High Market Valuations May Signal Low Future Returns: Morningstar / GMO

In the summer of 2000, I vividly recall accompanying John Rekenthaler to meet GMO co-founder Jeremy Grantham in a café in Chicago. Vanguard had just launched its U.S. Value Fund (VUVLX), for which GMO was the subadvisor, and I was the (somewhat) young analyst assigned to cover it. Grantham had agreed to meet to discuss GMO's approach and investment outlook.

I do not remember much about what Grantham said about GMO's approach to selecting individual stocks, but I know that he had a lot to say about market valuations. In particular, he had a firm belief--citing GMO's long-term asset-class forecasts--that U.S. growth stocks were incredibly overvalued. He also said that, as a value-oriented firm, GMO had suffered massive investor redemptions in previous years, thanks to investors' moving assets to more growth-oriented shops.

Of course, subsequent events proved Grantham and GMO correct. For three calendar years in a row, between 2000 and 2002, the Morningstar US Growth Index lost more than 25% of its value. Meanwhile, on a cumulative basis, the Morningstar US Value Index lost just a few percentage points. Fast forward a few years: Grantham and GMO's equity return forecasts proved accurate again in 2007, when they signaled that equity valuations were overheated prior to 2008's market meltdown.

Grantham and GMO are sounding alarms again. In its latest round of seven-year asset-class forecasts (registration required), GMO predicts that U.S. large- and small-cap stocks will deliver negative inflation-adjusted returns, while developed-markets international stocks will produce just slightly positive returns.

In most of the developed world, GMO considers valuations too high to generate solid returns during the next seven years. With respect to valuations, GMO's asset-class forecasts incorporate some amount of mean reversion, so as valuations fall over a market cycle, projected returns will decline as well. Note that GMO is not trying to make a short-term market call; rather, the firm highlights longer-term investment opportunities based, in large part, on valuation measures.

Other fundamentals-based, long-term-oriented valuation measures are flashing warning signs as well. In particular, Nobel Prize-winning Yale Professor Robert Shiller's favored measure, the cyclically adjusted price/earnings ratio (known as CAPE, or the Shiller P/E), also suggests that U.S. equity investors should temper their expectations for future returns. CAPE--which is a measure of equity prices divided by the past 10 years' earnings, adjusted for inflation--currently suggests that valuations are more than 60% above their historical norm.

Like Grantham, Shiller boasts an enviable record of forecasting asset-class returns. In his 2000 book Irrational Exuberance, Shiller--in contrast to many market commentators at the time--said that the equity market was in bubble territory and would therefore subsequently deliver disappointing returns. Like Grantham, he was right, though it is worth noting that both began raising concerns about market valuations several years earlier. Shiller updated the book in 2005 to argue that there was a bubble in the housing market--a view that also was vindicated when house prices subsequently crashed.

Research has shown that CAPE does an impressive job of forecasting future returns across a variety of equity markets. Based on research using more than a century of earnings and equity return data, Shiller and co-author John Y. Campbell found that CAPE was a strong predictor of U.S. stock returns over subsequent 20-year periods. And a study by Norbert Keimling of Germany's StarCapital has found that the relationship between CAPE and subsequent returns exists in 14 other markets as well. In short, when CAPE is very high, in general relatively low long-term equity returns will follow. (Click here to see current CAPE levels for countries around the world.)

Daniel Needham, Morningstar Investment Management's president and chief investment officer, agrees that "the U.S. market is very overpriced and is at a level that is associated with very low prospective returns." Moreover, Needham says that in this high-valuation, low-interest-rate environment, even small changes in earnings forecasts or interest rates can lead to greater volatility. In short, Needham expects "lower prospective returns and higher prospective volatility."

So, what is an investor to do with this information? Interestingly, despite the much higher-than-normal level of CAPE, Shiller recently told CNBC that he has not yet pulled back on his equity exposure. Despite the fact that "my own indicator (CAPE) is looking kind of scary," Shiller said that his expected longer-term returns from real estate or fixed income are even worse. So, in Shiller's view, equities might be the least bad of some weak alternatives.

Shiller has also pointed out that there may be some pockets of value in global markets. In terms of their asset-class forecasts, GMO's strategists agree. For example, at the end of 2014, GMO projected nearly 4.0% annualized real returns on emerging-markets stocks and a nearly 3.0% real return on emerging-markets debt. Both areas compare favorably with the projected annualized returns of negative 1.8% for U.S. large-cap stocks and negative 2.9% for U.S. small caps. Those seeking emerging-markets exposure would do well to look at Morningstar analyst favorites such as  American Funds New World  (NEWFX) or  Vanguard Emerging Markets Stock Index (VEMAX), while those who want bond exposure in developing markets will want to take a look at the likes of  Fidelity New Markets Income  (FNMIX) and  PIMCO Emerging Markets Bond (PAEMX).

Morningstar's equity research can also help investors uncover attractive opportunities. Although, in the aggregate, Morningstar analysts consider the market somewhat overvalued, there are individual stocks that are attractively priced. Morningstar analysts currently assign 5-star ratings to a couple dozen stocks, including  BHP Billiton  (BHP),  Priceline  (PCLN),  Apache  (APA), and  Cabot Oil & Gas (COG). Premium Members can define their own criteria to focus on stocks with the characteristics that they most desire.

Of course, when it comes to forecasting market returns, there are no guarantees that any methodology--even those that have often worked in the past--will be absolutely spot-on. But extremely high equity valuations and exceptionally low interest rates tilt the odds against investors. In addition to seeking out pockets of value, perhaps the best things investors can do are avoid counting on unrealistically high returns, save enough to compensate for potentially weak returns, and keep costs to a minimum. Those are not very exciting tips, but they may represent the most useful advice in what is likely to be a low-return environment.