Jeremy Grantham recently released his quarterly letter for GMO. The most interesting part of the letter was the fact that Grantham sounded the alarm bell over small cap stock valuations.
First of all the unemployment rate has continued to lag around 9%. During the 2005-2007 time period U.S unemployment rate was around 4.6%.
Secondly, consumers are in a process of deleveraging although revolving credit has shown an uptick according the Federal Reserve. Perhaps consumers have embarked on the beginning of another "debt driven consumption binge."
Finally, commodities have sky rocketed and one would think that the consumer's pocket book has been pinched. In particular, the rising cost of oil and gasoline should crimp consumer spending and revenue growth of small cap companies. Energy is currently at over 6% of all consumer spending.
With these three economic headwinds, there can only be 3 explanations for why the Russell 2000 index is trading at such frothy valuations:
a) market expectation that full employment will be achieved in the coming quarters
b) government stimulus has made up for lost private spending during the recession
c) the market is more concerned with the fact that corporate profits are at 2006 levels than with revenue growth potential
For much of 2011, hedge fund manager Doug Kass has been pressing his short positions in IWM which is the ETF for the Russell 2000. However the index has gained 10% since he first opened short positions.
You can read the full GMO letter and Grantham's commentary below.
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One group that we refuse to hold, however, is global small cap stocks and, in particular, U.S. small caps. On our data, U.S. small cap stocks are now as expensive as we have ever seen them. Perhaps more surprising still is the deafening silence about this distinctly frothy group. Although the S&P 500 price index is still some way below its all-time high, U.S. small caps are within spitting distance of theirs: a high that was last reached with a booming global economy, strong employment, and a debt-driven consumption binge in full swing.Indeed if one looks at a chart of the Russell 2000 index one can see that small cap stocks are up 35% since June 2010. The performance of small cap stocks would even make silver speculators jealous. The ETF for the Russell 2000, IWM is now trading at bubble year prices and recently made a 5 year high. IWM is trading at an 18X PE and corporate profits and only yields 1%.
First of all the unemployment rate has continued to lag around 9%. During the 2005-2007 time period U.S unemployment rate was around 4.6%.
Secondly, consumers are in a process of deleveraging although revolving credit has shown an uptick according the Federal Reserve. Perhaps consumers have embarked on the beginning of another "debt driven consumption binge."
Finally, commodities have sky rocketed and one would think that the consumer's pocket book has been pinched. In particular, the rising cost of oil and gasoline should crimp consumer spending and revenue growth of small cap companies. Energy is currently at over 6% of all consumer spending.
With these three economic headwinds, there can only be 3 explanations for why the Russell 2000 index is trading at such frothy valuations:
a) market expectation that full employment will be achieved in the coming quarters
b) government stimulus has made up for lost private spending during the recession
c) the market is more concerned with the fact that corporate profits are at 2006 levels than with revenue growth potential
For much of 2011, hedge fund manager Doug Kass has been pressing his short positions in IWM which is the ETF for the Russell 2000. However the index has gained 10% since he first opened short positions.
You can read the full GMO letter and Grantham's commentary below.
Cms Attachment Download
