By Olivier Le Moal @ Shutterstock.com
Jeremy Grantham’s GMO often offers useful insight. GMO’s head of asset allocation was interviewed by Barron’s recently.
Below are some of the highlights. Emphasis is ours.
Barron’s: You just more than halved the stock allocation in your flagship funds. What’s worrying you?
Ben Inker: We were getting very nervous about how much the markets had gone up. The risk/reward trade-off for equities had really gotten a lot worse than it was in March. Value stocks at this point are trading at some of the widest spreads we have ever seen.
The optimistic scenario is: We get a vaccine relatively quickly, or some affordable, very effective treatment for Covid-19 that allows us to go back to a normal economy. With the extraordinary rally we’ve seen from March, stocks are priced for that outcome. But in the event of that outcome, we expect that the stocks that will go up the most are the ones that got hit the worst on the way down and have not fully recovered. If people are willing to get in airplanes and go to restaurants and to concerts again, well, those companies that took the huge hit should be the biggest beneficiaries.
The less optimistic scenario is: We don’t get something that enables us to bring the economy back to life, and it takes a few very difficult years before we’re back to anything approaching normal. As of March 23, stocks around the world were priced for that. Since then, we’ve seen a rally of 25% to 30%-plus. To put that in perspective, a group of stocks trading at fair value deserves a real return [after inflation] of about 5% a year. So we’ve gotten somewhere between four and maybe as much as seven years’ worth of returns from stocks in seven weeks.
But you still own some U.S. stocks—in case the optimists are correct?
In early April, we were buyers of stocks with a cyclical focus. Certain industries have been hit very hard: hotels, airlines, energy, autos, and certain industrials. Even if the economic problems last a long time, the strongest companies in those spaces will make it through. Now, we’ve just shorted the market against them.
How overvalued are U.S. stocks?
We thought the S&P 500 was really quite overvalued coming into this. Our best estimate of fair value for the S&P is something a little bit south of 2000. [The S&P 500 closed at 2955.45on Friday.] So even at the March lows, it didn’t look cheap to us, but it had just fallen 33%, and the market seemed to be taking the pandemic pretty seriously. So in late March and early April, we were buying risk assets—international large- and small- caps, emerging market stocks, cyclical stocks, high-yield credit. There were a lot of risky assets that were priced with a reasonable margin of safety. And then they all went up.
Does that cause you to wonder if you should tweak your model to take secular changes into account?
Over the course of those 20 years, we have done a lot of digging into our assumptions, to understand where things have played out differently than we expected. One of the striking [observations]: Profitability around most of the world has been stable. Profitability for U.S. small- and mid-cap stocks has been stable. The one place that was absolutely not the case is U.S. large- caps, which have seen profitability, and their apparent return on capital, move up in a way that is fairly unique.
What’s going on?
Some of it is indeed driven by secular change: Health care and tech have structurally higher returns on capital. The U.S. market has more of them than other markets, and their weight in the U.S. has come up. But even more striking is that in the U.S., a tremendous number of industries have become more concentrated—and the profitability of those industries has gone up. One difference between the U.S. and everywhere else is that we have tolerated—perhaps even encouraged—an amount of consolidation that would not be allowed elsewhere. We’ve created oligopolies, and oligopolies have a pretty good return on capital.
They sound like great investments.
One thing you could say—which is almost certainly a bad idea—is, “Well, that’s the trend; let’s assume it continues.” And that would be ever-more industry concentration, and more and more profit would accrete to the very largest firms. That kind of trend is never sustainable, and it’s always dangerous to assume it’s going to continue.
What’s a more likely outcome?
Over the next 20 years, the world will probably be less friendly to the giants than it is today. And I would bet that the next 20 years see a slowly deteriorating return on capital for U.S. large-cap stocks. But it’s not going to be a natural occurrence, driven by competitive capitalism, because we have thrown sand in the gears of competitive capitalism.
How have we thrown sand in the gears of competitive capitalism?
It’s pretty straightforward: We used to have a world where we would not have allowed four wireless companies to turn into three, or seven major airlines to turn into four, because we wanted to maintain enough players to have competition, which is good for consumers. We allowed Facebook [ticker: FB] to buy up companies that could have plausibly become future competitors. That probably wasn’t a great idea. It’s not too late to change our treatment of future potential mergers, and change the way we regulate the companies.
If it is truly the case that social media and search are “natural monopolies,” we understand how to treat natural monopolies. Utilities are a natural monopoly, and we regulate their return on capital. U.S. large-cap companies have been able to get away with profitability that nobody else has, because they don’t have many competitors. Over time, you want a world where there is competition. If there are situations where competition is not possible, society should have another way of dealing with the fruits of that dominant position.
