2011 started with a glimmer of hope, as corporate earnings continued to strengthen and key metrics like unemployment started to move in the right direction (currently at 2 year low of 8.8%). However, danger signs were still in the peripheral, with a stumbling U.S. housing market and rampant commodity inflation affecting an already weakened consumer and economy. Geopolitical risks, including unrest in the Middle East and North Africa (MENA) and the earthquake/tsunami/nuclear disaster in Japan, haven’t helped either in the road to continued global recovery.
Despite this uncertainty, the markets (led by an “ever-increasing degree of super generous liquidity”) moved higher, with the S&P 500, DJIA, and the Russell 2000 rising 5.9%, 6.1%, and 7.9%, respectively, over the first three months of the year. In their words, “The perception of a rising economic tide lifted all boats”. The strongest sector in the S&P 500 was energy (+16.8%, on the backs of oil hitting a 30 month high in March), while the worst was consumer staples (+2.8%). When looking at size, small/mid caps outperformed large caps by roughly 300 basis points (8.7% compared to 5.9%). Not surprisingly, the Japanese market ended nearly 5% lower, which led to the EAFE index (in local currency) returning 1% during the same period.
After another strong quarter (and three consecutive quarterly gains in U.S. equity markets), we are back to asking a familiar question: is everything (once again) overpriced? GMO uses a Graham and Dodd P/E (10 yr trailing average), a valuation metric that I personally believe is second to none. Here is what they had to say: “At the end of the quarter, the S&P 500 stood at 1325. Over the last 10 years, the same index has produced an average of $56.6 of real earnings. Taken together, this means that the index finished the quarter with a cyclically adjusted price to earnings of 23.5 and suggests that the market is currently about 40% overvalued”.
Treasuries and corporate debt don’t look much better: the 10-year government bond (based on current inflation expectations of 2%) is priced for a real return of less than 1.5% per annum, while corporate debt (as indicated by record low yields on new issues) has seen narrowing credit spreads over the past few years. GMO closes by saying, “These factors taken together make it appear that we are approaching levels from which large drops in asset prices could easily occur.”
As a result of these developments, their current strategy is focused on high quality stocks (they believe small caps are as expensive “as we have ever seen them”) along with low duration fixed income, which can leave cash on hand in the event of a valuation correction. Some of the names that continually appear in their portfolio’s top ten holdings (among U.S. equities) include Microsoft (MSFT), Johnson & Johnson (JNJ), Wal-Mart (WMT), and Oracle (ORCL), to name a few. As indicated in the report, their largest country/sector bet is currently an overweight position in Russian energy.
As always, GMO has published an in-depth report well worth reading: see here for the link to the paper.