On 30th October 2015, the forecasts included:

-2.0% per annum for large US stocks

-0.9% per annum for US bonds

So, a $100 invested today in US stocks or bonds is forecast to be worth $87 or $94 respectively in 7 years. A miserable outlook for our saving, eh?

These forecasts are well below what GMO regard as normal:

+6.5% per annum for large US stocks

+4.0% per annum for US bonds

But of course, few professionals would regard today as a normal market, given the Bernanke Put.

#2: the theory

GMO don’t publish the math behind each forecast, but they do explain their logic. Above all, they are driven by a belief in mean-reversion.

Whereas, daily movements in stock and bond prices may look like they are random. Over the long-term, prices usually revert to trend. For example, take the S&P 500 over the last 140 years:

Link to the underlying data

#3 (and optional): the math

So how does GMO come up with a 7-year forecast?

For the stock market, they forecast:

sales growth (in real terms, i.e. before inflation)

change in profit margins

change in valuation

dividend yield

Here’s the analysis from a GMO white paper in 2012. At the time, they forecast US stocks would only grow at 0.4% per annum.

As you can see, at any moment in time, the different variables can boost (sales growth) or hurt (P/E valuation, margins, dividends) the overall forecast.

And the math for bonds?

Again, in a newsletter from 2013, GMO explained the 2 basic drivers for their bond forecasts:

Firstly, they assume that the real-cash return will revert to the long-term average

Secondly, that inflation will move to the long-term consensus view

So today, if we are in a period of low interest rates and low inflation, both drivers will hurt investors, as we move back to trend.

In the 2013 newsletter, they calculated nominal rates would have to rise from 2.5% to 4.9% to get back to trend.

But how did this mean-reversion dynamic lead GMO to suggest a real-return on US bonds of 0.2% per annum?

We need to acknowledge the various components: the shift in the yield curve; the real yield; and the roll down (from having a 10-year bond that after 1 year becomes a 9-year bond, and thus to ensure constant maturity, you sell and reinvest in a new 10-year bond).

For a bond-market novice, the data is hard to consume. But to put it in stock market language, the yield-curve shift is like the P/E valuation going down, and the roll-down+yield gain is because each year you sell the entire portfolio, and re-invest, getting a higher and higher dividend yield each year.

#4: What’s “normal”

GMO used to publish what they regard as the expected long-term real return. These forecasts are driven off what they’ve observed over the last 100 years.

It’s hardly surprising that:

Small US stocks are forecast to grow faster than large US stocks

Large US stocks are forecast to growth faster than other developed markets

US & international stocks are forecast to grow faster than US & International bonds

Emerging markets are forecast to grow the strongest both in stocks and bonds

All stocks are forecast to grow 2.0%+ faster each year than bonds.

(Aside: please remember these are pre-inflation figures).

#5: GMO’s track-record

To look at GMO’s track record, let’s cherry-pick 4 extreme dates:

The dot-com boom (July 2000, when they first published their analysis) The bottom post boom (March 2003) The pre-Lehman top (Sept 2007) The Great-Recession bottom (March 2009)

July 2000

At the time of dot-com boom, both bond markets and emerging markets had been forgotten. Even small cap stocks hadn’t benefited as much as large cap stocks.

Both US and developed international stocks were forecast to underperform their bond markets. Which is exactly what happened.

March 2003

World stock markets endured three years of horror. Developed international stocks became attractive, emerging markets too. US stocks were no longer dizzyingly expensive, but US bonds continued to be more attractive that stocks.

In the 4 years from March 2003, investors in US stocks didn’t even double their money. In contrast international stocks almost tripled and emerging market stocks nearly quintupled.

Blue: EM stocks; Red: EAFE stocks; Orange: S&P 500

Sept 2007

Before the Great Recession, there was literally “nowhere to hide” in the stock market. Emerging markets were particularly unattractive.

Across stocks and bonds, US and developed bond markets were the least bad option.

And where did everyone run to in the crisis? Safety in Uncle Sam and German Bunds.

March 2009

By the time governments adopted a “whatever it takes” approach, stock market valuations had become attractive.

Imagine, for the first since we’ve been tracking GMO’s forecasts, large US stocks were priced to outperform. On top of this, the gap between US stocks and bonds was remarkably big. This set the scene for the massive outperformance we’ve experienced over the last 6 years.

#6: Rock and a hard place

So where do we stand today?

Large US stocks are as unattractive as ever, international stocks too. US bonds are forecast to generate negative returns. International bonds look particularly expensive.

Emerging markets present the highest returns, though significantly below the long-term forecast.

So investors today find themselves in an even less enticing place than the pre-Lehman crash.

But of course, we can’t predict, with any accuracy, can we?

Be prepared!

If GMO are right, then the 7-year horizon isn’t rosy.

So, best you look at what you own today. Then ask yourself a couple of “what if” questions. Who knows, maybe you’ve got some prep to do?

Potentially, we’ll all need to save a lot more than we planned. Otherwise we are unlikely to meet our investment goals. Fortunately, saving is a lot easier than investing.

Timing versus investing

As KAL at the Economist points out, the noise on Wall Street is hysterical. So beware the temptation to trade.

So if your reaction to GMO’s forecasts is to try and time-the-market, think again. As Bernard Baruch said:

Don’t try to buy at the bottom and sell at the top. It can’t be done except by liars.

Timing the market can have some horrible consequences. You can miss the best days and dramatically cut your performance. As JPMorgan point out: six of the 10 best days occurred within two weeks of the 10 worst days.

So, don’t sell up and move to the proverbial log cabin. Instead, work out if your current portfolio is right for you, both short and long-term. And to quote Mr Buffett:

I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for ten years.

And if that’s not enough to convince you, here are Henry Blodget’s 9 reasons he didn’t sell stocks last year, even when he was worried about valuations.

My portfolio is well diversified I don’t invest money in the stock market that I think I will need to use in the next 10 years There’s nothing else to buy: The outlook for other asset classes over the next 10 years is no more attractive than it is for stocks (and, in some scenarios, it is worse) There is a reasonable likelihood that inflation will accelerate at some point over the next decade, and stocks are actually a good hedge against inflation I have learned the hard way that market timing is very difficult Even if I am right about lousy future returns, the market might just move sideways If I sell now, I’ll have to pay taxes Oddly, the best thing that could happen for my long-term stock returns would be for the market to crash 50% and then stay crashed for 5–7 years before going up again Lastly, importantly, just because I firmly believe that long-term stock returns will be lousy doesn’t mean that I know they will

A two handed economist

Feel free to accuse me of being a two-handed economist. The GMO data points to a less than rosy future for US stocks and bonds. But being out-of-the-market is a bad idea too.

Which is exactly why investing is simple but not easy.