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GMO Turns Negative on Small Caps

Plus, FDIC-insured 529 bill moves through U.S. Congress.

Morningstar Analysts, 05/03/2010

U.S. small-cap funds have been soaring. The average fund in Morningstar's small-cap blend category is up more than 55% over the past year through April 29. But these outsized returns aren't likely to continue, according to one prominent asset manager. That's because the recent run has made most small-cap stocks overvalued.

GMO, which has a successful track record in forecasting asset class values and their subsequent returns, now thinks U.S. small caps will return a negative 1.2% in real terms (registration required), which doesn't account for inflation, over the next seven years. It is the first time the firm has projected negative returns for the asset class since Dec. 31, 2007, when it forecast similar negative returns.

GMO derives its forecasts in part by assuming profit margins and price/earnings multiples for small caps will revert to historical levels over the next seven years. Because the firm thinks small caps are about 50% overpriced, they would have to fall about 1.2% a year in real terms over the next seven years to return to fair value.

GMO's forecasts have proved correct in the past. In December 1999, it projected small caps would return approximately 2.5% a year in real terms over the next decade before fees, transaction costs, and taxes. They ended up with a 2.3% annualized return.

FDIC-Insured 529 Bill Moves Through U.S. Congress
The House of Representatives recently passed a law that would create a new category of FDIC-insured 529 plans. The bill, known as the Deposit Restricted Qualified Tuition Program Act of 2010, would allow FDIC-insured savings accounts and certificates of deposits to be included in 529 plans for the first time.

The legislation is a reaction to the disappointment many college-savers voiced to their representatives after some "core" bond funds in various 529 plans experienced steep losses in 2008.

529 plans provide for tax-free growth of investments if used primarily for college-related educational expenses. Currently, most of the options under such plans carry no explicit government protection on their underlying investments.

The bill was passed without opposition and now moves to the Senate for consideration.

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