When big brains collide, there is a lot to be learned

This week, two of the biggest brains in the investing business published strikingly different outlooks for the stock market.

If Aswath Damodaran’s analysis is right, stocks are primed for some of their best returns in a generation. If Jeremy Grantham’s latest essay is correct, the market still has another 20 per cent or so to fall.

No matter which side of this debate you favour, there is a lot to be learned from watching how two brilliant observers assess the current situation.

Prof. Damodaran teaches finance at New York University. He has helped to educate a generation of Wall Street analysts and literally wrote the book on stock valuation.

Mr. Grantham co-founded asset manager GMO LLC in Boston, which has almost 1,000 employees worldwide. He built his reputation by loudly and correctly warning of the late 1990s bubbles in dot-com stocks and the 2007 bubble in U.S. housing.

Let’s start with Prof. Damodaran. In his Musings on Markets blog, he points out that last year was unusual even by the wild standards of the stock market. The S&P 500 index, dividends included, lost 18.1 per cent of its value. Runaway inflation added to the pain.

All told, investors incinerated 23.5 per cent of their wealth in real terms, making 2022 the sixth worst year in U.S. stock market history going back to 1928.

The market often rebounds spectacularly after a bad year, but speedy recoveries are not guaranteed. During the Great Depression, and again in 1973-74 and 2000-02, the S&P suffered two or more losing years in a row.

To assess the state of today’s market, Prof. Damodaran looks at the equity risk premium – in other words, the extra payoff, in terms of expected return, that investors are demanding to hold risky stocks instead of safe government bonds.

The key notion here is that a big, fat equity risk premium shows that investors are being cautious right now and avoiding irrational exuberance. They are investing in stocks only when stocks appear to offer a substantially better deal than bonds.

Prof. Damodaran calculates the equity risk premium by looking at the consensus estimates among Wall Street analysts for corporate earnings in coming years. He works out what those earnings estimates imply for stock prices, and then compares those expected results with the returns that are available on bonds.

His number crunching pegs today’s equity risk premium at nearly 6 per cent, an unusually high number by historical standards.

Remember that the premium is on top of what a risk-free government bond would pay. Put the two together and the expected return on the S&P 500 now stands at 9.8 per cent – the highest level since 1995.

It was a very bad year

The S&P 500 index lost 18.1 per cent in 2022. That wasn’t the

worst year on record since 1928, but it was close. The consolation

is that most years are much, much better. (Annual returns on S&P

500, dividends included, 1928 to 2022)

30

Number of years

25

20

15

10

5

0

<-25%

-20 to

-25%

-15 to

-20%

-10 to

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-5 to

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0 to

-5%

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5%

5 to

10%

10 to

15%

15 to

20%

20 to

25%

>25%

Annual returns

the globe and mail, Source: Aswath Damodaran

It was a very bad year

The S&P 500 index lost 18.1 per cent in 2022. That wasn’t the

worst year on record since 1928, but it was close. The consolation

is that most years are much, much better. (Annual returns on S&P

500, dividends included, 1928 to 2022)

30

Number of years

25

20

15

10

5

0

<-25%

-20 to

-25%

-15 to

-20%

-10 to

-15%

-5 to

-10%

0 to

-5%

0 to

5%

5 to

10%

10 to

15%

15 to

20%

20 to

25%

>25%

Annual returns

the globe and mail, Source: Aswath Damodaran

It was a very bad year

The S&P 500 index lost 18.1 per cent in 2022. That wasn’t the worst year on record since 1928,

but it was close. The consolation is that most years are much, much better.

(Annual returns on S&P 500, dividends included, 1928 to 2022)

30

25

Number of years

20

15

10

5

0

<-25%

-20 to

-25%

-15 to

-20%

-10 to

-15%

-5 to

-10%

0 to

-5%

0 to

5%

5 to

10%

10 to

15%

15 to

20%

20 to

25%

>25%

Annual returns

the globe and mail, Source: Aswath Damodaran

That sounds rather alluring. To sum up: What’s not to like about today’s stock market?

Quite a lot, argues the bearish Mr. Grantham. In a letter to investors this week that reads like the gloomy twin to Mr. Damodaran’s outlook, he says the carnage in stock prices last year leaves us just midway through a painful adjustment. “While the most extreme froth has been wiped off the market, valuations are still nowhere near their long-term averages,” he writes.

He is particularly concerned about what will happen if the global housing bubble implodes. He points out that the average U.S. home now sells for six times the average family income, a record high. As bad as that is, the situation is much, much worse in cities such as Hong Kong, Vancouver, London, Paris, Shanghai, Sydney and Tokyo, where homes typically sell for 10 to 20 times household incomes.

Stocks, too, look pricey when you compare them with long-run earnings trends. Mr. Grantham says his calculations suggest the S&P will likely fall to 3,200 by the end of this year, roughly a 20 per cent drop from its current level around 4,000.

This would be in keeping with history, according to Mr. Grantham. A 20-per-cent decline this year would bring the market’s total decline in 2022 and 2023 to around 40 per cent in real terms – slightly less than the 50 per cent or so decline that the market has historically suffered when it has reached similarly extreme levels of valuation.

So who is right here about what the coming year holds? It ultimately comes down to the unknowable matter of how the economy will perform.

Prof. Damodaran acknowledges the wide range of possibilities. In a scenario where inflation subsides quickly and the economy escapes a recession, he sees the S&P bouncing 10 per cent higher. On the other hand, if inflation stays high and a deep recession ensues, he sees earnings estimates being slashed and the index plunging to around 3,200 – pretty much Mr. Grantham’s baseline scenario.

For his part, Mr. Grantham is happy to recognize the many factors, from U.S. politics to a reopening China, that might give the market a short-term bounce. His point is simply that high valuations always unwind eventually. “The final low for this market might be well into 2024,” he writes.

Maybe the real lesson here is that no one has a crystal ball. Rather than trying to outguess the market’s swerves, investors are usually best served by simply picking a sensible asset allocation and sticking to it. A classic balanced portfolio of 60 per cent stocks and 40 per cent bonds seems entirely sensible at a time when even brilliant investors disagree about what will come next.