The institutional investment firm GMO LLC produces a seven-year asset-class return forecast. At present, its chart predicts U.S. high-quality stocks will produce a real annualized return of 4 percent over the next seven years (or 6.5 percent before subtracting 2.5 percent for inflation).
This is the only U.S. equity class that GMO’s forecast predicts will return positive real returns over the next seven years. The firm sees negative real annual returns for both U.S. small companies (-3.2 percent) and U.S. large companies (-0.5 percent).
GMO predicts timber will be the best-performing asset, generating a 6-percent real annualized return. Next, emerging equities are forecast to earn 4.5 percent annually, followed by the aforementioned U.S. high-quality stocks. International stocks are predicted to earn 2.9 percent real annually.
For fixed income, GMO sees real returns ranging between 1 percent and negative 1 percent for both U.S. bonds and international bonds, with the sole exception being emerging debt returning 1.7 percent annually over the next seven years.
Obviously, these asset-class returns are just one firm’s predictions—although GMO’s seven-year forecasting record has proved remarkably accurate. One thing that does stand out is that, on balance, these returns are not exactly going to get investors to sit up and get excited.
Consider the plight of pension funds who stubbornly maintain “assumed rates of return” on their plan assets of around 8 percent. A mix of bonds returning 1 percent and stocks earning 4 percent is going to fall far short of those lofty pension-fund-return goals. If so, this means their already onerous pension liabilities are ghastly understated.
A mix of 25 percent in bonds and 75 percent in stocks would crank out a 3.25-percent real return. This substantial shortfall explains why pension plans are migrating into alternative investments like hedge funds, private equity and venture capital. Yet, it is doubtful that these more adventuresome investment categories will boost returns enough to meet pension return goals.
For individuals holding cash returning a negative real return of about 2 percent, the default alternatives based on the GMO asset class forecast would be timber, emerging stocks and high-quality U.S. stocks. A handful of stocks and REITs can give investors access to timber holdings with attractive dividends and a hedge against inflation. Exposure to emerging stocks is best accessed via an ETF or mutual fund.
At present, the no-brainer asset class for investors seems to be large, high-quality U.S. stocks. Investors can own franchise corporations with “moats” around them for 10 to 12 times earnings, which is equivalent to 8-percent to 10-percent earning yields. By moats, think of businesses that cannot be easily duplicated and therefore are more resistant to competitive pressures.
Strong balance sheets provide reasonable downside-risk protection, and you get 2-percent to 4-percent dividend yields to boot. Think Microsoft, Intel, Eli Lilly, Pfizer, AT&T, Verizon, Walmart, Target, Exxon as a few examples of stocks to consider. Heck, value investors can even start to make a case for companies like Google and Cisco Systems.
The stock market seems to be unimpressed with the large, high-quality U.S. stocks. Ignored and relatively cheap, this means it is likely a good time to take a look at this asset class.•
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or firstname.lastname@example.org.