My Sister’s Pension Assets and Agency Problems
(The Tension between Protecting Your Job or Your Clients’ Money)
By Jeremy Grantham
April 18, 2012
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 inefficiencies 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 justified 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 fi red. 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,2 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.
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 well known 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.
What Keynes definitely did say in the famous chapter 12 of his General Theory is that “the long-term investor, he who most promotes the public interest … will in practice come in for the most criticism whenever investment funds are managed by committees or boards.” He, the long-term investor, will be perceived as “eccentric, unconventional and rash in the eyes of average opinion … and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.” (Emphasis added.) Reviewing our experiences of being early in several extreme outlying events makes Keynes’s actual quote look painfully accurate in that “mercy” sometimes was as limited as it was at a bad day at the Coliseum, with a sea of thumbs down. But his attribution, in contrast, has proven too severe: we appear to have survived.
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 fi re 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.3 The U.S. growth and technology bubble of 2000 was by far the biggest market outlier event in U.S. market history; we had previously survived the 65 P/E market in Japan, which was perhaps the greatest outlier in all important equity markets anywhere and at any time. These were the most stringent tests for managers, and we were 2 to 3 years early in our calls in both cases. Yet we survived, although not without some battle scars, with the great help that we did, in the end, win these bets and by a lot. Hypothetically, resisting the temptation to invest too soon in 1931 may have been a tougher test of survival in bucking the market. Luckily we, and all value managers, were not around to be tempted by that one. (Although Roy Neuberger – who died in December 2010, unfortunately – was, and he could talk about it as lucidly as any investor ever.)
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 deficiencies 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 Japan and the tech bubble proved. Thus, because asset class selection packs a more deadly punch in the career and business risk game, the great investment opportunities are much more likely to be at the asset class level than at the stock or industry level. But even if you know this, dear professional reader, you will probably not be able to do too much about it if you value your job as did the nearly 1100 analysts in my survey. Except, perhaps, with your own assets or, say, your sister’s pension assets.
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