Jeremy Grantham Clarifies His Projections

[CM]

Jeremy Grantham has written that the long-term PE10 is likely to be higher in the future than the past, but until now he hasn't (to my knowledge) offered an estimate.

Also, GMO (the asset manager he founded) publishes 7-year asset class return projections. Because they are based on a reversion to mean valuations at that horizon, and valuations are very high now, those projections are markedly negative for US stocks. In the interview below, he offers a 20-year projection. (The effect of falling valuation is less on a longer horizon.)

Here is the interview: https://www.wsj.com/articles/jeremy-grantham-predicted-two-previous-bubbles-and-now-1509937980

His 20 year projection for total, real US stock returns is 2.8% per year.

He expects valuations to fall 2/3 of the way from current levels toward the historical long-term mean, to reach a new, higher long-term mean. The current PE10 is about 31.3 and the long-term mean is about 16.8, so Grantham's estimate of the new "fair value" is about 21.6.

Note the current forward dividend is about 1.94% and historical real earnings growth (from Shiller, 1881 to present) is about 1.8%, so the future return can be estimated at 3.74% with constant valuations. Grantham expects a roughly 1% haircut due to falling valuations over the next 20 years.

In my opinion, that is reasonable, but to the extent it is incorrect, I think it is a bit more likely to be lower than higher.

If you are basing your plans on a historical 6.8% total real return to stocks, or even a "conservative" 4%, then you are likely to be disappointed, in my opinion.

***

I once made a 10-year bet with a colleague (payoff was supposed to be a beer), so I'll offer a 20-year bet here: The 20-year total real return of the S&P 500 from today will be less than 4%. The S&P 500 is at 2589.96 as I write.

I don't really care for beer, but if anyone would like to suggest a payoff of similar value I'll go for it.*  

 

 

[Donnie]

Well if the tax changes go through, rough math is that corporate earnings will increase by 23% and PE10 will decline to 25.4x. If corporate taxes aren’t changed, you can expect a significant stock market downturn / correction.

[CM]

Profit margins in recent years are the highest in history. High profit margins have never been persistent in the past.

The 10-year bet that I made with a colleague was that real earnings would be lower in 2016 than in 2006. I won that bet.

I made it because profit margins were at record highs (based on about 80 years of data) in 2006, and I calculated that if revenue grew at historical rates, but margins reverted to historical norms, then profits would fall.

Well, margins did not revert to historical norms, but I still won the bet.

[Zaphod]

CM wrote:

Profit margins in recent years are the highest in history. High profit margins have never been persistent in the past.

The 10-year bet that I made with a colleague was that real earnings would be lower in 2016 than in 2006. I won that bet.

I made it because profit margins were at record highs (based on about 80 years of data) in 2006, and I calculated that if revenue grew at historical rates, but margins reverted to historical norms, then profits would fall.

Well, margins did not revert to historical norms, but I still won the bet.

Click to expand...

they will increase with this tax bill if it passes, but making your bets at opportune times is definitely key, now might be a good one. they may not persist, inflation may come, etc...grumblings starting.

[Donnie]

CM wrote:

Profit margins in recent years are the highest in history. High profit margins have never been persistent in the past.

The 10-year bet that I made with a colleague was that real earnings would be lower in 2016 than in 2006. I won that bet.

I made it because profit margins were at record highs (based on about 80 years of data) in 2006, and I calculated that if revenue grew at historical rates, but margins reverted to historical norms, then profits would fall.

Well, margins did not revert to historical norms, but I still won the bet.

Click to expand...

My point was that any PE10- or margin-type analysis arguing for mean reversion needs to factor in the probability weighted impact of the tax reform passing.  Didn’t read the link, but it doesn’t sound like the linked analysis does that based on your summary.

[CM]

Donnie wrote:

CM wrote:

Profit margins in recent years are the highest in history. High profit margins have never been persistent in the past.

The 10-year bet that I made with a colleague was that real earnings would be lower in 2016 than in 2006. I won that bet.

I made it because profit margins were at record highs (based on about 80 years of data) in 2006, and I calculated that if revenue grew at historical rates, but margins reverted to historical norms, then profits would fall.

Well, margins did not revert to historical norms, but I still won the bet.

Click to expand…

My point was that any PE10- or margin-type analysis arguing for mean reversion needs to factor in the probability weighted impact of the tax reform passing.  Didn’t read the link, but it doesn’t sound like the linked analysis does that based on your summary.

Click to expand...

Grantham didn't specify if he thought current tax proposals were significant, or if he factored them into his analysis.

In my opinion, the current tax reform will not have significant effect on 20-year returns.

[CM]

Donnie wrote:

CM wrote:

Profit margins in recent years are the highest in history. High profit margins have never been persistent in the past.

The 10-year bet that I made with a colleague was that real earnings would be lower in 2016 than in 2006. I won that bet.

I made it because profit margins were at record highs (based on about 80 years of data) in 2006, and I calculated that if revenue grew at historical rates, but margins reverted to historical norms, then profits would fall.

Well, margins did not revert to historical norms, but I still won the bet.

Click to expand…

My point was that any PE10- or margin-type analysis arguing for mean reversion needs to factor in the probability weighted impact of the tax reform passing.  Didn’t read the link, but it doesn’t sound like the linked analysis does that based on your summary.

Click to expand...

Also, there is this from John Hussman:

"As for the stock market, understand that total annual U.S. corporate taxes presently amount to only about 1.2% of current U.S. equity market capitalization, and even if a cut was to pass, it would be unlikely to endure for more than a few administrations. The potential effect of even a substantial percentage reduction in statutory rates for several years is quite small when the present value of the tax reduction is compared with existing equity market capitalization. The likely cumulative impact comes to just a few percent of stock market value.

Against that, consider that the most reliable market valuation measures we identify (as measured by their correlation with actual subsequent S&P 500 total returns in market cycles across history) are currently between 2.5 and 2.7 times their historical norms (that is, 150% to 170% above those norms).

Put simply, it seems misguided to imagine that “tax reform” will somehow make the most obscene speculative bubble in U.S. history something other than the most obscene speculative bubble in U.S. history. Corporations are already enjoying strikingly light tax burdens from a historical perspective, and investors are already paying extreme valuation multiples on elevated earnings."

https://www.hussmanfunds.com/wmc/wmc171002.htm

The fifth graph down the page on this link reports that current corporate tax rates are as low as they have ever been since 1947.

[Donnie]

Valuation metrics are deeply tied to (i) net income after taxes and (ii) free cash flow after taxes. Not factoring in taxes is a mistake.

[CM]

Donnie wrote:

Valuation metrics are deeply tied to (i) net income after taxes and (ii) free cash flow after taxes. Not factoring in taxes is a mistake.

Click to expand...

Of course, taxes matter.

However, even if the current proposal passes and record profit margins go still higher for a time, I expect this effect to be dwarfed by larger forces that bring margins closer to historical norms over the longer term. (Recent margins are in the stratosphere, relative to history.)

It's also unlikely that the current proposal will survive the next administration, in my opinion.

[Donnie]

I don’t know, tax cuts have historically been pretty sticky.

[Zaphod]

CM wrote:

Donnie wrote:

CM wrote:

Profit margins in recent years are the highest in history. High profit margins have never been persistent in the past.

The 10-year bet that I made with a colleague was that real earnings would be lower in 2016 than in 2006. I won that bet.

I made it because profit margins were at record highs (based on about 80 years of data) in 2006, and I calculated that if revenue grew at historical rates, but margins reverted to historical norms, then profits would fall.

Well, margins did not revert to historical norms, but I still won the bet.

Click to expand…

My point was that any PE10- or margin-type analysis arguing for mean reversion needs to factor in the probability weighted impact of the tax reform passing.  Didn’t read the link, but it doesn’t sound like the linked analysis does that based on your summary.

Click to expand…

Also, there is this from John Hussman:

“As for the stock market, understand that total annual U.S. corporate taxes presently amount to only about 1.2% of current U.S. equity market capitalization, and even if a cut was to pass, it would be unlikely to endure for more than a few administrations. The potential effect of even a substantial percentage reduction in statutory rates for several years is quite small when the present value of the tax reduction is compared with existing equity market capitalization. The likely cumulative impact comes to just a few percent of stock market value.

Against that, consider that the most reliable market valuation measures we identify (as measured by their correlation with actual subsequent S&P 500 total returns in market cycles across history) are currently between 2.5 and 2.7 times their historical norms (that is, 150% to 170% above those norms).

Put simply, it seems misguided to imagine that “tax reform” will somehow make the most obscene speculative bubble in U.S. history something other than the most obscene speculative bubble in U.S. history. Corporations are already enjoying strikingly light tax burdens from a historical perspective, and investors are already paying extreme valuation multiples on elevated earnings.”

https://www.hussmanfunds.com/wmc/wmc171002.htm

The fifth graph down the page on this link reports that current corporate tax rates are as low as they have ever been since 1947.

Click to expand...

Thats probably true about not staying forever.

[CM]

Donnie wrote:

I don’t know, tax cuts have historically been pretty sticky.

Click to expand...

.

[Zaphod]

CM wrote:

Donnie wrote:

I don’t know, tax cuts have historically been pretty sticky.

Click to expand…

Who knows what the future will bring?

However, Hillary Clinton is probably the only candidate in history that could have lost to Trump. Their pre-election unfavorable ratings were apparently the highest ever recorded (according to every talk show I watched).

Trump won on populism, which is ironic. Bernie would have beaten him, and I think it’s likely that we’ll get a Bernie-type with the next election.

That would mean much higher taxes for you and me, and probably higher taxes on corporations as well.

Save as much as you can now. Winter is coming.  

Click to expand...

Bernie wouldve been crushed. If he won the primary, his road show and increased exposure would have crushed him. Hes exactly like Trump except the opposite side of the coin. He didnt know anything about anything, no depth. He also would have been so easy for Trump to tear down in a debate or to make into a money stealing socialist caricature that would easily sway voters.

Sadly you may be right for next time since we keep swinging from one type to the opposite.

Nobody seems to want to admit there just isnt a bunch of room in the tax code for magic. We need reform on the problem side of things.

[CM]

Zaphod wrote:

Bernie wouldve been crushed.

Click to expand...

.

[CM]

thevaluedoc wrote:

I am interested in taking this bet depending on what you accept as the benchmark to assess real returns. CPI? Or some other metric.

As for wagers,
Cheap: 2 x 1 oz American Eagle silver rounds
Moderate: 20 x 1 oz American Eagle silver rounds
Expensive: 1 x 1 oz American Eagle gold round
Or equivalent
I am usually a cheapskate but willing to splurge on this bet.

Would even consider a 10 year term with 3%/year “real” return.
Again, want to know how real return will be calculated before any agreement.

Click to expand...

I think Shiller uses CPI-U for his calculations. That's the usual metric, don't you think?

Do you prefer something else? (I'm sure Crixus would say the CPI-U will give you an unfair advantage.   )

Regarding the wager, the value of the American Eagle precious metal coins 20-years from now is unpredictable, and this is for entertainment purposes only.

When I contacted my former colleague in the middle of 2016 about our 10-year wager, he had lost interest. We live in different cities now, so I didn't call to collect when the final 2016 earnings figure became available. The fun was gone.

This wager may end up the same. If I am alive and not demented in 20 years, I will remember. However, it wouldn't be any fun to sting you with a meaningful loss if I win, and it definitely wouldn't be fun to pay up if I lose. The payoff should be symbolic, like a plastic trophy.

Regarding the 10-year bet, that's cutting it too close for me to bet with confidence.