GMO: "US Markets Are Not A Little Bit Overvalued — They Are Overvalued By A Hefty Margin"
Monthly Market Commentary From Jeremy Grantham's GMO, via Wells Fargo Absolute Return Fund
“You want a prediction about the weather, you're asking the wrong Phil. I'll give you a winter prediction: It's gonna be cold, it's gonna be gray, and it's gonna last you for the rest of your life.”
—From the movie Groundhog Day (1993)
The Street is always looking for short-term indicators. The January indicator is a common one: It basically says January sets the tone for the rest of the year. Or even the Groundhog Day effect, which also sent a nasty signal just recently. Clearly, these two are pointing to a sober 2014. Look, maybe these indicators work. Maybe they don’t. Trying to find a reliable one-year crystal ball is a fool’s errand. Our sober forecasts for equities, especially the broad basket of U.S. equities, have nothing to do with January pull-backs or silly little rodents seeing their shadows. Our methodology is a bit more ho-hum. Valuations are stretched. Profit margins are stretched. And given that these two have been reliable mean-reverting indicators, they are what drive our sobriety. We’re not saying the party’s over. For all we know, 2014 could post another positive year for the risk markets. There’s enough good news out there in terms of cash on the sidelines, declining unemployment numbers, U.S. as a safe haven in the event of an emerging meltdown ... yada, yada, yada. All we’re saying is that, as value investors, we’re nervous about the longer-term prospects for equities, especially in the U.S. Markets in the U.S. are not a little bit overvalued—they are overvalued by a hefty margin, especially small-cap stocks. And it is this concern, above all else, that will be driving our asset allocation decisions.
Momentum from a spectacular 2013 and some early positive economic news sent U.S. equities up to record highs in mid-January. Markets did an about-face, however, toward the end of the month as the Federal Reserve reminded us that the taper would not just continue but accelerate, as a weak Purchasing Managers’ Index reading came from China and fears of a slowdown continued, and as emerging markets currency troubles spooked the global markets. Emerging equities (and currencies) were the worst victims, but the developed markets also felt the pinch. U.S. equity markets did indeed experience a January pull-back, with the S&P 500 Index down 3.5% and the Russell 2000® Index down 2.8%. EAFE lost 4.0%, spread pretty evenly across Europe and Japan. The real story in January, however, was emerging equities, which gave back 6.5%, as measured by the MSCI Emerging Markets Index.
For fixed income, January’s hiccup ended up being good news, as yields came in modestly higher. The Barclays U.S. Aggregate Bond Index posted a solid 1.5% return, and global bonds did slightly better.
Wells Fargo Advantage Absolute Return Fund
Against this backdrop, the Absolute Return Fund lost 1.8% on the month. Our quality position, which has often held up relatively well in market downturns, was essentially down in line with the broad indexes. Concern about global, particularly emerging markets economic exposure, was most likely the culprit. Consumer staples—a traditional defensive sector—was one of the worst-performing areas this month, as the market perceived that slowdown outside of the U.S. would hurt earnings for these high-quality global brands. Our international value exposure did slightly better than international growth sectors, but only marginally. And both, importantly, were still down. Our emerging equities exposure was the largest negative contributor.
On the fixed-income side, emerging country debt exposure hurt, but the TIPS position that we established back in July and August 2013 posted some positive returns. In addition, our absolute return strategies, the GMO Alpha Only Fund and the GMO Alternative Asset Opportunity Fund, each posted positive returns, albeit modest.
By the end of January, equities represented a bit over 50% of the portfolio. We hold a diversified equity basket across quality, currency-hedged international value, and emerging, with a modest allocation to the risk premium strategy. We are maintaining roughly a 9% allocation to credit via asset-backed securities and the GMO Emerging Country Debt Fund. Treasury Inflation-Protected Securities holdings represent roughly 13%, while our absolute return sub-strategies, in aggregate, represent a bit over 27%.