GMO LLC Co-founder and Chief Investment Strategist Jeremy Grantham's letter for the fourth quarter of last year is out and contains insightful equity-market forecasts for this year and beyond.
In the very near term, Grantham conceded the U.S. stock market could go higher. Fifteen years ago, he and a colleague developed an explanatory model that showed that low, stable inflation and high profit margins tend to drive the market higher.
Currently, inflation is low and profit margins are high. However, the equity market is depressed by gloomy macroeconomic news. But, whenever negative news cools down for a week or so, the stock market could conceivably go higher.
In the intermediate term, the global equity market as a whole looks to be fairly valued, according to Grantham. Still, stocks, unlike bonds, are good inflation hedges. Inflation is arguably a relevant, looming threat down the road given the U.S. Federal Reserve's hyperloose monetary policy.
Grantham recommended underweighting U.S. stocks, except for those in the top quartile of quality, which is defined as blue-chip companies with a proven record of profitability and safe balance sheets. He also recommended slightly overweighting non-U.S. stocks.
In the long term, however, Grantham is worried about the U.S. stock market. He noted that before the era of cheap money begun in 1987 by Federal Reserve Chairman Alan Greenspan -- and continuing today by successor Ben S. Bernanke -- all of the great bull markets ... ended by going below their trend line for several years.
In the aftermath of the global financial crisis of 2008-2009, this has not happened: The U.S. stock market took only three months to recover to trend thanks to the massive bailout orchestrated by the Federal Reserve and federal government.
However, as the Federal Reserve runs out of stimulus options -- and assuming the U.S. stock market slips into a more typical bear market -- the S&P 500's future performance could look something like the chart below, which GMO compiled based on the average of the 10 pre-Greenspan stock-market busts.
In the long term, Grantham recommended investing in resources. GMO itself has a significant presence in timber investing. Global farmland could be attractive, if investments are done with care and experience.
Natural gas also works.
In the short term, though, these long-term resource plays may suffer losses, warned Grantham.