Tuesday, July 23, 2013

What If There's No Mean Reversion? (Grantham Mayo Van Otterloo quarterly letter July 2013)

From ZeroHedge:

James Montier Explores "The Possibility Of No Mean Reversion"
From Jamies Montier of GMO (pdf)
The Purgatory of Low Returns

This might just be the cruelest time to be an asset allocator. Normally we find ourselves in situations in which at least something is cheap; for instance when large swathes of risk assets have been expensive, safe haven assets have generally been cheap, or at least reasonable (and vice versa). This was typified by the opportunity set we witnessed in 2007.

Likewise, during the TMT bubble of the late 1990s, the massive overvaluation of certain sectors was offset by opportunities in “old economy” stocks, emerging market equities, and safe-haven assets.
However, today we see something very different. As Exhibit 2 shows, today we see something very different. As Exhibit 2 shows, today’s opportunity set is characterized by almost everything being expensive. As I noted in “The 13th Labour of Hercules,” this is a direct effect of the quantitative easing policies being pursued by the Federal Reserve and their ilk around the world.
The Fed has been unusually transparent in explaining its thoughts on the impact of quantitative easing. Brian Sack of the New York Fed wrote in December of 2009 (bold emphasis added):
A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel.
Market participants have (at least until the last month) reacted to this situation by “reaching for yield” as witnessed by the more detailed fixed income forecasts in Exhibit . This could be described as a “near rational” bubble (inasmuch as investors are reacting to the very low cash returns, which they expect to last for a long time). I’ve described it as a “foie gras” bubble as investors are being force-fed higher risk assets at low prices. The bad news is that reaching for yield rarely ends well.
Of course, like all of our published forecasts, the forecasts for government bonds and cash assume mean reversion...
The Possibility of No Mean Reversion!
As regular readers will know, we at GMO are stalwart supporters of the concept of mean reversion in general. However, if ever there was an economic case for a question mark over mean reversion, it is surely with respect to cash rates and bond yields. The simple reason behind this seemingly heretical statement is that rates are (can be) policy instruments. As Keynes noted, “The monetary authorities can have any interest rate they like… They can make both the short and long-term [rate] whatever they like, or rather whatever they feel to be right… Historically the authorities have always determined the rate at their own sweet will.”...