On Grantham, QE Likelihood and a Yoga Tip!

From: Aditya Rana
Date: Sun, Apr 22, 2012 at 11:41 AM
Subject: On Grantham, QE Likelihood and a Yoga Tip!


Jeremy Grantham’s (who runs the value fund manager GMO) quarterly letters are usually masterpieces containing a wealth of market wisdom , and his latest piece is no exception to the rule. The letter is divided into two sections, with the first part analysing the negative impact of “career risk”, through multiple channels, on investment performance and the second part covering the current market outlook (which is written by his colleague Ben Inker). To summarise:

-A central truth of investing is that professional investor behaviour is driven by “career risk” – which forces investors to act with a herd mentality. It explains the significant deviations between stock market performance and remarkably stable GDP growth and growth in the market’s “fair value”. (Please see the graph below and also note that the deviations ultimately converge back to the GDP growth trend, and over time the stock market does track GDP growth).

-Analysing data since 1882, it is clear that the market is about 19 times more volatile than its underlying fundamental engines – GDP growth and growth in fair value. This volatility arises from the herding, or momentum seeking, behaviour of investors.

-Two-thirds of the value of a stock lies in the expected cash-flows of a stock beyond 20 years, though the stock market often trades as if all the value lies in the immediate future. Ignoring short-term fluctuations to focus on the long-term fundamentals is simply too dangerous for careers.

-A method to survive this bull market irrationality involves; 1) allow a “margin of safety” in your investments – i.e. wait patiently for the fat pitches, 2) stay reasonably diversified, and, 3) never use leverage.

-In investing, “it is simple to see what is necessary but, but not easy to willing or able to do it”. In 1998 and 1999, 1100 professional investors (when asked to vote) expected the S&P p/e to revert back to 17 (and stay there) from a then historical high of 35 ( implying a major bear market) but almost all later reassured clients that there was no need to worry and that they should stay invested.

-Therefore, because asset class selection has a critical impact on career risk, the best investment opportunities are likely to be at the asset level than in individual stocks and industries.

-A classic failing of value managers (and poker players) is to get impatient and bet too hard too soon- they have tended to be about 2.5 years too early in major bull markets (a bit shorter for bear markets). However, diversification and a reasonable amount of safety margin has left the pain for clients at just tolerable levels.

-Based on his experience in managing his sister’s pension assets since 1968, which has done better than their first institutional asset allocation fund, the two key factors behind the outperformance have been: 1) being able to focus on absolute returns and not being subject to investor constraints, and, 2) the freedom to make big bets when it made sense- like in 1998 to 1999 and 2007.

-Their benchmark-free allocation strategy (which provides more freedom to be less invested when the market was overpriced) has returned 151% since 2001, compared with 72% for their global asset allocation strategy and 25% for the global balanced benchmark.

-Another important indicator of performance is the Sharpe Ratio – which measures how many units of price volatility (risk) an investor has received in the past per unit of return. The global balanced benchmark had a Sharpe Ratio of .25 (four units of volatility per unit of return) , the global asset allocation strategy had a Sharpe Ratio of 0.6 (less than two units of volatility per unit of return) , and the benchmark-free asset allocation strategy had a Sharpe Ratio of 1.1 which implies twice the efficiency of the global asset allocation strategy and four times that of the global balanced benchmark.

-However, clients have typically focussed on the “raw” return and ignored the increased efficiency due to lower volatility. The Sharpe Ratio is one of the few aspects of financial theory which does offer real value to investors, by measuring (albeit in the short-term) the chance of a real loss of money.

-The risk of a benchmark-free asset allocation strategy is underperformance in bull markets, but it mitigates the real risk of investing – a permanent loss of capital. The cardinal rule of investing is not to underperform in bear markets.

Market outlook:

-The big question for investors today is whether to take the bait offered by the Fed – which is to entice investors into risky assets by keeping rates very low and taking government bonds out of the market through quantitative easing.

-Moving into bonds and cash, which are unattractive assets, actually increases the portfolio risk whereas in previous years like 2007, moving away from risky assets lowered portfolio risk.

-Typically they construct their portfolios based on a 7-year time frame for mean reversion to fair value for each asset class, and expect the portfolio to outperform irrespective of when the asset mean reverted over the 7-year period. However, the portfolio you would want to hold today if assets mean reverted immediately versus gradually over 7-years would be very different.

-Today stocks, bonds and cash are all expensive relative to fair value, and if valuations were guaranteed to mean revert gradually over 7-years then it would imply holding equity-heavy portfolios because the risk/return gap between stocks and bonds or cash is wider than normal. However, if mean-reversion happens earlier, then having a heavier weighting in bonds and cash would make sense as bonds and cash have a shorter duration than stocks and their prices would fall by less.

-Because of this peculiarity in current market conditions, they are weighted slightly less in equities than what their 7-year forecasts would imply – 48%-58% for absolute return oriented portfolios. Their bonds holdings are also lower than normal – mainly in Australian and New Zealand government bonds (because of favourable real yield and government policies), and their holdings of cash and “other” assets is higher than normal.

Deep insights and further bolsters the argument in favour of being a contrarian investor and utilising fully the main advantage individual investors have over the professionals (as detailed in his last quarterly letter)– patience! In addition, as suggested in previous letters, holding a well diversified portfolio covering EM equities (China, India, Brazil, and select others) , US energy and global natural resources stocks, high quality multinationals, EM US$ and local currency bonds, US credit funds, gold and cash would be a appropriate strategy in the currently peculiar environment. I personally hold the view that the 7-year mean reversion will commence at least after 2014 due to QE polices by global central banks, implying that one cannot get too bearish.

A recent note from the Goldman Sachs Strategy team puts it very well:

"While the economic backdrop, neutral valuations, and moderate geopolitical and economic risks favour equities in our opinion, we also recognize that investing in equities entails volatility. As an asset class with 15% annual volatility, it is typical for equities to decline by 5% or more about 3 times a year and 10% or more about once a year, on average. So to capture the upward trend in equities, an investor has to tolerate the frequent downdrafts. The latest non-farm payroll and heightened concerns about peripheral Europe might well result in one of these downdrafts; in fact, our very short-term momentum signals have turned negative. But as investors – rather than traders – we recommend staying long equities. For those who are underinvested, we recommend using downdrafts as opportunities to build equity positions."

And for those who still doubt the dependency of markets on QE programmes, I present a chart from the bond fund manager Jeffrey Gundlach. The likelihood of further QE remains high!

A Yoga Tip:

The spine plays an important role in Yoga and Ayurveda, and blockage/compression/tension in the spine can negatively impact the nervous system and blood flow. Maintaining a healthy and supple spine is therefore critical for good health and there are two simple Yoga asanas (postures) that I do regularly and have found to be very effective (have suggested them to a few other people who have found them to be very helpful):

-Lie on the floor (or on a hard bed) on the stomach, with legs together, raise your head and cup your chin with your palms, keeping your elbows together and perpendicular to the ground. Lie in this position for 5 minutes (or more) – you can watch TV while you do this if you would like! The best time is morning (after waking) and in the evening before sleeping. This posture gently stretches the whole spine and is great for lower back aches and neck pain or stiffness. A variation is folding one leg at a time gently , bringing your heel as close to the buttocks as possible, for a minute or so and then folding both legs together. After finishing, curl into child’s pose (buttocks on heels, forehead on the floor and arms stretched out alongside the head) for a few minutes – this is a reversal of the posture.

-Lie on your back on the edge of your bed, with your head over the side and your shoulders just over the edge, for a few minutes. You can then bring your arms up alongside your head and stretch gently by interlocking the fingers. After completion slide back on the bed (make sure you don’t jerk your neck!). This posture is especially beneficial for neck stiffness and pain and is based on the simple principle of reversal as one spends most of the day with the spine bent forward.

Generally speaking, if you have spinal issues any forward spending postures are usually prohibited. Back bending and spinal twisting postures are usually beneficial. And don’t sit for more than 30 minutes at a stretch, take a walk for a few minutes in-between. Of course, if you have had spinal surgery please consult our doctor before trying these postures. More on spinal health in the next newsletter!

Here is to keeping your spine supple and healthy!





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