http://www.marketwatch.com/story/small-cap-investors-paying-too-much-for-risk-2011-04-15?dist=countdown
By Brett Arends
LONDON (MarketWatch) — Watch out for small caps.
That’s the latest warning from legendary fund manager Jeremy Grantham, chairman of fund shop GMO and one of the few people who successfully called the 2008 crash in advance.
His firm’s latest calculations predict that investors in U.S. small-cap stocks will actually lose about a fifth of their money in real terms over the next seven or so years. That’s an annualized loss of about 2.8% after inflation.
As always when it comes to predictions, there are no guarantees. But GMO’s forecasts have a good track record.
Risky assets are supposed to make you money over the medium term, as compensation for owning them. Actually paying money to take risk makes no financial sense whatsoever.
The last time Grantham’s firm warned that people were actually paying for the privilege of owning risky assets was back in 2007, just before the wheels started to come off. Grantham himself, on a recent trip to London, warned about the valuations of U.S. small-cap stocks.
You can see something similar if you just take a step back from the day-to-day action of the market and take a longer view. The Russell 2000 Index
RUT +0.91% of small cap stocks has recently skyrocketed against the broader market. According to FactSet, it is now by far the highest it has been against the Standard & Poor’s 500 Index
SPX +0.39% in at least a quarter century.
It isn’t hard to work out why. Since the Federal Reserve decided to flood the world with free money, under the program known as “QE2” (like the ship) or Quantitative Easing 2, money has been chasing risk and action. Small caps give you a lot of action for the money.
It’s a reckless game. Some people say it’s going to end in tears, and QE2 might be better known as Titanic 2. The Federal Reserve is due to cease QE2 in the second quarter.
The latest surge in small caps is yet another sign that animal spirits are getting overheated on the markets, yet again. According to the latest Bank of America/Merrill Lynch survey of fund managers, institutions are now loading up on risk. The brief panic following the tsunami is now long since forgotten.
They are heavily overweight boom-and-bust stocks such as industrial and energy companies. They are loaded up on emerging markets and commodities.
Cash levels are low. Nobody much wants boring things like utilities or telecom stocks. Nobody wants boring old Japan, which enjoyed a short, bizarre investment vogue following the tsunami. (Aside: Fund managers also say gold is overvalued. They have said this for years…all the way up!)
So-called QE2 isn’t the only reason small cap stocks have risen so far.
A lot of private investors and financial advisers believe that small-cap stocks will always outperform over the long term, albeit at the cost of greater volatility.
Admittedly this blind faith raises some awkward questions. How, for example, can any asset can possibly outperform, regardless of the price paid? And why would an asset be so volatile if it guaranteed such great long-term performance? But never mind. Many believe in small caps regardless.
So those who are behind the curve on their retirement, and who have missed out a lot of the market gains in the past two years, may be tempted to bet wildly on smaller stocks to catch up.
Good luck with that. Make sure you get out in time.
People should at least know what they are doing, and the risks they are taking. Generally speaking in this business, one makes more money over the long term buying assets when they are cheap and selling them when they are expensive. Buying them when they are expensive, in the hope of selling them when they are even more expensive to someone else, is gambling.
