By Tom Bradley

As regular readers will know, I follow Jeremy Grantham and his colleagues at GMO with great interest.  Jeremy’s quarterly missives are always enlightening and the firm, which is based in Boston, has a great long-term track record. 

One of the things GMO does every month is publish a return forecast for a number of asset classes.  The chart projects 7-year ‘real’ returns (after inflation).  I’ve always been reluctant to make forecasts like this because it’s pretty much a crap shoot (GMO provides lots of warnings to that effect), but I think their work is useful as a gut check.  In a period of great volatility and depressing news, the projections get us back to what ultimately drives returns from financial assets - long-term profitability and valuations.

Because of their longer-term nature (7 years), the numbers don’t move around much from month to month, but over the course of 2008 they’ve changed a lot.  For example, on December 31st, 2007 they projected a return for U.S. large-cap equities of -1.1% (real return per annum for the period ending 2014).  Some other equity categories were slightly better, but it was a pretty uninspiring outlook. 

Given what’s happened in 2008, the latest forecast (November 30th) is considerably more positive (see attachment).  GMO is now looking for U.S. large-caps to return 7.4% real.  The other equity categories are even higher – U.S. high quality (11.4%), International large-cap (9.2%) and emerging markets (10.7%).

These estimates are certain to be wrong, but they’re instructive nonetheless.  According to GMO, we’ve gone from extremely poor value to exceptional value in a matter of months.  The numbers reinforce something we’ve been reminding our clients and readers, which is that we should be adjusting our return expectations...UPWARDS...not down.  Double-digit equity returns are quite likely over the next 3 years.

We don’t know if we’ve seen the market bottom, or it’s yet to come (and the GMO numbers don’t help us with that).  But everything we look at – valuation, investor sentiment (bearish) and capital flows – tells us that this isn’t the RRSP season to skip.  The reward/risk tradeoff hasn’t looked this good since the gloomy campaign of 2003.