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Managers Say Stocks Have Been Cheaper

Plus, a star manager leaves Morgan Stanley, and more.

Morningstar Analysts, 03/02/2009

Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition.

Many managers have been telling us and their shareholders that the stocks in their portfolios are cheap--really cheap. As in, "I have never seen valuations so low before in my investment career" cheap. While it may be true that stocks may offer potential returns in excess of their historical cost of equity or historical returns, they have been cheaper. The last time stocks were very cheap, according to two prominent fund industry veterans, was back in 1982, almost 27 years ago. And the market would have to fall a lot more to reach those levels, they say.

GMO's Jeremy Grantham has seen many different market cycles since helping to start GMO in 1977 and entering the investment business in the 1960s, and he recently described the market's valuation this way:

     "The forecast for the S&P has been jumping around 6% to 7% real, with other global equities slightly higher. To put that in perspective, a 1-year forecast done on the same basis we use today that started in December 1974 would have predicted a 14% return (which, by the way, it did not deliver since the market stayed so cheap). For August 1982, the forecast would have been shockingly high - over 20% real! So do not think for a second that this is as low as markets can get."

I estimated that the S&P 500 Index would have to trade near 550 to offer a 14% real return using GMO forecasts. To reach 1982 levels of "cheap," the S&P would have to approach the 400 level.

John Hussman, manager of Hussman Strategic Total Return HSTRX, came up with similar numbers with a different methodology. To match the worst historical troughs of market valuations he estimates the S&P 500 Index would have to decline to somewhere between 500 and 550. At that level, "stocks would be priced to deliver total returns over the following decade in the likely range of 14-17% annually," he recently wrote in a commentary. Hussman thinks the market's current valuation would lead to nominal returns in the 9%-11% range. Assuming less than 3% inflation, the estimates are almost identical.

So in two different markets--1974 and 1982--stocks fell to the point where they offered investors real prospective returns of at least 14% before hitting bottom. Even with the S&P 500 now hovering around 750 the index would have to shed about another 200 points (roughly a 25% drop) to reach 1974 valuations. That doesn't mean stocks will get cheaper, but it does mean that they could. That's worth bearing in mind as you reset your return expectations.PAGEBREAK

Star Manager Elmasry to Leave Morgan Stanley
We can now disclose that Hassan Elmasry, one of the best managers in his field in our view, is leaving Morgan Stanley at the end of April to start his own money management firm in London. Elmasry and his team currently run Van Kampen Global Franchise VGFAX (and its Morgan Stanley clone), Van Kampen American Franchise VAFAX, and Van Kampen Global Value MGEAX (and its Morgan Stanley clone), as well as similar funds domiciled in the U.K., Australia, and Luxembourg.

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