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A Lean, Mean Reversion MachineJohn Mauldin
This week we look at a thoughtful analysis by one of my long time favorite analysts, Jeremy Grantham, on what stock market returns should be over the next seven years, comment on the employment numbers and a softening economy and explore what that could mean to our investment portfolios. If we have enough space I will add a few thoughts on the Fed meeting next week. But first, I would like to thank the people responsible for the enthusiastic and very kind reviews at Amazon.com for Bull's Eye Investing that were posted while I was on vacation (well, OK, one guy just plainly doesn't get it, but you can't please everyone). Jay Kelly writes: "...My guess... At the end of the decade when 'absolute returns' has moved from a semi-fringe idea to a mainstream buzzword, this book will be viewed as THE definitive resource on the subject." And then Salvador Lee writes that "It will change the way you see the stock market. John is superb in this book. The whole book is full of wisdom. John systematically explains why we are currently in a secular bear market and how you should take financial analyst comments with a grain of salt. This book is required reading for anybody retiring within the next 25 years. I rarely read a book twice, I read this book already twice and keep browsing for useful advice. Excellent work by John, you will get your money's worth and more." To see these reviews and more and get a 32% discount, go to Amazon. Stop procrastinating, if you have not yet bought, and buy one for a friend if you have. Outside the Box As long time readers know, I read an awful lot of material each week, from a very wide variety of sources. Some of the best reading I get is sent to me by readers. My reading (and interests) is probably more eclectic than you might think, even though my day job is finance and investing. I have often wished I could give you access to some of the material I see. I have gotten my publisher to agree to start another weekly letter and a website. We are going to call it "Outside the Box." Once a week, probably on Monday evening, I will send you an e-letter written by someone else that I think is interesting and worthy of attention. I will write a two paragraph opening to give you an idea of whether you want to read it. I may or may not comment at the end. We will also provide links to other articles and reports we find of interest. The topics will be quite eclectic. In addition to the world of investing and economics, we will be looking at history, politics, science, book reviews and the odd or unusual. It will also be able to include graphs and charts. In short, if I find it interesting and challenging, if it expands our world and thinking, then it is potential for inclusion. The key is to help us think Outside the Box. We will be starting the letter in late August. You will of course be able to unsubscribe, but I think this is going to end up being one of your favorite letters. And please feel free to submit ideas, research or sources. And now, let's get to today's letter. Fair Value vs. Irrational Exuberance Readers of this letter and Bull's Eye Investing are familiar with Jeremy Grantham, as I freely use his excellent research. He is a highly respected money manager and analyst, in fact almost a guru in the investment industry. His firm, Grantham, Mayo, Van Otterloo (GMO) Advisors, manages over $60 billion. Grantham is a famous deep value investor. He was taking his clients out of stocks in 1998 and 1999 (and even earlier) when--by his calculations--the value in traditional stock portfolios simply got out of line. (This was no small thing, as he had a lot of clients pull billions of dollars in assets because he just "didn't get it." He was right, and now his assets under management have tripled. Score one for the value guys.) Grantham's investment theory is that over time investment classes come back to the average. When asset classes are well above trend he avoids them, and when they are well below trend he buys them. While it can take a long time for some classes to revert to the trend, this style is successful if you have time and patience. Grantham has been very successful at simply investing for the long term using history as his guide. As a student of history, I like his approach because you are able to get on the right side of long-term trends. You will miss bubble tops and get in too soon on irrational bottoms, but patience and time will see you rewarded. Last month, he authored yet another study, giving us an idea of what type of returns we can expect over the next seven years from the US stock market. It will be an excellent place to start this week's letter. The long term historical average of the stock market is a P/E ratio of about 14, but the recent trend line has the P/E ratio at a slightly higher 16, so that is where Grantham starts. If stocks were priced at a P/E of 16, or at what Grantham calls fair value, then you could expect to see stocks yield a 5.7% real (inflation adjusted) return over the next seven years, based upon growth in sales and dividends. (You can quibble with that number a few points either way, but that is not what is important in today's thought process.) Lean, Mean Reversion Machine Stocks are currently at a P/E ratio of 22, based upon 12 month trailing earnings. What, Grantham asks, would be the total stock market return over the next seven years if P/E ratios revert to the mean of 16? Remember my contention that stock market valuations have always proven to be a lean, mean reversion machine. This can be good when valuations are to low, but it is painful for future returns when valuations are too high or above trend. There are four components to the growth of stock market returns. Two of them are real sales per share growth and dividend yields. Grantham expects real sales to grow at about 2.9%, which he admits is optimistic. Sound too low? Long term real sales growth per share has been around 1.8%. Even in the powerhouse 90's, real (inflation adjusted) sales per share growth was a very average 1.9%. Compare this with my study which shows earnings growth for the ten years beginning 1993 was a meager 1% per year or 4% if you included inflation. Grantham, optimist that he is, assumes that dividend yields for the next 7 years will grow to 2.3%, up from the historically low 1.7% at which they are today. Combine these two returns and you get 5.2% growth over the next 7 years (again in real terms). But then it gets ugly. The major component of stock markets returns is either the increase or decrease of P/E valuations. If we see the P/E ratio return to "fair value" or drop from 22 to 16, that reduces returns by a negative -4.5% per year over the next seven years. Again, remember that 80% of the growth in the stock market from 1982 to 1999 had nothing to do with earnings growth or inflation. It was due entirely to an expansion of the P/E ratio, from single digits in 1982 to around 32 in early 2000. What provided the wind in the sails in the boom will be the drag of a heavy anchor as valuations revert to the mean. Profit margins are the final component. Today they are high, almost off the top of the charts, at 7%. Historically, profit margins run around 4.9%. Grantham (again, perhaps optimistically) thinks they will only fall to 6%. Why would profit margins fall? Because as Grantham jokes, "If profit margins do not mean revert, capitalism is broken." What does he mean by that? Any time margins get too high for a business, some competitor looks at them and says, "I can do that cheaper and will be glad to take smaller margins." Competition serves to hold down prices and profit margins. Conversely, when profit margins are too thin, businesses tend to fail thus opening the way for the survivors to charge more. This ebb and flow is part of the business cycle that began shortly after the Medes started trading with the Persians. But if margins begin to erode, their contribution to stock market growth will become negative. Grantham suggests that the result will be a negative real return of -2.1% per year over the next seven years. Adding all four components together, and you get a compound real annual return over the next seven years of a negative -1.7% a year. Add in expected inflation and you still get less than 1% annual returns. Not a thrilling ride for investors expecting 10%. This squares with Yale professor Robert Shiller's study which suggests that investors would be better off in money market funds for the next ten years than to invest in stocks when P/E ratios are in the range of 22, as they are today. More on the negative psychological effect on investors later. What if stocks were to go to fair value or the average historical valuation tomorrow? US large caps stocks would drop -38% and US small cap stocks would drop a negative -41%. International stocks would drop in the neighborhood of 15-16% and surprisingly emerging market equities would not drop at all. Grantham, by the way, sees the most potential upside for emerging market equities over the next seven years, at a compound and cool 6.6%, which I assume does not take into account any drop in the dollar. He compares the potential decline in asset prices over a US and foreign based assets if they all were to hit fair price tomorrow. "This is a fairly brutal looking [set of statistics], but it does strongly suggest that the pain involved outside the US is far less than inside it. In fact, the gap has never been materially higher. It is a two standard deviation event, the kind that should occur randomly every 40 years or so. As such, it represents the single best liquid way to reduce potential pain in ordinary portfolios - that is, by weighting equities away from the US." One last quote before we go on: " ...The US market at 22 times adjusted trailing is priced to return just 3.4% in perpetuity (the WSJ uses 21 times, but their number is unadjusted). This is presumably what Warren Buffet had in mind a year ago, when the market was much cheaper, when he said it was priced to return about 4%. The problem with that 4% and today's 3.4% is that it simply is not going to happen. These returns are far lower than is commensurate with the risk in equities; they do not give enough of a premium over bonds, and most importantly, they are far lower than is expected by institutional investors who are looking for nearly 6% real and individual investors who expect over 10%. And the really bad news about row 2 is that all of the returns are below both investors' expectations and our estimate of fair returns, with only the riskiest category 'emerging equity' priced to deliver a fair return." More on our Recession Watch Now let's put the future price returns of the stock market on hold and let's visit some recent economic news. Remember that two weeks ago I said we needed to go on "Recession Watch." By that, I meant not that we could see a recession or predict one, but that the recovery is now "getting a little long in the tooth." All things come to an end, and we need to start looking for signs of this. In such a mode, negative information becomes a little more meaningful. When you are in the beginning and early stages of a recovery, you can ignore a lot of negative information unless it clearly demonstrates a new trend. One month's number should not set off alarm bells. Today, however, we need to pay more attention. And the numbers this week were feeble. First, today's employment numbers were dismal. Dismal.com noted that "Payroll employment gains were far weaker in July than expected with only 32,000 net new jobs created. The weak result was mainly due to lackluster service job creation; manufacturing employment rebounded. Moreover, the weak June total was revised down, from 112,000 to 78,000 net new jobs." The economy needs to generate at least 150,000 new jobs PER MONTH (and some economists suggest 200,000), to simply keep up with population growth. We have seen only 110,000 jobs in the past two months. This is not a good trend. How, you ask, can the economy be growing and not producing any more jobs than it is? And it is growing by around 3% last quarter. But recall that above 3% growth is required to lower unemployment. You need 1% growth just because of population growth and 2% growth for increasing productivity just to stay even. As the economy "softens" to merely good, it is natural for employment to not grow at a healthy pace. But there is even more to suggest the trend is not our friend. Going to good friend Greg Weldon's Money Monitor of today, he looks deep into the employment survey to find the following tidbits: "Now, we add the latest input from the US labor market figures, in terms of DISTRESS showing up within the data-details, distress related DIRECTLY back to the CONSUMER, and, a STIFF expenditure-headwind. Scalpel please ...
"Okay, we 'could' argue that the glass is half full, with jobs being 'taken,' and income being generated. BUT, we CANNOT envision a macro-nirvana-scenario that INCLUDES workers whose PRIMARY SOURCE OF INCOME ... is ... a PART-TIME JOB!!! The combination of DISCOURAGED job-seekers, and a sudden, sharp rise in workers willing to take multiple part-time jobs ... REEKS of desperation, in terms of GROPING FOR INCOME." The ECRI Weekly Leading Index has now been declining for the last six months. Typically, this index leads the economy by about 8 months. It is not yet signaling a recession, but the clear trend is down and bears repeated watching. Retail sales are soft, and especially car sales. Home loan delinquency rates are close to record levels. Mortgage refinancing, a major source of consumer spending power, is down huge from last year's peak. For the first time in three years, we have no new tax stimulus or payments coming in the summer. The rise in home prices looks to be stalling in many areas. The things which contributed to solid growth in consumer spending in the past few years are beginning to dry up or are not present. All this sounds pretty bad, but as noted above, we are still nowhere close to a recession. It is simply suggesting things are getting "softer." It is something to be mindful of. The economy is not going to fall into recession this quarter or even the fourth quarter or the first quarter of next year. These things take time. There are still some legs in this recovery, and typically the US economy surprises us on the upside, with far more resiliency than one would imagine. My current thinking is that we see more of the same for quite some time. Just a slow tendency to soften - nothing dramatic (barring some major terrorist event.) High energy prices eat into consumer spending potential. The lack of real growth in wages for the past few months slows consumer spending potential. The lack of new jobs begins to eat into consumer confidence. Without real job growth - and this is the key - we eventually slip into recession. Maybe later rather than sooner, but it will happen. Lack of job growth hurts consumer confidence and spending and housing prices. It takes time, of course, but it will happen. Attention, Stock Market Shoppers And now we come back to the stock market. I look for a factor which is going to drive stock prices into a new bull run and I find little to encourage me. Profits are at an all-time high and the recent powerhouse growth in profits (albeit from recession lows) must moderate. Margins, as noted above, cannot grow too much more. Valuations are already high. As Grantham noted, simply coming back to trend, which markets always do, without fail, no exception will mean at best a sideways to down trading channel such as we have seen for some time now. But we are not going to get 7 years with a sideways pattern. At some point, we are going to get that recession. Stock markets drop an average of 43% during a recession. How much above or below that average depends on the level of the recession and the valuation of the markets going into that recession. Given today's high value and the potential for a serious drop within a few years, I see no upside in investing in a long only direction in US equities. We are going to be able to buy these same equities "on sale" in the future. Smart, value oriented investors might be better served by looking for other places for their money than the broad US equities market. With pension funds expecting high market returns and average investors still looking for 10% annual returns, there are going to be some very unhappy people in the next few years. Frustrated investors become poor investors, chasing momentum in one sector or another or giving up entirely. When momentum turns decidedly negative, traders and hedge funds will start to switch their emphasis and the long only investor is going to get seriously hurt. I should fully acknowledge that there are going to be hundreds of stocks which are going to double, triple or more over the next few years. Out of thousands of stocks, they will not be able to hold the broad indexes even, let alone see them increase. The trick in this market is to choose your stocks carefully. This is not a time for index investing. Forever is Longer than Twenty Years Of course, there are very smart people who disagree. You can't time the market, they argue. Listen to Jack Bogle, founder of Vanguard: "The idea is to own the stock market, own every company in America, and hold it for Warren Buffett's favorite holding period--forever. And that's the secret: Own everything, and hold it forever." Of course, Buffet is sitting on $35 billion in cash, with a portfolio of mostly private cash cow type of companies he believes in. He certainly doesn't own every company in America. With that much cash, he clearly doesn't see a lot of value. You cannot time the market on a year to year basis, at least I can't. But there are very clear trends in the rise and fall of valuation which can be useful guides for general timing. Stick to them, like Grantham, and you will outperform the market over time. In fact, do exactly what Buffett does. He buys a small group of companies that he believes have value. If he can't find value, he stays in cash. As I try to make clear in my book, if you have 75 years for your "long run," buy and hold makes sense. But if your long run is 10 or 20 years from now, you better get a sense of timing. There are more than a few periods of 10, 15 and even 20 years in the last hundred or so where you would have been better off in money market funds. They have one common characteristic: they all started with valuations that were close to the level we see today. If history is any indication, valuations will probably be half what they are today in the future. You are going to get another chance to invest at good value in the stock market. Patience, grasshopper. Values always revert to the mean and then go far below the mean. In that future time, I will probably start talking about getting back into the market too soon, eager beaver that I am. But that is not this day or month or even year. If you want to trade, then do so. But this is not the time to put money into an S&P 500 Index fund and plan to hold it for the next five years. The Fed Has to Raise Rates Just a quick note on the upcoming Fed meeting next week. They obviously have to raise rates by 25 basis points. They have clearly signaled that to the markets. To not do so, because of a weak employment number, would simply make the market throw up. They key will be to watch whether or not they change their language. Will they give themselves some wiggle room to stop raising rates? Not raising rates might suggest they think the economy is weakening which would of course, be bad for the stock market. If the employment numbers are weak next month, would a raise hurt as well? Are they damned if they do and damned if they don't? Right now, the clear bias is toward moderate raises at each meeting until rate equilibrium, whatever that is, is accomplished. History suggests they continue to raise rates longer and higher than most observers expect at the beginning of the process. But these are interesting times with few really close parallels in history. The wording in this next meeting release is going to be important. I should note that the Fed funds futures rate does not price in a September increase. Stay tuned. San Francisco, Bermuda, London and Lost Baggage Not quite two weeks ago, my bride and I left for Montreal on vacation, taking a direct flight from Dallas on American Airlines. Somehow, our four bags did not make that trip, even after being market for special handling by the helpful counter personnel. The next day, we find they had been separated, they were not quite sure where they were, but we were ever hopeful. Thankfully, we were staying with Ann and Martin Barnes (the astute and humble editor of the Bank Credit Analyst, who has severely admonished me to never call him frighteningly brilliant again, so I won't). They lent us a few things and were quite good sports as we waited for news. On the third day, most of the luggage caught up with us Quebec City and I got my last bag the next day. We saw moose in Maine, had a wonderful time in New Hampshire and had to come back a day early. I will be speaking at the annual MAR Hedge Fund conference (maybe the largest such conference of the many in the industry). You can find out more by going to http://www.marhedge.com click on conferences. I am speaking three times at
the next Money Show event in San Francisco on September 22-24,
2004, at the San Francisco Marriott. They asked me to pass on
the following note: Attend over 150 FREE educational workshops,
14 panel discussions, and general sessions focusing on economic
and investment presentations and browse over 100 exhibits...
all FREE. For complete details or to register online click the
link below or call 800/970-4355 today. Don't forget to mention
me (John Mauldin) and Thoughts From The Frontline, along with
priority code 003336. I am planning a trip to London and Paris and possibly Switzerland in early September, so September looks to be a busy traveling month. I will try to enjoy the next few weeks at home, staying indoors in the Texas heat. I trust you are enjoying your summer. The Yankees are in town next week, so I will be "working late" with a few friends to see if the Rangers can stay in first place. Texas Ranger fans know we have to wait until September to see if our pitching can withstand the Texas summer. I have promised myself I would not get excited yet, although I am beginning to look to see if I need to cancel any speaking engagements around the World Series week. Your 'quite the October optimist' analyst,
August 6, 2004 Copyright ©2004 John Mauldin. All Rights Reserved. John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Thoughts from the Frontline may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273. This information
is not to be construed as an offer to sell or the solicitation
of an offer to buy any securities. |
