GDP growth are population expansion and productivity gains. Given the worldwide clamor to immigrate to the US, our population will continue to expand. Given our national commitment to fundamental research and product development, I can not imagine our productivity ever going into negative territory for an extended period.
Therefore, GDP should grow over a 7 year stretch, although minor downward excursions are plausible. This means that earnings growth rate, when integrated over that same period, should also be a positive contributor.
I concur that the market is not immune to recessions. Bad stuff happens, and is likely to happen within the 7-year timeframe of the forecast. But the same history cited by MikeM also demonstrates our recovery resourcefulness. Indeed 1974-75, 2001-03, and 2008-9 were wealth eroding periods. We will surely experience similar cycles again; that’s built into the nature of a capitalistic system.
But in each instance, we recovered relatively quickly. Our marketplace has proven its resiliency. It will do so in the future. I believe that a continual 7-year downward cycle of productivity loss, or its equivalent negative corporate earnings growth rate, is highly improbable.
So I choose not to bet against our historical performance. Betting against the odds may be exciting and rewarding occasionally, but is hardly ever profitable over the long haul.
MFO provides a terrific forum to exchange divergent viewpoints, We should all benefit from these discussions if conducted in a polite, honest way. I think we did that on this thread.
Please do not extrapolate my present disagreement with the GMO US equity forecast into the future. This may prove to be a one-shot event. Note that I did not take issue with their foreign market projections. Overall, from my limited perspective, GMO is a reliable and trustworthy operation.
In this singular instance, I take exception to the GMO forecasts. I am always suspicious of anyone’s forecast, mine as well as the GMO version. The most probable returns outcome is likely to find an equilibrium between both of our estimates. Predicting is a hazardous business.
Once again, thank you all for your outstanding commentary.
Best Wishes.
David
Also, I believe that GBMFX history as an open mutual fund is very short. If I understand it correctly, for quite a long time it was kind of internal fund in GMO, which great flexibility and absolute tax inefficiency. You can understand it by comparing its NAV price at Yahoo, which practically did not change from 2003 to 2008, and the M* chart which shows that it gained a lot during the same time. These charts strongly disagree because of great drops in NAV in the end of each year due to the distributions. It seems to be very different now, it is rather tax efficient, its NAV slowly grows since 2009, but its overall performance is much less exciting than it was in its early years. The story may be similar to what happens when the hedge funds become regular funds, but continue using the history of their prior returns. I confess that my study of this fund was incomplete, so you may try to research it on your own.
Hi David,
Thank you for participating. That alone guarantees an expansive readership.
Wow, that’s quite an astute recommendation to examine the asset allocation of the GBMFX fund to gain insights into Jeremy Grantham’s market actions relative to his forecasts.
According to Morningstar, he is eating his own cooking with his heavy two-to-one commitment to foreign holdings over US equity positions. Perhaps his confidence level in his forecasts might be viewed as thin given that one-quarter of that fund’s portfolio is currently sequestered in a Cash account. It certainly is not a damn the torpedoes, full speed ahead endorsement.
And what about that exorbitant entry level price tag? Again referencing Morningstar, a 10 million dollar opening commitment is required; that is a bit pricy for a few MFO members. I guess he’s strategically operating that specific offering like a Hedge fund. In no way would I deny him that option or opportunity.
Apparently, other financial institutions are providing indirect access to GBMFX at significantly lower entry obligations. Wells Fargo lists one such product, its WARAX fund which only reinvests in the Grantham billionaires product . But that Wells Fargo offering carries a heavy weight front-end load fee.
In a composite sense, the total fees working through Wells Fargo seem massive, thus reducing any likelihood that the small investor can benefit from Grantham’s wisdom, at least in that fund.
Where are the mutual fund angels?
But why worry? It’s not the end of the investment world. As cartoonist Charles Schulz correctly observed: “It’s never the end of the world. It’s already tomorrow in Australia.”
Best Wishes.
:
Hi Andrei,
Thank you for your research on this matter. I did download your referenced paper, but only glanced at it. Duke financial professors do good work. But I hesitate to go any further examining GBMFX because of the size of their excessive entry point requirement and/or the multi-tiered fees demanded by secondary suppliers to that fund. So, I’m not in this ballgame whatsoever.
Best Wishes.
You are exactly right. The fund doesn't reflect their forecasts. None of their products really do. Perhaps only Grantham's management of his sisters assets may come close.