BAYZF - GMO's And Bridgewater's Analyses Imply Markets Currently Overvalued By Up To 40%

Summary

• GMO and Bridgewater recently published research notes that paint an unfavorable picture for US equities.
• According to GMO, US Large caps are forecast to return -1.6% after inflation over the coming 7-year period.
• Bridgewater Associates believes that the only way to slay inflation is a recession, which would entail a 20% drop in corporate profits.
• GMO and Bridgewater are eventually talking about two sides of the same coin.
• Their beliefs and forecasts imply that US stocks are overvalued by 20-40%.

GMO, a large hedge fund founded by Jeremy Grantham, recently published its 7-year predictions of real returns for various asset classes. Its forecast doesn't paint a rosy picture for US equities: according to its analysis, holders of US large caps and small caps are bound to lose 11% and 12%, respectively, in real terms in the upcoming 7 years.

Grantham has received a lot of media attention last year when he predicted the market decline . In another recently published note, GMO claims that the 2022 bear market was just the first and easy leg of a longer bear market, predicting a bumpy 2023, effectively implying that the early 2023 run-up in equity prices was nothing more than a bear rally.

GMO is not alone in its gloomy predictions. Bridgewater Associates, whose Alpha Fund outperformed the S&P 500 by 26% in 2022, also predicts a rough patch ahead. According to its analysis, inflation pressures will persist until the labor supply-and-demand relationship gets back into balance; and for that to happen, unemployment needs to rise by 2%. This would be accompanied by a drop in corporate profits of around 20%.

Back of the envelope, that implies at least a 2% rise in unemployment sustained over a long enough period of time to adjust the supply/demand balance for labor, a 2% decline in real GDP, and about a 20% decline in operating earnings as an inducement for the necessary layoffs.

Bridgewater Associates

The most recent inflation figures are supporting Bridgewater's theory that the economy has not yet experienced enough hardship for price pressures to dissipate. January PCE rose 5.4% y-o-y, 0.5% more than expected. If Bridgewater's hypothesis is correct and the Fed is indeed committed to its inflation firefighting, we may see more interest rate hikes and a soft landing is nothing more but wishful thinking.

The S&P is Overvalued by up to 40%

GMO's and Bridgewater's analysis imply an overvaluation of US markets by 20% to 40%. The stock market's expectations about future returns are over-exuberant and are currently not pricing in a double-whammy of lower earnings and higher interest rates. A drop of more than 20% below 3,200 would be a fairer reflection of the S&P's value. GMO's analysis implies that we face the risk of an even more dramatic drop in the S&P 500 to levels in the range of 2,500-3,000. This would bring the index back onto its long-term trend path and provide for expected long-term nominal returns of around 8.5% (6.5% real return + 2% expected inflation) , in line with historical returns.

The S&P 500 does indeed look expensive on a P/E basis. It currently trades at 21x trailing earnings. Last time it was this expensive was during the run-up to the dot-com bubble (I am disregarding recessionary periods which lower the denominator, which leads to a high multiple); and briefly at the beginning of the Trump's administration, before it fell again in 2018.

The picture is even more bleak when looking at Shiller's CAPE (cyclically adjusted P/E ratio), which, despite a recent drop to 29x, is still frighteningly high. While CAPE is not particularly useful to predict market turning points, it is a powerful predictor of long-term returns.

Based on GMO's and Bridgewater's views, we see three possible scenarios how this situation can play out for investors.

In a low-inflation-low-volatility environment, we will see several years of measly annual returns with the S&P trading sideways in a range of 3,800-4,200 for most of the time. Multiples will stay relatively high for the time being before starting to compress as earnings growth gradually returns on course.

In a low-inflation-high-volatility environment, rates will continue to go up throughout 2023 until inflation is brought back into control. We will see a recession coupled with a decline in corporate earnings, investors will lose their nerves and the S&P 500 will drop significantly.

A third scenario is "higher-inflation-for-longer". If the Fed does not bring inflation under control, nominal company earnings may continue to rise, but lag behind inflation. Real earnings growth would be negative while we may see positive nominal stock returns.

While there is not a one-size-fits-all strategy that will outperform in all three scenarios, investors do have choices and alternatives to make tactical adaptations enabling them to lower their investment risk while keeping some options open to re-rotate back into the S&P in case of a broader market decline.

Implications for Your Portfolio

Firstly, be overweight on cash, short-term fixed income securities or term deposits. With one-year treasuries yielding >5% , investors do have a choice to stand by the sidelines and watch the situation unfold all the while earning a positive nominal, risk-free return, unlike the past several years.

Secondly, passive investing may not cut it anymore going forward, at least not until short-term macro risks are not resolved. In order to generate meaningful returns, investors may want to start picking stocks or look for services of professional money managers who will do that for them. We recently identified one undervalued opportunity in German Bayer AG ( BAYZF ) - read our well received analysis here .

As a side consequence, a general underperformance of passive funds and outperformance of active managers could reverse the flow of funds towards active asset managers. In such a case, you would want to hold stocks in companies like T. Rowe Price ( TROW ), Franklin Resources ( BEN ) or Northern Trust ( NTRS ), and consider twice investing in BlackRock ( BLK ). We consider executing this tactical allocation as a bit farfetched right now, but we'll be on our watch.

Thirdly, if you don't mind getting your hands and Excel sheets dirty and do your own picking, avoid highly leveraged companies, in particular those with variable interest rate debt and high short-term refinancing needs. Markets may be overly optimistic about expectations of imminent interest rate decreases. Some highly levered companies, many of which can be found in the real estate sector, may suffer from significant earnings declines caused by higher interest payments.

Fourthly, infrastructure stocks may present an interesting asset class to invest in right now. As a group, infrastructure assets can offer a degree of protection against inflationary pressures while being non-cyclical. However, the definition of infrastructure assets is fairly broad and encompasses a large universe of picks. Investors therefore need to be cautious of the investments' attributes, in particular in regard to the nature and character of revenues, cost structures and balance sheets. The best infrastructure assets are monopolistic in nature and demand-inelastic, enabling them to grow revenues at least in line with inflation. Due to the broad definition of infra-assets, we expect large variances in the returns of individual stocks. We would, therefore, recommend looking for active managers who can distinguish duds from winners such as mutual funds or closed-end ETFs including Cohen & Steers Infrastructure ( UTF ); and avoid blindly investing in passive vehicles like iShares Global Infrastructure ETF ( IGF ) or SPDR S&P Global Infrastructure ETF ( GII ).

Fifth, and last recommendation, with GMO forecasting decent positive real returns for emerging market value companies, investors may want to consider getting overweight in international equities. Those who don't want to get their hands all too dirty may therefore want to have a look at ETFs such as the iShares MSCI Min Vol Emerging Markets Index ETF ( XMM:CA ) or the iShares Emerging Markets Dividend ETF ( DVYE ). However, US investors in particular need to beware of FX risks. The downside of this strategy is that the US dollar may once again act as a safe haven in a time of turmoil (e.g. global recession), so any dividend and capital gains may be offset by losses stemming from assets deriving their profits in foreign currencies.

Wrapping it up

It is certainly not easy to wrap your head around the market & macro environments these days. In the recent two years we have likely passed some structural macro breaks from a regime that lasted for several decades, such as increasing globalization and rising international trade, the inclusion of hundreds of millions of workers in the global labor pool, a stable global political situation, favorable demographics and a low-inflation-high-growth environment. Mr. Market is underappreciating the impact of these breaks on future returns, and he is simply too optimistic, as signified by the high P/E ratios of the S&P 500. Until markets adapt to these structural shifts, it will likely take some time, and we believe strongly that now is the time to be more selective than ever in what you invest in. Investors need to tread the stock market waters carefully.

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