This market forecaster has a 14-year winning streak
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Since 2000, investors could have done very well imitating the investment fund GMO. Will the streak continue?
Is the stock market really just guesswork, as so many people allege? Can you really not “beat” the indices? Would you really be better off just throwing darts at a list of stocks?
Maybe not.
New research looks at some of the most widely-respected stock market forecasts available on Wall Street — those published monthly by Boston-based white shoe fund firm GMO. And it finds that they have actually been pretty good.
Since 2000 GMO, which is chaired by Jeremy Grantham, has published “medium-term” forecasts for various classes of stocks — U.S. large and small caps, international large and small caps, and emerging market stocks. Initially the firm sought to predict the likely returns for each class, adjusted for inflation, over the following 10 years, but they soon moved to a seven-year horizon.
The forecasts, which are updated monthly, are based on some simple economics. Essentially, GMO looks at valuations, and assumes some kind of reversion to long-term averages.
Professor Edward Tower of Duke University, assisted by students David Barry and Edward Stansky, went back to 2000 and looked at GMO’s forecasts from that and subsequent years, and then compared them with the subsequent seven-year returns, adjusted for inflation.
What did they find? GMO has been pretty good at predicting which groups of stocks would do best over the subsequent seven years. And it has been even better at predicting whether markets overall would do well or badly.
Let’s imagine that back in 2000 you had decided to follow GMO’s advice. You invested your portfolio equally in the three classes of stocks it liked best. Then, every quarter, you checked their forecasts and adjusted your portfolio accordingly to keep yourself invested equally in their top three classes of stocks.
How would you have done? Over the past 14 years you would have doubled your money in real, inflation-adjusted dollars, a compound annual real return of 5.5%. By contrast, if you’d invested in the S&P 500 index you’d be up a total of just 22% after inflation. The GMO strategy trailed emerging-markets and small-cap stocks over that period, but it beat U.S. and international large caps.
Curiously, the Duke researchers found that over the past 14 years you would have done better to invest in GMO’s third favorite group of stocks at any given moment, rather than its first or second favorite.
Maybe this is just a fluke. Maybe this is just a snapshot in time. GMO is a value-oriented investment firm, and 2000 was the moment when value stocks were their cheapest, relative to growth stocks, in modern history. There are no guarantees these forecasts will do as well in the future.
GMO’s Grantham famously warned about the impending crashes of 2000-03 and 2007-09. And during the depths of the financial crisis in 2008-09 he also, famously, defied the doomsayers and turned aggressively bullish.
GMO’s record has looked less good in the past few years. It has been warning about stock market valuations, especially in the U.S., for at least two years, but so far markets have kept going up and up. Many value investors argue that we are in the midst of another bubble, largely driven by Federal Reserve policies, and that this will follow the course of the previous two sooner or later.
How can you use this research?
Today GMO’s three favorite classes of stocks are what it calls Emerging Markets, U.S. High Quality (a new category not included in the Duke research, as GMO did not follow it as far back as the others), and International Large Caps, meaning the EAFE (Europe, Australasia and Far East) index.
“U.S. High Quality” refers to blue-chip stocks with strong balance sheets, cash flow and franchises. Investors can buy all three of these sectors with low-cost ETFs — including iShares MSCI US Quality Factor QUAL +0.26% .
However, the Duke research also found that GMO was better at predicting the overall returns from stocks than it was at predicting returns for one class of stocks versus another. And in that light it is worth noting that GMO’s forecasts today are very gloomy indeed. It predicts negative real returns for U.S. large and small caps, and barely positive real returns for international stocks. It also thinks real returns will be poor from bonds.
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