Jeremy Grantham's 3rd Quarter Commentary - Career Risk and Stalin's Pension Fund: Investing in a World of Overpriced Assets (With a Single Reasonably-Priced Asset)

Inside GMO there are three different views on whether and how rapidly the market will revert to its pre-1998 normal

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Dec 14, 2017
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Inside GMO there are three different views on whether and how rapidly the market will revert to its pre-1998 normal: James Montier feels it will be business as usual and revert within 7 years. Ben Inker also holds out for a 7 year period, but includes a 33% chance it will revert to a higher average valuation (the “Hell” scenario). I believe that the reversion on valuations will take 20 years, and that profit margins will probably only revert two-thirds of the way back to the old normal.

â– â–  All three outcomes are quite possible. This creates a difficult investment challenge.

â– â–  My proposition, though, is that there is an optimal investment for all three outcomes:

a heavy emphasis on Emerging Market (EM) equities, especially relative to the US.

â– â–  The next difficulty lies in deciding how much to emphasize this investment, which is perceived as riskier than most, and can of course fail.

â– â–  I firmly believe that asset allocation advice should not be offered unless you are willing, on rare occasions, to make major bets and accept a big dose of career and business risk. Otherwise asset allocation should be indexed.

â– â–  In contrast, a traditional, diversified 65% stock/35% fixed income portfolio today, designed to control typical 2-year career risk, I believe is likely to produce a return over 10 years in the 1% to 3% real range – a near disaster for pension funds.

â– â–  To concentrate the mind, I fantasize about managing Stalin’s pension fund where the penalty for failing to deliver 4.5% real per year over 10 years is death. I believe only a very large investment in EM equities will give an excellent chance of survival.

â– â–  Since February 2016, EM equities have already moved 11% relative to the US. But their three earlier moves since 1968 were at least 3.6x the developed world markets!1 Absolutely, at around 16x Shiller P/E, EM equities can keep you alive.

  • Even a quite successful attempt to leap out of the market and back in, although likely to beat the conventional approach, is unlikely to beat a very heavy EM equities portfolio.

â– â– Conclusion. Be brave. It is only at extreme times like this that asset allocation can earn its keep with non-traditional behavior. I believe a conventional diversified approach is nearly certain to fail.

Background: A Rapid Market Fall Back to the Old Trend or a 20-Year Slow Retreat?

At GMO these days we argue over three very different pathways to a similar dismal 20-year outlook for pension fund returns. James Montier thinks it is likely that we will have a very sharp market break in the near future, back to the old pre-1998 levels of value and that we will stay there, with the last 20-year block becoming an interesting historical oddity. Ben Inker – the boss – also believes things will revert over 7 years, but considers it plausible that the valuation level the market will revert to has changed, leaving near-term returns better than James’ view, but the 20-year return largely the same. I represent a third view, that the trend line will regress back toward the old normal but at a substantially slower rate than normal because some of the reasons for major differences in the last 20 years are structural and will be slow to change. Factors such as an increase in political influence and monopoly power of corporations; the style of central bank management, which pushes down on interest rates; the aging of the population; greater income inequality; slower innovation and lower productivity and GDP growth would be possible or even probable examples. Therefore, I argue that even in 20 years these factors will only be two-thirds of the way back to the old normal of pre-1998. This still leaves returns over the 20-year period significantly sub-par. Another sharp drop in prices, the third in this new 20-year era, will not change this outcome in my opinion, as prices will bounce back a third time.

These differences of assumptions produce very different outcomes in the near and intermediate term. Near-term major declines suggest a much-increased value of cash reserves and a greater haven benefit from high-rated bonds.

My assumption of slow regression produces an expectation of a dismal 2.5% real for the S&P and 3.5% to 5% for other global equities over 20 years, but also a best guess of approximately the same over 7 years. This upgrades the significance of the positive gap between stocks and cash and downgrades the virtues of cash optionality and long bond havens. This much is clear.

What is not so intuitively obvious is how similar all three estimates are for 20 years. All three are within the range of 2.5% to 3% real return for the US – a dismal outlook for pension funds and others – and within nickels and dimes for other assets.

A problem for investors following GMO’s writing is which of these three alternatives to choose. It is pretty clear to me that all three are possible. Ben Inker, our head of Asset Allocation, has tried hard to make our clients’ portfolios relatively robust to either a very bad medium-term outcome (the James scenario) or a relatively benign outcome (my scenario). I am going to attempt something much simpler here – some might say oversimplified, but I hope not – of asking which investments are appealing in all three outcomes, but particularly the 7-year and 20-year versions. My conclusion is straightforward: heavily overweight EM equities, own some EAFE, and avoid US equities. The next question is how brave to be in this type of situation, where there is only one asset that is reasonably priced in a generally very high-priced world. This is the topic I want to emphasize this quarter.

What is the point of asset allocation? Making good-sized bets and winning.

If you mean to offer a useful asset allocation service to institutions, one that is designed to beat benchmarks and add value as well as lower risk, then you must make bets. And when there are great opportunities, which is all too often not the case, you must make big bets. If you mean only to tickle the allocation with slight moves, you may have a good framework for coffee time conversation with clients but you are not going to make a difference. Ever. If you are not prepared to put considerable career or business risk units on the table (and be prepared to persuade the clients’ managers to do the same!), for example, in a classic equity bubble like 2000, or a classic housing bubble with associated junk mortgage paper in 2007, then you should not offer the service. Let the client index the allocation, as many do. Given plenty of company they can at least sleep well, knowing that if they run off a cliff, which they will do every 10 or 15 years, they will not be noticed in the herd. Keynes explained career risk (and how it encouraged momentum investing) first and still best in Chapter 12 of The General Theory in 1936: Never, ever be wrong on your own. If you are “you will not receive much mercy.” Yet, he also pointed out earlier in 1923 that for advice to be useful it needs to rise above faith in long-run regression to normal. “This long run,” he famously said, “is a misleading guide to current affairs. In the long run we are all dead. Economists [and market gurus] set themselves too easy, too useless a task, if in tempestuous times [such as bull markets] they can only tell us that when this storm is past the ocean is flat again.” And this unusual “tempest” of way over old-normal prices has lasted for 20 years and still continues.

The Catch 22 of asset allocation: career risk (and clients’ patience)

The Catch 22 of trying to give useful asset allocation advice is that you cannot expect to be right all the time. You will make mistakes, mostly in timing, but possibly also in analysis, and you will pay a price. Your objective is to be as aggressive as you can be and just not lose too much business. Some cycles are well-behaved and sometimes most of us, anyway, get lucky. But once in a dreaded while opportunities that were already brilliant become incredibly brilliant just as early 1998 broke out above the previous record P/E on the S&P of 21x in 1929 and then went on to 35x! So there is no easy answer. You can know in your bones what to do but still not have enough career risk units up your sleeve, or the natural risk-taking tolerance to do it. That is, as we like to say, why these opportunities get to exist in the first place. It would certainly help if your firm is designed to withstand some considerable career and business risk. Independence is good. Looking back, 1999 seemed to prove that no large investment house felt that it could afford the client loss of exiting the market early. Overwhelmingly they rode the market up and rode it down. And the one notable outlier changed its mind at the 11th hour and moved money into growth stocks from a very value-based approach. None of them was in that sense offering useful asset allocation advice. The proof of the pudding was in the degree to which the severe 50% losses in 2000-02 and in 2008-09 were avoided or not. Ingenious client communication and preparation on such occasions will certainly reduce the commercial pain of an error, but will by no means remove it.

Stocks are getting more efficiently priced…asset classes are absolutely not

Long ago, in the good old days, if you bought a company with obvious extreme financial or marketing problems and it did not work out, you were considered an absolute idiot – every sane person (clients would say) knew to avoid such folly. Since they represented dangerous career threats, these companies became that much cheaper to own; although some would fail and hurt you, the average return would be handsome. Thus a portfolio of “dogs” as we called them, with the lowest P/Es and lowest price-to-book ratios, would regularly outperform the blue chip favorites – universally recommended then by established banks – by five or six points a year.

Then, into this story perhaps too good to last, came an army of quants and more highly-trained analysts than had been normal at least in the pre-1990 era. The price-to-book effect was easily modelled as were an increasingly sophisticated army of measurements of out-of-favor stocks. Simultaneously, clients were advised by academics and practitioners alike that sophisticated investors looked at the bottom line – the portfolio performance as a whole – and did not obsess about individual stock successes or failures. Thus the career risk of picking down-and-out companies dropped away, and with it, not surprisingly, much of the extra performance for buying them. Buying “dogs” had become reasonable and prudent, even on occasion trendy – who would want more overtly successful companies when cheap companies had a 4% edge, or 3% or 2% or even 1%? And so the big easy wins of “cheap stocks” got on the boat with Tolkien’s elves and sailed off, to be remembered as a golden era. Even a moderate edge now required more sophisticated, more accurate measures of true economic value. The army of quants and the influx of talented people had done the damage – who needs to be building fusion or fission plants when they could be making multiples of their salary helping build models and trading in nanoseconds (to pick on that least socially useful tax on institutions)?

But the severe market breaks of 2000 and 2007 showed one thing very clearly: that at the asset class level there was not even a hint of increased efficiency. The peak of 2000 offered perhaps the all-time best packet of mispriced asset classes – one versus another. Value and small cap had never been cheaper compared to growth and large cap. Small cap looked as if it could rally 70 percentage points to catch back up, which it duly did. Even more remarkably, perhaps, US REITs yielded 9.1% at the very top of the market against the all-time low yield on the S&P 500 of 1.5% – all to be justified by a 1% per year faster growth in dividends! By the time the S&P was down 50%, the REIT index was up close to 30% (and small cap value was up 1% or 2%, also not bad). The new long real bonds, or TIPS, yielded 4.3% and regular long bonds yielded 5% or 3.5% real. All amazing. Then more recently in 2007-08 there was the broadest overpricing across all countries, over 1 standard deviation, than there had ever been. So, major opportunities at the asset class level have been alive and well in this period of the last 20 years and compare, for once, favorably to the “good old days.” Why?

Why asset classes are still inefficiently priced

In contrast to the increased acceptability and lowered career risk that had narrowed the value opportunities at the micro level, there was still nowhere to hide at the asset class level. You go to cash too soon and your business or career melts away, you stay too long and you are seen as useless. In short, investing at the asset class level remains dangerous to career and profits and is, hence, inefficient, thereby allowing for occasional great opportunities with the old attendant caveats.

The inefficiencies today: EM and EAFE vs. US equities

Which brings us to today and Exhibit 1, which is GMO’s 7-year forecast, including that for EM Value stocks. Exhibit 2 shows how remarkable the estimated gain is for EM Value relative to the next best asset on our data, compared to the greatest gaps available over recent years. But, Exhibit 3, from Minack and Associates in Sydney, suggests that GMO’s forecast may still be understating the opportunities in EM equities. It plots the straightforward measure of Shiller P/E (price over 10 years of average real earnings after inflation). My using an outside source is deliberate: to cross-reference and also to suggest that GMO’s estimates, in the interests of safety, are conservative (discussed later). Note that at the recent low in February 2016 (Point 1), the multiple on EM equities was lower than after the crash in 2009! Remarkable. Meanwhile (Point 2), the multiple on the US had gone from 12 to 22, an almost 100-percentage-point spread in favor of the US in just 7 years. The Emerging index had sold at 38x in late 2007 (Point 3), a very substantial premium (52%) by any standard over the 25x of the US index. It had sold again at a premium as recently as 2011 after the crash. And early last year, the US was at a 120% premium the other way. When you see the absolute and relative volatility of these three indices in Exhibit 3, doesn’t it suggest money to be made and pain to be avoided, even with less than perfect predictive power? It certainly indicates an old-fashioned level of extreme market inefficiency at the asset class level.

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