Friday, May 2nd, 2014
three in one

The GMO quarterly letter often triggers a great deal of discussion.  The first tweets about the latest edition started shortly after its release yesterday, the blogosphere will parse it every which way over the next few days, and the opinions expressed in it will reverberate among asset owners and investment organizations for weeks and months to come.

That is all part of the marketplace of ideas that characterizes today’s investment ecosystem.  An examination of those dynamics might be interesting, but it’s the letter itself that is under review in this posting.  Or should I say the three letters, since this quarter’s GMO missive is really three in one.GMO | If you register, you can get access to the letter and email notifications of future GMO publications.

First up is Jeremy Grantham, the leader of the organization.  The title, “Looking for Bubbles, Part One: A Statistical Approach,” sets up the exercise concisely.  He is on a bubble hunt, a very common activity these days.  Once you go on a bubble hunt, you are bound to report whether you have found one or not.

The best part of Grantham’s section comes up front, when he explores the underpinnings of the value approach, including the open derision and mocking (and loss of assets) that must be endured while the world does its thing — behaviorally very difficult even if the knowledge that “we will win in the end” is deeply engrained.

Grantham looks at past bubbles, using two standard deviations from trend as the line of demarcation.  (This level of precision is, of course, as silly as that used by those who anoint “bull” or “bear” markets by the numbers.WSJ Experts | This is my comment in that regard for the Wall Street Journal.)  He references John Hussman’s valuation work, but also looks at the January effect and the presidential cycle — and has caustic comments for the bubble-blowing series of Fed chairs.  In the end, he pronounces that the market will go still higher and even throws out a number (2,250 on the S&P 500) to strengthen the interpretive frame.

It is the least enlightening section of the letter.  Grantham reminded me of the prognosticator who feels the need to “call” the market, “It’s going to do this, then this, then that.”  It’s exactly the wrong kind of guidance for most decision makers, even if his instincts turn out to be amazingly accurate.  The bottom line for many will be, “Grantham sees more room to run,” tempting them to continue full speed ahead despite the risks of doing so.  (Which is not to say that I necessarily disagree with his prognostication:  In a business of herdingthe research puzzle | This posting talks about the foundations and behaviors of the investment world. — the growth of such business not being accurately accounted for in historical comparisons of market behavior — momentum can be very powerful.)

The second section (“Looking for Bubbles, Part Two: A Sentimental Approach) was written by Edward Chancellor and features “a non-valuation approach to bubbles.”  He lists eight characteristics of market manias and includes his assessments of where we are today.  His conclusion is that “sentiment has reached an extreme level,” while noting that there are some things that don’t fit with past patterns, especially the lack of strong credit growth (although there are plenty of other credit-related indicators that are flashing red).

Chancellor includes a chart of a combined sentiment indicator to visually represent his point, and says that buying at this level of that indicator has historically led to negative real returns.

Ben Inker anchors the team with a section titled, “In Defense of Risk Aversion.”  It complements the others and drives home a critical point:  Whatever you might think is going to happen in the next few months, you have some hard choices to make today.

GMO, despite Grantham’s predictions, is selling equities, knowing that in doing so they “are voluntarily reducing the expected returns of our portfolios on our own forecasts.”  Why?  “The behavior follows from a belief we have about the markets and a belief we have about what we should be doing with our portfolios.”

Aha.  It is in keeping with the firm’s investment beliefs.the research puzzle | I have written a variety of things about investment beliefs over time.  This piece has that title.  As Inker says, doing so may not be in keeping with yours.

But look at the key belief:  GMO wants to “minimize the expected shortfall against our real return target.”  Isn’t that what most asset owners should be doing?  For the most part, that’s not the way the game is played.  Instead, investors expect to walk up to the precipice,the research puzzle | Just like we expect analysts to do. identify the specific nature and timing of the calamity coming our way, and act accordingly.

The details of Inker’s argument are important.  In a simple way, he looks at the theoretical trade-offs between volatility and return, and focuses on the choices available to an asset owner at a time of rich valuations across many asset classes.  It forces you to think about acting to lower the commitment to equities, even though doing so “reduces the expected return of the portfolio at a time when it's already harder to earn a decent return.”

It is not the gospel of the industry — and certainly not the sermon of the pundits — that shepherding a portfolio that needs to achieve a targeted rate of return should be “most concerned about how far short of that return it might be over time.”  In what is assumed to be a low-return environment, many are taking on more risk to try to reach for a target.  Ironically, that act of reaching now may make the brass ring harder to grasp in the future.

Whether you agree or disagree with GMO or the authors of the respective sections, this is a great document for examining your own approach.  How do beliefs lead to action?  What is the role of forecasting?  Where are you at on the momentum/mean reversion spectrum?  How do you triangulate when approaching a question?  And, most importantly, what should you be doing (or not doing) today to reach your long-term target?