In his latest quarterly letter, GMO’s Jeremy Grantham offers some very interesting data on the disconnect between the stock market on one hand, and the economy and “fair value” of the stock market on the other.
“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,” Grantham writes in the letter, which is available on GMO’s web site. “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!”
Grantham says the biggest reason for this disconnect is career risk for professional investors. Being wrong on your own can be career suicide, he says, so most of the pros “go with the flow”; that way, even if they are wrong, they can say that they weren’t alone. And that creates herding and momentum, which drive markets far out of whack with economic and corporate realities.
Grantham talks about how his firm has tried to battle that tendency, and offers some tips for how to go against the flow: “You apparently can survive betting against bull market irrationality if you meet three conditions,” he says. “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.”
“Because asset class selection packs a more deadly punch in the career and business risk game,” he adds, “the great investment opportunities are much more likely to be at the asset class level than at the stock or industry level.”
Grantham’s colleague, Ben Inker, also offers GMO’s take on the current market as part of the quarterly letter. “Today, stocks are expensive relative to our estimate of long-term fair value,” Inker says. “The trouble is, so are bonds and cash. If everything was guaranteed to revert to the mean over 7 years, we would hold equity-heavy portfolios, because the gap between stocks and either bonds or cash is wider than normal. But we don’t know that it will take 7 years. Because cash and (most) bonds have a shorter duration with regard to changes in their discount rate than stocks do, fast reversion would lead to smaller losses for them than for equities.”
With that in mind, GMO is a little lighter on stocks than their long-term projections would warrant. Inker says GMO “around 63% to 64% in equities for a portfolio managed against a 65% equities/35% bonds benchmark and 48% to 58% in equities for absolute return oriented portfolios, depending on their aggressiveness and opportunity set.” The firm sees little to like in the bond market, “leaving us with significant holdings of cash and ‘other.’”