Jeremy Grantham, a highly successful long-term investor and principal for investment management firm Grantham, Mayo & Van Otterloo, noted in his quarterly letter to shareholders that he saw the potential for enormous amounts of pain in the U.S. stock markets, deeming the next two years "a black hole."
There are, of course, as many opinions about the stock market and its prospects as there are market participants. Certain people have built up long histories of credibility through their thoughtful dissection of events in the past. Grantham certainly fits this bill. In a stock market that is highly dominated by the viewpoint that we have entered into a new bull market, Grantham's words of warning deserve some attention.
We at the Fool aren't huge market commentators. We've done it, of course, and we recognize fully that the emotional tendency of the beast creates a high level of correlation between the returns of individual equities and the market as a whole. But whereas I may simply be invested in a list of a very few companies that I consider to be good values at current prices, the fact remains that the polity of this readership makes up a pretty good proxy for the American equity market. And according to Jeremy Grantham, in order for the valuation of U.S. stocks to return to their trends in earnings and in price-to-earnings ratios, large caps must lose about 38% of their value, and small caps 41%.
His rationale is simple: Both profit margins and P/Es are above trend at present. As profit margins are higher than they have been at almost any point in history, there isn't much room for them to grow. The other answer that would generate positive returns would be an increase in P/Es. But from a long-term wealth generation perspective, this would be "a disaster." The trend line suggests that fair value for the Standard & Poor's 500 index sits at about 700. One of Grantham's defensive moves is to seek out equities that have low to negative correlation with the stock market. One of these is timber, with companies such as Plum Creek Timber (NYSE:PCL) or Deltic Timber (NYSE:DEL) logical candidates.
Grantham also notes that we're entering an era of uncharted risks because of the rapid ascent of hedge funds, which tend to: a) use substantial leverage, and b) be averse to volatility. Should volatility in certain asset classes rise, the $2 trillion hedge fund industry may have to retrench in ways that could disjoint the market. Grantham's point was not that this will happen, but that it might. His message for the overall risk in the U.S. stock market, though, was definite.
Bill Mann owns none of the companies mentioned in this article. Plum Creek Timber was Bill's selection for Stocks for Mom, based in part on its hefty dividend. Interested in other dividend payers? Take a free trial to Mathew Emmert's Income Investor newsletter today!
