“Investors still seem too comfortable... and that makes us nervous.”
US value fund giant GMO’s contention that investors seem “comfortable” might seem odd, given US stocks have endured their second-worst start to a year in history. However, GMO’s so-called comfort model suggests markets are not fully pricing in the increasingly unstable fundamental backdrop.
The comfort model examines three factors – corporate profits, economic growth, and inflation – and is based on the simple idea that valuations are higher when conditions are stable and predictable. High profits, stable growth and low inflation result in greater investor comfort and therefore higher valuations, as has been seen over the last decade.
Currently, the problem is that, while valuations have fallen, the deterioration in the fundamentals has been even more extreme. Consequently, the difference between the S&P 500′s actual valuation and the valuation predicted by GMO’s comfort model is wider than at any time since the late 1990s.
Now, this doesn’t mean stocks must fall. A rapid decline in inflation and a soft economic landing would result in a brighter investment outlook. However, that is not a given.
If investors react to conditions as they have done historically, says GMO, the US stock market “may well have significantly further to fall”.
