Here's something that should scare you: If the market reverts to its average valuation using finance professor Robert Shiller's CAPE measure, then the S&P 500 (SNPINDEX:^GSPC) at its current level of earnings should be around 1,100 rather than its current height above 1,500. That's almost a 30% drop from current levels.
But even if the overall market is overpriced, you can still find opportunities. There are just fewer of them. This is where Jeremy Grantham of investment management firm GMO says to focus: on the nooks and crannies of the market. Think of it as looking under your couch cushions for that spare change among a set of furniture with little else to offer.
Just where are these nooks and crannies? Why is everything else potentially so overvalued?
Reasons to fear
Grantham rails against the Federal Reserve's policy in his recent Q4 letter:
The longer the engineered rates stay below true market rates, the higher asset prices become. ... [Then] a long period of over-investment begins and returns are bid down and everything moves into balance, often helped along if asset prices get too high, as in 2000 and 2007, by a good healthy market crunch. (This strategy will be seen in future years as archetypical of the Greenspan-Bernanke era: badger and bully investors into taking more risk and eventually pushing assets -- houses or stocks or both -- far over replacement value, followed eventually, at long and hard-to-predict intervals, by exciting crashes....)
He believes the Fed's low rate policy has distorted markets above their true value. He also mentions that the Fed's growth predictions are too high, and for an institution that is extremely influential to markets, wrong assumptions will not help develop correct policy.
To add to Grantham's bearish thoughts, corporate profit margins are at an all-time high, with analysts expecting them to rise even higher in 2014. If corporate profits fall to the historic average and P/E ratios remain constant, stock prices could fall nearly 45%. Add in the potential for natural disasters, like droughts that cost as much as hurricanes, and human disasters, like Congress' inability to come to a budget resolution and a sticky student debt situation, and there are plenty of reasons to fear where the market at large could end up.
But that's the perfect time to take cover in nooks and crannies.
Finding winners in a seemingly winless world
Grantham points out some general areas he believes are "only moderately overpriced": Japan, emerging markets, risky European companies, and forestry and farmland. He fears most other things are "brutally overpriced," and dislikes fixed income, especially with the risk of inflation.
As I see it, an investor can look at broad-market ETFs to gain exposure to these broad ideas, or pick single companies in these sectors with the potential to outperform. Below are a few ideas I came up with that I believe align with Grantham's thoughts.
For Japan, the iShares MSCI Japan Index (NYSEMKT:EWJ) has jumped about 14% over the past three months since the government approved a $100 billion-plus stimulus package. Japan's Nikkei index trades at a third of what it did during its 1990 bubble, and the demographics of an aging population don't instill confidence in future growth. But a new government stimulus program might be enough to thwart its economic headwinds.
For emerging markets, I see South American fast-food franchisee Arcos Dorados (NYSE:ARCO) capitalizing on the biggest brand name in fast food with plans for revenue growth between 10% to 15% annually. A relatively strong U.S. dollar and devalued local South American currencies have depressed earnings in the past, resulting in the stock losing roughly 40% since its 2011 IPO. But the potential for growth as the top chain within a region of 500 million people makes its forward P/E of 18.6 look appetizing.
Grantham gives the highest praise to forestry and farmland opportunities, even if they are deemed a bit expensive like everything else. I like Adecoagro (NYSE:AGRO), which produces corn, wheat, soybeans, rice, dairy products, sugar, ethanol and electricity products in South America, giving it diversification to protect it from any single negative commodity trend. It also trades at a forward P/E of 13.7. And if you like the seal of approval from well-known investors, George Soros now owns over 20% of the company.
Forestry stocks have dramatically increased in share price with the housing market, and each of them have a unique mix of revenue sources. Some are more heavily weighted toward real estate, like Pope Resources, which earns a third of its revenue from real estate. Others rely on other sources of revenue, such as Rayonier (NYSE:RYN), which gets 70% of its sales from cellulose products used to make a variety of goods like diapers, paint, pharmaceuticals, and digital displays versus just 3% from real estate. Since last May, Pope's shares are up twice as much as Rayonier's. A majority of publicly traded timber companies also operate as REITs, which gives them a special tax status of which investors should be aware.
The loose change of the stock market
Grantham doesn't see much upside even in the hidden potential of the nooks and crannies. High returns, to him, are going to be tough to achieve, and the goal will be avoiding the worst of the market. He believes the market might continue to bid up stock prices, and timing a fall will be tough. Being cautious in the nooks and crannies might not reward you in the near term, but could save you from a major correction.
Fool contributor Dan Newman has no position in any stocks mentioned. The Motley Fool owns shares of Arcos Dorados. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.