Jeremy Grantham Explains How To
"Survive Betting Against Bull Market Irrationality"
Submitted by Tyler Durden
on 04/18/2012
http://albertpeia.com/grantham.htm
Ridiculous
as our market volatility might seem to an intelligent Martian, it is our
reality and everyone loves to trot out the “quote” attributed to Keynes (but
never documented): “The market can stay irrational longer than
the investor can stay solvent.” For us agents, he might better have said “The
market can stay irrational longer than the client can stay patient.”
Jeremy
Grantham
As
one may have guessed by now, the topic of this post will be Jeremy Grantham's
much anticipated quarterly letter, titled "The Tension between Protecting
Your Job or Your Clients’ Money" - a topic very germane to most asset
managers, who according to Grantham, engage not so much in alpha discovery (or
even pursuing levered beta), as much as preserving their careers, and in the
process succumbing to the one fundamental flaw of finance- herding. But don't worry: everyone
else does it too. Which is precisely what makes it so
attractive. After all, if everyone underperforms, nobody stands out, and
vice versa, which is why for every manager who succeeds and becomes a
billionaire, there are 999 others who try to break away from the herd, blow up
and are never heard of (pardon the pun) again, thank you survivorship bias. It
is this tension between the draw for riches and the probability of flaming out
on one hand, and the slow steady grind, associated with being a member of the
"flock" that more than anything, is at the
true heart of modern capital (mis)allocation
decisions. And it is because precisely of this herding effect that stock prices
end up whiplashed around fair value by a margin of ±19% two-thirds of the time,
even as GDP and fair values moves at a glacial ±1 pace. Call it momo, call it "safety in numbers", it's real name is irrationality.
It is precisely this irrationality that Keynes had in mind when he may or may
not have uttered his infamous quote.
This
is how Grantham puts it.
The
central truth of the investment business is that investment behavior is driven
by career risk. In the professional investment business we are all agents,
managing other peoples’ money. The prime directive, as Keynes knew so well, is
first and last to keep your job. To do this, he explained that you must never,
ever be wrong on your own. To prevent this calamity, professional investors pay
ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either
completely or partially. This creates herding, or momentum,
which drives prices far above or far below fair price. There are many other ineffi ciencies in market
pricing, but this is by far the largest. It explains the discrepancy between a
remarkably volatile stock market and a remarkably stable GDP growth, together
with an equally stable growth in “fair value” for the stock market. This
difference is massive – two-thirds of the time annual GDP growth and annual
change in the fair value of the market is within plus or minus a tiny 1% of its
long-term trend as shown in Exhibit 1.
The
market’s actual price – brought to us by the workings of wild and wooly
individuals – is within plus or minus
19% two-thirds of the time. Thus, the market moves 19 times more than is justifi ed
by the underlying engines! This incredible demonstration of the
behavioral dominating the rational and the “efficient” was first noticed by
Robert Shiller over 20 years ago and was countered by
some of the most tortured logic that the rational expectations crowd could
offer, which is a very high hurdle indeed. Shiller’s
“fair value” for this purpose used clairvoyance. He “knew” the future flight
path of all future dividends, from each starting position of 1917, 1961, and
all the way forward. The resulting theoretical value was always stable (it
barely twitched even in the Great Depression), but this data was widely ignored
as irrelevant. And ignoring it may be the correct response on the part of most
market players, for ignoring the volatile up-and-down market moves and
attempting to focus on the slower burning long-term reality is simply too
dangerous in career terms. Missing a
big move, however unjustified it may be by fundamentals, is to take a very high
risk of being fired. Career risk and the resulting herding it
creates are likely to always dominate investing. The short term will always be
exaggerated, and the fact that a corporation’s future value stretches far into
the future will be ignored. As GMO’s Ben Inker has
written, two-thirds of all corporate value lies out beyond 20 years. Yet the
market often trades as if all value lies within the next 5 years, and sometimes
5 months.
Since
in our day and age, the only way to generate wealth is to manage asset, not to
collect wages (as everyone's favorite peak Marxism chart has shown over and
over), everyone is now an fund manager. Which means that the above observations have to be put in the
context of managing one's portfolio. Grantham does that next, and this
is the part that the hedge funders, those so terrified to fight the Fed, and
thus shivering in groups of like-minded momentum chasers, should pay attention
to:
Ridiculous
as our market volatility might seem to an intelligent Martian, it is our
reality and everyone loves to trot out the “quote” attributed to Keynes (but
never documented): “The market can stay
irrational longer than the investor can stay solvent.” For us
agents, he might better have said “The
market can stay irrational longer than the client can stay patient.”
Over the years, our estimate of “standard client patience time,” to coin a
phrase, has been 3.0 years in normal conditions. Patience can be up to a year
shorter than that in extreme cases where relationships and the timing of their
start-ups have proven to be unfortunate. For example, 2.5 years of bad
performance after 5 good ones is usually tolerable, but 2.5 bad years from
start-up, even though your previous 5 good years are wellknown but helped someone else, is absolutely not the
same thing! With good luck on starting time, good personal relationships, and
decent relative performance, a client’s patience can be a year longer than 3.0
years, or even 2 years longer in exceptional cases. I like to say that good
client management is about earning your fi rm an incremental year of patience. The extra year is very
important with any investment product, but in asset allocation, where mistakes
are obvious, it is absolutely huge and usually enough
So is
there any hope for those who wish to break the mold, fight the Fed, and be
contrarians for the sake of reality, and, well, because sometime it is just
much more fun to tell the lemmings the cliff ended 10 feet ago. Why, yes
You
apparently can survive betting against bull market irrationality if you meet
three conditions. First,
you must allow a generous Ben
Graham-like “margin of safety” and wait for a real outlier before you make a
big bet. Second, you
must try to stay reasonably diversified. Third, you must never use
leverage. In my personal opinion (and with the benefit of
hindsight, you might add), although we in asset allocation felt exceptionally
and painfully patient at the time, we did not in
the past always hold our fire long enough or be patient enough. It is the
classic failing of value managers (and poker players for that matter) to get
impatient and bet too hard too soon. In addition, GMO was not always optimally
diversified. We are generally more cautious (or, if you prefer, “more
experienced”) now than in 1998 with respect to, for example, both patience and
diversification, and at least we in asset allocation always stayed away from
leverage. The
Yet
even so, doing the right thing is often precluded by one's career limitations:
This
exemplifies perfectly Warren Buffett’s adage that investing is simple but not
easy. It is simple to see what is necessary, but not easy to be willing or able
to do it. To repeat an old story: in 1998 and 1999 I got about 1100 fulltime
equity professionals to vote on two questions. Each and every one agreed that
if the P/E on the S&P were to go back to 17 times earnings from its level
then of 28 to 35 times, it would guarantee a major bear market. Much more
remarkably, only 7 voted that it would not go back! Thus, more than 99% of the
analysts and portfolio managers of the great, and the not so great, investment
houses believed that there would indeed be “a major bear market” even as their
spokespeople, with a handful of honorable exceptions, reassured clients that
there was no need to worry.
Career
and business risk is not at all evenly spread across all investment levels.
Career risk is very modest, for example, when you are picking insurance stocks;
it is therefore hard to lose your job. It will usually take 4 or 5 years before
it becomes reasonably clear that your selections are far from stellar and by
then, with any luck, the research director will have changed once or twice and
your defi ciencies will
have been lost in history. Picking oil, say, versus insurance is much more
visible and therefore more dangerous. Picking cash or “conservatism” against a
roaring bull market probably lies beyond the pain threshold of any publicly
traded enterprise. It simply cannot take the risk of being seen to be “wrong”
about the big picture for 2 or 3 years, along
with the associated loss of business. Remember, expensive
markets can continue on to become obscenely expensive 2 or 3 years later, as
As
usual, terrific advice from one of the few people out there who still gets it. Much more in the full letter below (pdf link)