Executive Summary
Given today’s low yields and high valuations across almost all asset classes, there are no particularly good outcomes available for investors. We believe that either valuations will revert to historically normal levels and near-term returns will be very bad, or valuations will remain elevated relative to history. If valuations remain elevated indefinitely, near-term returns will be less bad but still insufficient for investors to achieve their goals. Furthermore, given elevated valuations in the long term, long-term returns will also be insufficient for investors to achieve their goals. It would be very handy to know which scenario will play out, as the reversion versus no reversion scenarios have important implications both for the appropriate portfolio to run today and critical institution-level decisions that investors will be forced to make in the future. Unfortunately, we believe there is no certainty as to which scenario will play out. As a result, we believe it is prudent for investors to try to build portfolios that are robust to either outcome and start contingency planning for the possibility that long-term returns will be meaningfully lower than what is necessary for their current saving/ contribution and spending plans to be sustainable.
Introduction
Over the past few years, my colleague James Montier and I have written extensively on the possibility that there has been a permanent shift in the investment landscape.1 The investment landscape today is an unprecedented one, where we believe it is not so much that asset prices look mispriced relative to one another (although some of that is going on) but that almost all asset classes are priced at valuations that seem to guarantee returns lower than history. Our standard forecasting approach assumes that this situation will gradually dissipate, such that seven years from now valuations will be back to historical norms. James calls this scenario Purgatory because it means a finite period of pain, followed by a return to better conditions for investors. An alternative possibility, which James refers to as Hell, is that valuations have permanently shifted higher, leaving nearer-term returns to asset classes somewhat better than our standard methodology would suggest, but at the expense of lower long-term returns. By now some of our clients are probably thoroughly sick of hearing about the topic, but this piece is going to delve into it yet again, because the question of whether we are in Purgatory or Hell is a crucial one, not only for its implications for what portfolio is the right one for an investor to hold at the moment, but also for the institutional choices investors have to make that go well beyond simple asset allocation. In his letter this quarter, Jeremy Grantham (Trades, Portfolio) is exploring a slightly different version of the Hell scenario. His version of Hell is driven more by weaknesses in the arbitrage that should force asset prices back to equilibrium rather than changes to discount rates, but it has similar implications for investors and institutions.
The distinction between Purgatory and Hell is an important one, because each scenario creates different challenges for investors. In short, Purgatory creates an important investment dilemma today, as the “optimal” portfolio looks strikingly different from traditional portfolios. If we are in Hell, by contrast, traditional portfolios are not obviously wrong today, but the basic assumptions investors make about their sustainable spending rates are dangerously incorrect. These twin issues – the implications for today’s portfolios and the implications for institutional decisions into the future – are crucial for us in the Asset Allocation group at GMO. And they are the reason why most of the investment conversations I have had with my colleague John Thorndike2 over the past few months have either been on this topic or have been impacted by the dilemma of which scenario to assume. The rest of this paper is largely a summary of our discussions on the topic, which we recently presented at our annual client conference.
Why all the discussion of Hell?
There are a couple of important points to make about why we spend so much time discussing the Hell scenario today when we have not done so in the past. The first is that we would likely not be discussing it at all if it did not seem to be priced into the market. If asset prices today were generally clustered around normal valuation levels, we would spend very little time concerning ourselves with the possibility that all assets would simultaneously rise in price and valuation to a new high plateau, which would, in the future, be considered normal. In other words, we run the risk here of making the same mistake that we have accused plenty of other investors of making in the past, trying to justify the price level of an overvalued market with those ever dangerous words “This time is different.” The second is that unlike many points in history, the change to the expected returns to assets involved in going from a Purgatory scenario to a Hell scenario has very important implications for the correct portfolio to hold today. Even had you known in 2000 or 2003 or 2007 whether the future was going to evolve consistent with the Purgatory scenario versus the Hell scenario, you would not have needed to run a particularly different portfolio. Today’s portfolio is much more profoundly different depending on which you think is correct. And finally, Hell goes beyond being merely an “investment problem” into the realm of being an “institutional problem,” with implications for foundations, endowments, pension funds, and individual savers that are much broader than the simple question of what portfolio is the right one to run today.
Purgatory and Hell, the seven-year view
Our standard assumptions for long-term asset class returns are that equities should deliver 5.5-6% above inflation in the long run, bonds 2.5-3% above inflation, and cash 1-1.5% above inflation. These assumptions are broadly consistent with the long-term returns to each of these assets, and embody what we feel are appropriate premia for bonds and stocks above cash, given the risks that each impose on holders. The assumptions for Hell are 1.25% lower equilibrium returns across the board. In other words, in Hell the equilibrium return on cash is 0% real and risk premia are otherwise left unchanged. The implications for our asset class expected returns over the next seven years are shown in Exhibit 1.
As you can see, for all assets other than cash, expected returns are higher in Hell than in Purgatory. This is because, other than cash, these are all reasonably long-duration assets, and gains made by not having to fall to the lower valuations of Purgatory outweigh the lower income generated by the fact that valuations are higher on average over the period. An assumption of higher ending valuations will always make for higher expected returns over a seven-year period for stocks and bonds. But for much of history, this wouldn’t necessarily have affected the correct portfolio to hold. Exhibit 2 shows the result from a simple optimization given our standard 7-year forecasts as of June 2000 and the result if we adjusted the forecasts for the Hell terminal assumptions.3
Continue reading the letter here.
Also check out:
