Ben Inker, co-head of GMO’s Asset Allocation team, writes in Ditch the Good, Buy the Bad and the Ugly (my emphasis):
It is probably a pretty accurate statement to say that the outperformance of the U.S. stock market over the last few years has been due to the superior economic growth in the U.S. over the period. Forecasters are projecting that superior economic growth to continue into 2015 and beyond. History strongly suggests that investing in the U.S. due to that forecast is a bad idea. Not only are economic forecasts notoriously inaccurate, but the driver of profits and equity returns is really about the macroeconomic surprises, which are almost by definition difficult to forecast. Investing where the valuations are lower has been a far better strategy historically, and, despite all of the worrying features of the economic environment outside of the U.S. today, we believe that investing in the various bad and ugly places in the world is going to wind up far more rewarding than the admittedly good-looking U.S.
Throughout my career as an investment manager, I constantly reminded myself that the dollar numbers and the percent weightings displayed on portfolio spreadsheets were, in reality, hard-earned savings belonging to real people. My relative performances carried absolute consequences for the actual investors.
The process of overweighting and underweighting such and such continent, country, industrial sector and security is the bread and butter of all money managers measured against a benchmark. For many large investors (e.g. pension funds), such relative performance mandates can make sense. For most investors, however, especially those not wealthy enough to get investment professionals’ strategy notes other than from the Web, the diversification game played and advocated by people like Bob Inker makes little sense.
Why would an investor invest in “bad and ugly” Europe? Inker provides all the reasons to stay away from Europe:
- (…) profits have compounded at -6% over the last four years in U.S. dollars, real GDP has grown at an annualized 0.3%, “accelerating” to 0.4% over the past six months, and consumer prices have been falling since April (…)
- The new Greek government is heading for a showdown with its paymasters, which may put it on a path to exit the eurozone, and far left and right parties are on the rise in much of Europe, which is not a shock given that the German-inspired austerity path to prosperity seems to be failing.
- We have never seen an economic environment quite like the one the eurozone is facing, with demographic headwinds, a seriously flawed monetary union, high debt loads, and falling household incomes.
And he forgot to mention China, Russia, Ukraine, Putin, …
But, what the heck, these are all known knowns already priced in if we believe him. “If You’re Going To Be a Jerk, at Least Be a Contrarian Jerk”.
(…) history tells us that if you are going to be a knee-jerk anything, at least be a knee-jerk contrarian. The 20% of developed stock markets that outperformed most over a three-year period underperformed on average by 1.3% in the following year and by 2.4% annualized over the next three years. The worst 20% of prior performers outperform by 1.6% and 0.8% annualized.
I have not checked what history actually and really tells us but such quantitative analysis is truly meaningless for most people. I also don’t believe that markets are like clockworks. Most rational people would not care to underperform by 1-2% with their U.S. equities if they still get positive absolute returns without incurring unreasonable absolute zone, country and currency risks.
But Inker has a surprise for us. Note how assertive he is (my emphasis):
If you can find cheap countries that are going to have a big positive GDP surprise over the next three years, you’ll outperform by a whopping 14.1% per year for the next three years, whereas if you are unlucky enough to buy the cheap countries that will have the worst GDP surprise, the outperformance is only 0.7%. Expensive countries with the best GDP surprise only underperform by 1.2%, whereas the expensive countries with the worst GDP surprise lose by 6.1% annualized. GDP surprise certainly matters, but our strongest takeaway at GMO is that even the cheap countries with the worst GDP surprise still outperform, and even the expensive countries with the best GDP surprise still lose.
In brief, buy cheap equities and hope for positive growth surprises. Heck, even without the good surprise, cheap countries always seem to outperform. Sell expensive countries, they always underperform.
I do not have GMO’s extensive database and minions, nor do I have Inker’s quantitative capabilities, but perusing these J.P Morgan charts I can’t escape noticing the following:
- Europe may be cheaper (14.1x forward EPS vs 16.2x for U.S.), but Europe is not particularly cheap. Relative to their last 10-year history, EU equities are at record P/Es while U.S. equities are merely matching their 2004 peak. In fact, both markets are selling at the same 17.5% premium to their respective 10-year average, even though U.S. earnings are 19% above their previous cyclical peak while EU earnings are 24% lower. This is like paying similar relative P/Es for two companies, even though one is demonstrably much superior and far less risky than the other.
- The 15% premium multiple for U.S. equities is easily justified by past earnings performances and Inker’s above mentioned numerous and complex European challenges.
- Also consider that J.P. Morgan is using forward earnings. One may like surprises but any sensible betting person would place much better odds on U.S. companies’ earnings at least meeting consensus.
- EU equities have been cheaper than U.S. equities for a while. Inker’s approach to buy the cheaper markets has not delivered during the last 5 years (chart from FT).
The J.P.Morgan charts above only provide 10 years of data but these are the years during which all the eurozone “travails” listed by Inker have become visible to everybody. If you had followed Inker’s method during the last 10 years, your only surprise would have been that you have lost your shirt, at least you relative shirt…Well, another surprise might have been that you lost your job in 2012 given that the U.S. Shiller P/E has been at a historically large premium to the EU Shiller P/E since 2009.
- Yes Europe is cheaper. But they normally and justifiably are. And who really knows what will happen there during the next 1-2-3 years? In fact, everything, even anything happening in Europe will be surprising…
- Yes the U.S.market is expensive, especially if one uses “the better single valuation measures out there, the cyclically adjusted P/E for the U.S. stock market is 26, versus just under 16 for the U.K. and Europe and a little under 14 for emerging.” But Ben, the U.S. Shiller P/E, with all its peculiarities (see The Shiller P/E: Alas, A Useless Friend), has remained well above its historical mean of 16.6 since 1990! How good (useful) an index is that for measuring value? So much for “the better single valuation measures out there”.
If you live in a relative world and manage other people’s money, you may be able to find some justification in selling the U.S. and buying Europe. Maybe you will be lucky enough and Draghi’s latest gambit will have finally worked, Greece will have paid its debt, the banks will be back on their feet, the Euro will be 1.50, France will be a strong harmonious country and Merkel will have been re-elected with her strongest majority ever.
Being a contrarian does not necessitate being a jerk. Being a contrarian on Europe is investing in “something” nobody really knows what it is, what it should be, how it can be and how it will be. It is like buy a company with too many CEOs thinking differently and all managing in different directions. You may think you are a contrarian investing in it, but you are just being “a contrarian jerk”.
So if, unlike me, you like surprises, do sell your “beloved U.S. quality stocks in favor of the various problem children of the investing world.” My inkling is that you might be really surprised, not only relatively surprised. Your biggest surprise may be that your absolute performances may not end up being all that superior to what you would have achieved had you kept your U.S. equities and not paid your substantial capital gains taxes on them…