What's ahead for 2007?
Five top investment strategists trade tips and insights as they size up the forces that will shape the economy and the markets in the coming year.
NEW YORK, (Fortune Magazine) -- Markets have been hitting new highs, prompting some Wall Streeters to celebrate while others tremble. The real estate bust is officially underway - will that tank the economy or just shift the action? And how much longer can the U.S. consumer carry on? If ever an investor needed expert guidance, it's now. That's why we brought together five of the best big thinkers in investing.
Jeremy Grantham supports his sharp-edged views with deep quantitative analysis; Abby Joseph Cohen, one of the Street's most celebrated seers, is Goldman Sachs's chief U.S. investment strategist; David Herro, who manages three Oakmark international funds, brings global expertise; Rich Bernstein is Merrill Lynch's chief investment strategist, known for turning bearish on stocks in the late '90s; Jack Rivkin, chief investment officer at Neuberger Berman, a Lehman Brothers company, has a broad perspective on the whole investing landscape.
The panel sat down recently in New York City to talk about where they see danger (commercial real estate) and opportunity (blue chips), the long-term outlook for stocks (face the slow music), and much else. Edited excerpts follow.
Fortune: We hear a lot of forecasts of an economic slowdown, and yet for the past few weeks, markets have been in record territory. What in the world is going on?
Abby Joseph Cohen, Chief U.S. investment Strategist, Goldman Sachs: It seems to me there are several crosscurrents. First, the slowdown in U.S. economic growth can be viewed as a reasonably favorable phenomenon if one believes that it means the economic cycle can last longer. There were significant concerns in 2006 that fast economic growth would lead to inflation and an unfriendly Fed. But now many investors take the point of view that in 2007 economic growth will be slower, profit growth will be slower, but the Fed can stay friendly longer, and we will have a longer-lasting economic and profit cycle.
Rich, does that make sense to you?
Rich Bernstein, Chief investment Strategist, Merrill Lynch: It does. I think the collapse of oil prices and energy prices has been a huge stimulant to the consumer. Real wage growth in the U.S. - average hourly earnings adjusted for inflation - is now the highest in eight years. But in '07 we should probably look to the consumer to slow down quite a bit as the effects of the housing slowdown really take effect.
Jeremy, I know that about a year ago you were arguing that stocks looked kind of expensive. What do you think now?
Jeremy Grantham, Chairman, GMO: I think they look moderately more expensive. Much to my irritation.
What's your explanation?
Grantham: Basically profit margins. I've been born and bred on the understanding that capitalism is based on competition bringing down excessive profit margins and allowing depressed margins to rise back. Profit margins around the world, not just in the U.S., have gotten to be way over trend. If they don't go back to trend, it will be the first time in history. The reason we have had high margins for so long is that we've been living in a wonderful world of sustained pleasant surprises. One of the big pleasant surprises has been global GNP growth. What I think is going to happen next year is basically the end of pleasant surprises. They don't have to be unpleasant; they just have to be neutral. The abnormally high profit margins will come down next year, I think. Two-to-one is my money, anyway, that they're going to come down next year.
Jack, what's your big-picture view of the U.S. market?
Jack Rivkin, Chief investment Officer, Neuberger Berman: We're about to enter the third year of the presidential cycle. And we're entering it with an economy that is likely to be growing at a below-normal rate. That allows for stimulus as we move through the year, which is typical in that period. Historically that third year of the presidential cycle has been a double-digit grower for the market.
David, what about the global perspective?
David Herro, Portfolio Manager, Oakmark: The global economy until recently has been powered by the U.S., combined with a couple of larger emerging markets. Productivity growth, immigration growth, population growth -- all these things that make our economy free and open have allowed us to outgrow our more developed peers. Japan and Germany, the world's No. 2 and No. 3 economies, have not really done much in the past ten years. Now we're starting to see Japan perform, and starting to see some hope in Germany and the rest of Western Europe. So it's only natural that the U.S. takes a breather. I make my money investing outside the U.S., but over the very long term I think the U.S.'s basic economic fundamentals are far superior to those of its developed-market peers, and that's what drives long-term economic growth.
One key question for next year is whether the U.S. consumer can continue to carry the economy.
Cohen: When we look at 2007, the expectation is that some consumers will be in trouble. A lot of the low savings rates and over indebtedness is really concentrated in the lower-middle income group and below. We believe that the retailers that cater to those individuals and households may have much more of a problem than the retailers and others who provide services to upper-middle income and above.
How does the housing slowdown play into this?
Cohen: There's wide variation by city and locality in terms of whether home prices are reasonable or not. The areas where there should be the greatest concern have a couple of characteristics. No. 1, they tend to have a very significant turnover of housing - for example, vacation properties, second homes, and so on. The second set of characteristics typically involves lending institutions that were very aggressive. Think back to the savings and loan crisis in 1990. Most of the S&L failures were concentrated in some of the same localities where we think the housing market is most overpriced today: parts of Florida, parts of California, Nevada, parts of Texas, and so on. So in some communities we think there will be ongoing pressure.
Rivkin: Abby, where would that put you on the stocks of the housing companies?
Cohen: Our analysts would argue that these stocks look rather inexpensive. However, the question becomes the catalyst, and our analysts believe that we're going to need to see housing starts stabilize and then start to move up before we start to see the stocks recover.
Rivkin: Really? I almost think we might be better off seeing housing starts fall as the catalyst, that we're working off the inventory. And it makes those stocks attractive now. I actually think in a long-term sense the U.S. housing market is quite attractive. If the dollar continues to weaken, assets here will look cheap for the rest of the world, particularly in the resort areas. That might be attractive to buyers outside this country.
What assets seem most attractively valued today?
Bernstein: If we think about the demographics in the U.S. and the baby-boomers, their age and where they will be over the next five to ten years, I think there is a chance that they will - to use the word loosely - panic, and they will save a lot, and they will save in very risk averse, income-producing investments, which I would argue right now are some of the cheapest assets in the world.
Elaborate on that, because anytime you identify some of the cheapest assets in the world, we want to know more.
Bernstein: The easiest ones, I would say, are large-cap, high-quality U.S. companies - high quality as defined by very stable growth in earnings and dividends over an extended time frame. I think those are very cheap. And this is going on globally, not only with high-quality stocks but with high-quality bonds as well.
Abby, why are the high-quality names underpriced?
Cohen: One reason may be the flows into the market. Hedge funds, for example, have been very enthusiastic about short-term portfolio moves, particularly in smaller-cap names where they can play a large role. The second phenomenon is that many of these high-quality companies are based in industries that have done okay but not great on a relative basis with regard to revenue and earnings growth.
David, let's have your view on that.
Herro: It's been a global phenomenon where waves of money have gone into real estate, emerging markets, small caps, commodities, energy, etc. All that money has come from large-cap stocks that had their heyday from about 1995 to 2000. Where we're finding value is in big companies that have underperformed in the past five or six years. They could be in media - in the United Kingdom we own names like British Sky Broadcasting (Charts) and Trinity Mirror, Johnston Press; and in France, Publicis (Charts), an advertising holding company. Or they could be pharmaceutical companies like Novartis (Charts) or GlaxoSmithKline (Charts) or even some of the highquality cyclicals like BMW.
Jeremy, let's have your view on this because so far we have total unanimity.
Grantham: Rather than say the glass is half-full, I feel compelled to say it's half-empty. It's not that these guys are cheap. It's that risky things have become extremely expensive. What we have seen is multiyear continuous pressure on risk. The risk premium in bonds - emerging debt had a 14-point spread over U.S. governments that went down to four. We were told by bond people that it was a better bargain at four than it had been at 14. But, wham! Two years later it was back to a 15-point spread over U.S. governments. Then it ducked below two. And the same is true right across the length and breadth of the land and the world in general: Junky companies have done better than high quality companies; junky bonds have done better than high-quality bonds.
You're all nodding vigorously. Why has the market embraced risk?
Bernstein: The relationship between equity market volatility and the performance of quality stocks is amazing. Lower-quality stocks do exceptionally well when volatility is down, and high-quality stocks do exceptionally well when volatility goes up. And what we've seen in the past several years has been a distinct downward trend in volatility - recently the CBOE volatility index dipped below ten. You have to go back to December 1993 to find lower figures.
What's driving down volatility?
Bernstein: I would say the No. 1 influence on that volatility index is monetary policy. Liquidity fosters risk-taking. But the lag times are quite long - longer than people think. And so we've had the Fed tightening for two years or so. We now have the Bank of England tightening. The European Central Bank has tightened. The Bank of Japan is probably going to tighten. So I don't think it's going to be a good bet over the next year, year and a half, to say that volatility is going to continue to go down. I want to move on to basic asset allocation for individual investors.
Herro: I would go on the notion that large-cap global stocks are probably the most attractively priced financial assets, and if investors are underweight they should add more to them. I think other things that have run up in price over the past three or four years - we mentioned resources, we mentioned energy, we mentioned real estate - they should back off on all of those and look for things that haven't moved in four, five, six years.
Grantham: Since I think everything is expensive, I would say, take as little risk as possible. Own as few U.S. equities as you can, and if you have to own them to feel like you look like your neighbors, then make sure they're big, conservative blue chips. Better yet, own non-U.S. equities, and make sure they are pretty decent blue chips. Play it safe. Cash is perfectly fine. Patience is a huge virtue. Wait until things are cheaper again.
Rivkin: I wouldn't vary greatly from what I would call the market value of the various asset classes. Because growth outside the U.S. - particularly in Asia - is going to be higher, I might overweight that segment of the world.
Grantham: Recently at a client conference we had a very interesting exhibit showing that in the intermediate term, there is no correlation between a country's growth rate and its market return. Going back over 20, 30 years, it simply doesn't exist.
Then what about other asset classes, like real estate, gold, or other commodities?
Grantham: I think real estate is overdone. Globally and in the U.S., commercial property is badly overdone - buildings are selling way over replacement cost. I have a soft spot for timber, which is a close cousin of real estate, but timber, unfortunately, has somewhat fallen prey to this let's-all-diversify-into exotic- areas trend. Even so, I think it's the only fairly priced asset other than cash out there in the whole world. If you have an irresistible urge to take some risk, I can't see any reason why one day emerging-market equities will not sell at a premium to the S&P. Yes, they'll have some setbacks, but in the longer run they look really terrific.
Bernstein: At Merrill Lynch we have different guidelines for aggressive investors and income investors and other kinds of investors, but the baseline is 50% equities, 30% bonds, and 20% cash. It's not that we're so bearish on equities. We just think that asset returns across the board are going to be remarkably similar, and that's what that asset allocation reflects.
Grantham: I think our advice to aggressive investors is, don't.
Looking over the next ten years, what returns can we expect from the stock market?
Cohen: I think that the market today is modestly underpriced, which suggests that I think returns on average over the next ten years will be close to trend. I would expect returns from the broad U.S. market to be somewhere on the order of 8% to 10% per annum on average, not adjusted for inflation.
Bernstein: I would argue that we'll see about 5% to 7% total returns. One of our themes has been that there is just simply too much money chasing too few ideas around the world. And asset returns are just getting bid away.
Grantham: About 2%, so with 3% inflation, that would be 5%, with less than a fifty-fifty shot of doing better.
But Jeremy, you talk about everything reverting to the mean. Isn't the mean much higher than that?
Grantham: Profit margins are so high, there'll be a lot of pain as they go back to normal.
Herro: I would have to agree pretty much with Abby, 8% to 10%. Stocks are modestly underpriced. Foreign stocks might do a bit better because they're a touch cheaper. But as a U.S. investor in foreign stocks, you have to be concerned about currency. I think that in developed markets, you'll lose a little bit because the dollar will weaken against those currencies. Against the emerging markets, you're going to gain a bit on currency.
Rivkin: I think the U.S. return on stocks will lag the global return, but I think that we're into a very interesting period here where we're bringing large chunks of the global population into the world marketplace, and I think that could lead to significantly higher growth over the next ten years - not that there aren't geopolitical risks, not that there aren't domestic political risks. But I think we could be into a period when global returns will be higher than normal, possibly in the 9% to 11% range.
Because there will be so many more participants in global markets?
Rivkin: Yes. With a billion and a half or two billion people consuming and moving up the per-capita-income scale, and with capital markets developing around the world, I think the U.S. as a portion of the world capital markets will shrink, but the global pie will expand. So I'm a little more optimistic on a ten-year time frame than what we've heard here.