Tag Archives: grantham mayo van otterloo

You Can’t Get Blood Out Of A Stone

My title comes from Jeremy Grantham’s recent CNBC interview. This remark occurs in a discussion about likely returns from the U.S. stock market. Everyone at Grantham’s firm, Grantham, Mayo, van Otterloo (GMO), agrees that over the next two decades stocks will deliver around 2% after-inflation or “real” returns, says Grantham himself. Traditionally, the market has delivered 6%-7% annualized real returns, but trying to achieve that now will be like trying to draw blood out of a stone. Investors hoping for the historical 6%-7% are bound to be disappointed.

The reason for Grantham’s pessimism is simple — P/E ratios are high. Grantham uses the Shiller PE (current price of the S&P 500 Index relative to the underlying constituents’ past 10-year average real earnings). The long term average of that metric is around 16, but over the past quarter century is has been over 20. But Grantham doesn’t think the average will return to 16 soon or in a way that value investors want. It will likely take around two decades instead of a more typical 7-year cycle. And, in a way, that’s more painful than having a market crash. A crash amounts to a valuation re-set; prices get cheap, and the opportunity to invest presents itself to those with courage. But a slow movement from a Shiller PE of 30 (where it sits now) to 16 is a real problem for long term investors who won’t get a good opportunity for returns for a generation.

Besides expensive valuations, the economic cycle will not be in investors’ favor. Grantham thinks recent growth numbers reflect a one-time bump of sidelined workers getting back into the labor market from the time of the financial crisis. That increase has produced an aritificial percentage point of growth in recent years, Grantham estimates, which means the U.S. isn’t growing at, say, 2.5%. Instead it’s growing at more like 1.5%. That will be apparent, in Grantham’s opinion, as the last workers who were frightened out the labor market after the crisis re-enter. Perhaps that game of re-entry can persist for a few more years, Grantham speculates, but it’s not a permanent feature of the economy. When it ceases, growth will suffer.

Moreover, population growth in the U.S. is declining. We need a 2.1 fertility rate to keep growing, and the U.S. has a 1.76 fertility rate. Also, the fertility rate is below that in every other developed country. The population growth rate in the developed world “has gone to hell,” says Grantham. Only emerging markets countries present the prospect of stronger population growth. Besides a growing population in emerging markets, Grantham is also impressed with China’s emphasis on engineering and science education. China is beginning to dominate Artificial Intelligence and green energy, for example. India isn’t far behind, and, when pressed to single out a country that might be the single best investment in the emerging markets space, Grantham singled out India. Even if Grantham is uncomfortable making a specific country call, all of this means he thinks emerging markets are the future for equity investors. It’s a given, however, that emerging markets investors will have to endure volatility.

Grantham is less keen on Europe. Population growth is worse there than in the U.S., and the recent problems with immigration will only worsen, stressing the EU considerably. And a weakened EU grants more opportunity to China and Russia to misbehave. It also increases uncertainty. Brexit looks like it might be delayed, and when it’s delayed it looks like the odds of overturning it might increase somewhat. Still, Grantham provides no guarantees regarding the country of his birth.

While population growth — or lack thereof — present problems for the economy, at least it’s beneficial for the planet. Grantham has devoted time and resources to combat global warming and harm to the environment. Grantham proudly drives a Tesla, but noted that, as a value investor, he wasn’t interested in the company’s stock. He did allow that the stock could be successful, as Amazon’s has been.

The message investors should take from Grantham’s remarks is that stock returns in the developed world will be low for the next decade and possibly longer. That means you must increase your savings rate to meet your retirement and other goals. The market probably won’t do the heavy lifting that it’s done in the past.

GMO: Did The Bubble Just Start To Burst?

Do current stock prices reflect a speculative frenzy? It’s a crucial question for anyone trying to preserve and grow their capital, but also a difficult one to answer. Martin Tarlie of Boston asset manager Grantham, Mayo, van Otterloo (GMO) has just published a short paper trying to quantify investor sentiment and whether it has driven prices to the stratosphere.

Many, including GMO’s James Montier, have commented on how strange this run-up in prices has been. Cab drivers aren’t eager to tell passengers about their latest technology stock purchases. Euphoria seems absent. But prices keep rising, making the rally seem cynical to Montier. And that has made it seem like there’s a disconnect between how investors feel and what they are doing – and, therefore, also difficult to call current prices a frenzy.

But Tarlie’s Bubble Model tries to capture both the “quantitative and anecdotal euphoric elements of a bubble.” Central to Tarlie’s thesis is the concept of “mean aversion.” Most of the time when price trends and valuations become extended they snap back or “mean revert” in some span of time. But, more rarely, they remain extended for long periods, and Tarlie calls this “mean aversion.” This happens when speculators dominate markets.

Mean reversion speeds vary over time. But in a few instances mean reversion displays a negative speed, and this is Tarlie’s quantitative measure of euphoria. Between 1881 and today there have been five periods of explosive dynamics or mean aversion – the late 1910s, 1929, the early 1980s, the late 1990s, and 2017-2018. Two of these periods coincide with bubbles – 1929 and the late 1990s, and two others are characterized by low valuation – the late 1910s and the early 1980s. Tarlie notes that in the latter two periods are characterized by an anti-bubble mood that is more “dysphoric” than euphoric.

The fifth period – from 2017 through late 2018 – matches the other four quantitatively, though it lacks a sense of euphoria. Then in the fourth quarter of 2018, the trend reverts. Tarlie finds some substitutes for the cab drivers and shoe shine boys with stock tips of past generations. Instead of the stock market itself, Big Data, Artificial Intelligence, and Bitcoin were where animal spirits found outlets most recently. Moreover, in the last quarter of 2018 there is a “dramatic change from an explosive mean averting phase to a strongly mean reverting” one. The scale and duration of the change in move resembles the market turns in 1929 and 1999.

The five incidents show that extreme changes stem from valuation extremes. In the late 1910s and in the early 1980s, stocks were unusually cheap. In 1929 and in 1999, they were unusually expensive. And when sentiment changes occur at moments of valuations extremes, prices can change rapidly.

The upshot of this analysis for investors now is that even though earnings are still strong, disappointments when expectations and valuations are so high can turn the market downward in a hurry. Changes in sentiment are also difficult to understand, which is why timing bubbles is so difficult. What matters isn’t the level of sentiment, but the degree of change, and that’s hard to predict. The fourth quarter (downward) move in stocks could be a head fake, Tarlie notes, but odds are that this is the beginning of the end of the bubble of 2017-2018. The bubble can always reflate, though, just as it did after Long Term Capital Management blew up in 1998, but Tarlie’s advice is “to continue to own as little U.S. equity as career risk allows.”

It’s Okay To Hold Some Cash

The great sage and baseball legend, Yogi Berra, once said:

“It’s tough to make predictions – especially about the future.”

But financial planning is all about contemplating how much money will result from a particular savings rate combined with an assumed rate of return. It’s also about arriving at a reasonable spending rate given an amount of money and an assumed rate of return. In other words, plugging in a rate of return is unavoidable when doing financial planning. Perhaps financial planners should use a range of assumptions, but some assumption must be made.

The good news is that bond returns stand in defiance to Berra’s dictum; they aren’t too difficult to forecast. For high quality bonds, returns are basically close to the yield-to-maturity. Stock returns are harder, but there are ways to make a decent estimate. The Shiller PE has a good record of forecasting future 10-year stock returns. It’s not perfect; low starting valuations can sometimes lead to low returns, and vice versa. But it does a decent job. And the further away the metric gets from its long-term average in one direction or another, the more confident one can be that future returns will be abnormally high or low depending on the direction in which it has veered from its average. Currently, the Shiller PE of US stocks is over 30, and its long term average is under 17. That means it’s unlikely that future returns will be robust.

The following graph shows end-of-April return expectations for various asset classes released by Newport Beach, CA-based Research Affiliates. One will almost certainly have to venture overseas to capture higher returns. And those likely posed for the highest returns – emerging markets stocks – come with an extra dose of volatility. Along the way, there will be problems caused by foreign currency exposure too, though Research Affiliates thinks foreign currency exposure will likely deliver some return.

Hope for a correction? Move some money to cash?

Given this return forecast, investors will have to contemplate saving more and working longer. But investors who continue to save should also hope for a market downturn. As perverse as that sounds, we are in a low-future-return environment because returns have been so good lately. We have basically eaten all the future returns over the past few years. And nothing will set up financial markets to deliver robust returns again like a correction. That’s why the Boston-based firm Grantham, Mayo, van Otterloo (GMO), which views the world similarly, though perhaps a bit more pessimistically, to Research Affiliates has said that securities prices staying at high levels represents “hell,” while a correction would represent investment “purgatory.” If prices stay high, and there are no deep corrections or bear markets, there will be little opportunity to invest capital at high rates of return for a very long time.

Investors who aren’t saving anymore should hold some extra cash in anticipation of purgatory. If we get purgatory (a correction) instead of hell (consistently high prices without correction), the cash will allow you to invest at lower prices andva higher prospective return. How much extra cash? Consider around 202%. The Wells Fargo Absolute Return fund (WARAX) is run by GMO, and 81% of its assets are in the GMO Implementation fund (GIMFX). Around 6% of the Implementation fund is in cash and another 16% of the fund is in U.S. Treasuries with maturities of 1-3 years, according to Morningstar. So more than 20% of the Implementation fund – and nearly 20% of the Absolute Return fund — is in Treasuries of 3 years or less or cash.

Around 52% of the Implementation fund is in stocks, most of them foreign stocks. So around 40% of the Absolute Return fund is in stocks. (The other holdings of the Absolute Return fund are not invested in stocks as far as I can tell.)

If you normally have something like a balanced portfolio with 50% or 60% stock exposure, it’s fine to take that exposure down to 40% right now. There is no question that this is a hard game to play. The cheaper prices you’re waiting for as you sit in short-term Treasuries or cash, with roughly one-third of your money that would otherwise be in stocks, may not materialize. After all, as Berra said, “It’s tough to make predictions.” Or the lower prices may materialize only after your patience has expired, and you’ve bought back into stocks at higher prices just before they’re poised to drop.

These adverse outcomes are real possibilities. But the buy-and-hold, strictly balanced allocation (60% stocks/ 40% bonds) also isn’t easy now for those who (legitimately) fear a 30+ Shiller PE. That’s why it’s arguably reasonable to move some of your stock allocation into cash and/or short-term Treasuries, but not the whole thing. And sitting in cash hasn’t been this easy for a decade or more, now that money markets are yielding over 1% and instruments like PIMCO’s Enhanced Short Maturity Active ETF (MINT) are yielding over 2%. Those yields at least act as a little bit of air conditioning if investment hell persists and prices never correct while you sit in cash with some of your capital.

Don’t Expect Another Free Lunch In The Markets

The most recent quarterly letter from Grantham, Mayo, van Otterloo (GMO) contains an interesting argument about bonds. Over the past five years, bonds have provided great performance, but also more diversification from stocks than they have since the Great Depression. That, along with a tamer stock market, has helped balanced portfolios have lower volatility than usual. Indeed the Vanguard Balanced Index Fund (VBAIX) has a five-year standard deviation of 6%, according to Morningstar. Over the longer term, volatility of balanced portfolios has been around 10%.

Ben Inker, author of the letter, argues that if an investor, over the last five years, had wanted to target a volatility of 10% — the historical long-term volatility of a balanced portfolio – such would have entailed a leveraged portfolio of 143% stocks, 96% bonds, and -139% cash. Moreover, levering up a balanced portfolio 139% would mean achieving returns of more than 7% annualized over cash, according to GMO’s asset class return forecast.

But Inker isn’t advocating using such leverage, as so many “risk parity” portfolios do. This situation amounts to a free lunch that Inker doubts will persist into the future. It’s possible that risk and risk premia have fallen so that levering up to achieve returns is less dangerous than it used to be. But it’s more likely that the recent “easy” environment is a temporary one in Inker’s opinion. As he puts it:

”Even if the natural volatility of the economy has fallen over time and even if policy response is better than it was 80 years ago, neither markets nor economies are all that well-behaved. Stability breeds instability, as Human Minsky pointed out 40 years ago.”

Why do stocks usually have a premium over bonds?

To arrive at his conclusion, however, Inker recounts some recent history, reminding readers of the basic difference between stocks and bonds along the way.

First stocks are riskier to buyers than issuers. Companies can go bankrupt, after all, and the equity is usually worth nothing in that instance. But, according to Inker, that “idiosyncratic risk” is not why stock investors have achieved such a premium historically. The other reason why stocks typically offer a long term premium over bonds is that equity losses occur at exactly the moment it is most painful to own them.

After all, stocks usually go down when the whole economy goes down. So, if you have a stock-heavy portfolio, your portfolio is likely to tank exactly when you lose your job, compounding your misery.

However, if fears of economic downturns have diminished, then the risk premium that stocks usually have over bonds might dry up. It wouldn’t make sense for stocks to offer higher long term returns in an environment that suddenly became safe and free from recessions. And Inker argues that’s what happened right before the Financial Crisis. Riskier assets were poised to deliver lower long term returns than less risky assets. And as much of a shock as the crisis was to this point of view:

“The rapid recovery corporate cash flow in the aftermath and the consequent lower levels of distress than previous cycles experienced have served to assuage investors’ economic concerns.” 

The passage of time from the last crisis has also convinced today’s investors that they could withstand a new one regardless of how they behaved last time.

Not only have fears of economic downturns receded, but it has seemed easier than ever to protect portfolios. High quality bonds did their job in the last crisis (provided you held enough of them). Recessions help high quality bonds in two ways: deflation makes existing coupons more attractive, and central banks lower rates.

What has made bond performance (and bonds’ low correlation to stocks) so astonishing in recent years is that bonds have posted great returns in the absence of a recession. Bonds are not supposed to behave quite this well and in quite this uncorrelated fashion from stocks in non-recessionary environments. Don’t look for that negative correlation to continue, and don’t try to juice your returns by levering up a balanced portfolio.

Citywire Article: Can You Spot A Bubble? What About Now?

This is my most recent Citywire article on an academic study of bubbles. Despite what Eugene Fama asserts, they have telltale signs.


The return of volatility earlier this month set stock markets on edge, but are we really in bubble territory?

Divorced From Reality: Prices & Fundamentals

There are many ways of assessing the value of the stock market. The Shiller PE (price relative to the past decade’s worth of real, average earnings) and Tobin’s Q (the value of companies’ outstanding stock and debt relative to their replacement cost) are likely the two best. That doesn’t mean those metrics are accurate crash indicators, or that one can use them profitably as trading signals. Expensive stocks can stay expensive or get more expensive, and cheap stocks can stay cheap or get cheaper for inconveniently long periods of time.

But those metrics do have a good record of forecasting future long-term (one decade or more) returns. And that’s important for financial planning and wealth management. Difficult though it is sometimes, everyone must plug in an estimated return into a formula for retirement savings. And if an advisor is plugging in a 7% or so return for a balanced portfolio currently, he or she is likely not doing their job well. Stocks will almost certainly return less than their long-term 10% annualized average for the next decade or two given a starting Shiller PE over 30. The long-term average of the metric, after all, is under 17.

Another way of looking at how expensive the market has gotten recently is to look at sales of the S&P 500 constituents and relate it to share price. Companies are always manipulating items on income statements to arrive at a particular earnings number. Recently, record numbers of companies have supported net income numbers with non-GAAP metrics. That can be legitimate sometimes. For example, depreciation on real estate is rarely commensurate with reality. But it can also be nefarious, as Vitaliy Katsenelson recently argued in criticizing Jack Welch’s stewardship of General Electric, which Katsenelson characterized as being more interested in beating quarterly earnings estimates rather than in creating long-term wealth. And that’s why sales metrics can be useful. They are less easily manipulated.

So I created a chart showing sales per share growth and price per share growth of the S&P 500 dating back to the end of 2008. From the beginning of 2009 through the end of 2016, companies in the index grew profits per share by nearly 4% annualized, a perfectly respectable number for a mature economy. But price per share grew by a whopping 14.5% over that time. Over that 8 year period, sales grew less than 50% cumulatively, while share prices tripled.

Anyone invested in stocks should worry about this chart. How do share prices get so divorced from underlying corporate sales? One likely answer is low interest rates. But there must be other reasons because we’ve had low interest rates and low stock prices before – namely in the 1940s. That was after the Great Depression, and stocks were still likely viewed as suspect investments. Today, by contrast, stocks are not viewed with much suspicion, despite the technology bubble peaking in 2000 and the housing bubble in 2008. Investors still believe in stocks as an asset class.

And yet, the decline in rates over the past four decades has been breathtaking, as has Federal Reserve intervention. James Montier of Boston asset manager, Grantham, Mayo, van Otterloo (GMO), has studied stock price movements over the past few decades and found that a significant percentage of upward price movements have occurred on or before Federal Open Market Committee (FOMC) days. Montier estimated that 25% of the market’s return since 1984 has resulted from movements around FOMC days. Moreover, the market has moved higher regardless of what the FOMC decision was.

If this is a stock market bubble – and the data shows unusually high prices relative to sales and earnings – it is a strange one. One doesn’t hear the anecdotal evidence of excitement – i.e., cab driver’s talking about their latest stock purchases, etc…. This is perhaps a kind of dour bubble, where asset ownership at any price seems prudent in an economy that is becoming less and less hospitable to ordinary workers. Or, as Montier wrote in a more recent paper, this may be a “cynical” bubble where investors know that shares are overpriced, but think they can be the first ones out when the inevitable decline begins.