Saturday, December 16, 2017

Jeremy Grantham—GMO Quarterly Letter: Career Risk and Stalin’s Pension Fund

From Grantham Mayo Van Otterloo, Q3:

Career Risk and Stalin’s Pension Fund: Investing in a World of Overpriced Assets (With a Single Reasonably-Priced Asset)
■ Inside GMO there are three different views on whether and how rapidly the market will revert to its pre-1998 normal: James Montier feels it will be business as usual and revert within 7 years. Ben Inker also holds out for a 7 year period, but includes a 33% chance it will revert to a higher average valuation (the “Hell” scenario). I believe that the reversion on valuations will take 20 years, and that profit margins will probably only revert two-thirds of the way back to the old normal.
■ All three outcomes are quite possible. This creates a difficult investment challenge.
■ My proposition, though, is that there is an optimal investment for all three outcomes: a heavy emphasis on Emerging Market (EM) equities, especially relative to the US.
■ The next difficulty lies in deciding how much to emphasize this investment, which is perceived as riskier than most, and can of course fail.
■ I firmly believe that asset allocation advice should not be offered unless you are willing, on rare occasions, to make major bets and accept a big dose of career and business risk. Otherwise asset allocation should be indexed.
■ In contrast, a traditional, diversified 65% stock/35% fixed income portfolio today, designed to control typical 2-year career risk, I believe is likely to produce a return over 10 years in the 1% to 3% real range – a near disaster for pension funds.
■ To concentrate the mind, I fantasize about managing Stalin’s pension fund where the penalty for failing to deliver 4.5% real per year over 10 years is death. I believe only a very large investment in EM equities will give an excellent chance of survival.
■ Since February 2016, EM equities have already moved 11% relative to the US. But their three earlier moves since 1968 were at least 3.6x the developed world markets! 1 Absolutely , at around 16x Shiller P/E, EM equities can keep you alive.
1 According to Minack Advisors, the three times were from 1968 (5x), from 1987 (6x), and from 1999 (3.7x).

■ Even a quite successful attempt to leap out of the market and back in, although likely to beat the conventional approach, is unlikely to beat a very heavy EM equities portfolio. 
■ Conclusion . Be brave. It is only at extreme times like this that asset allocation can earn its keep with non-traditional behavior. I believe a conventional diversified approach is nearly certain to fail.
A Rapid Market Fall Back to the Old Trend or a 20-Year Slow Retreat?
At GMO these days we argue over three very different pathways to a similar dismal 20-year outlook for pension fund returns. James Montier thinks it is likely that we will have a very sharp market break in the near future, back to the old pre-1998 levels of value and that we will stay there, with the last 20-year block becoming an interesting historical oddity. Ben Inker – the boss – also believes things will revert over 7 years, but considers it plausible that the valuation level the market will revert to has changed, leaving near-term returns better than James’ view, but the 20-year return largely the same. I represent a third view, that the trend line will regress back toward the old normal but at a substantially slower rate than normal because some of the reasons for major differences in the last 20 years are structural and will be slow to change. Factors such as an increase in political influence and monopoly power of corporations; the style of central bank management, which pushes down on interest rates; the aging of the population; greater income inequality; slower innovation and lower productivity and GDP growth would be possible or even probable examples. Therefore, I argue that even in 20 years these factors will only be two-thirds of the way back to the old normal of pre-1998. This still leaves returns over the 20-year period significantly sub-par. Another sharp drop in prices, the third in this new 20-year era, will not change this outcome in my opinion, as prices will bounce back a third time.

These differences of assumptions produce very different outcomes in the near and intermediate term. Near-term major declines suggest a much-increased value of cash reserves and a greater haven benefit from high-rated bonds.

My assumption of slow regression produces an expectation of a dismal 2.5% real for the S&P and 3.5% to 5% for other global equities over 20 years, but also a best guess of approximately the same over 7 years. This upgrades the significance of the positive gap between stocks and cash and downgrades the virtues of cash optionality and long bond havens. This much is clear. What is not so intuitively obvious is how similar all three estimates are for 20 years. All three are within the range of 2.5% to 3% real return for the US – a dismal outlook for pension funds and others – and within nickels and dimes for other assets.

A problem for investors following GMO’s writing is which of these three alternatives to choose. It is pretty clear to me that all three are possible. Ben Inker, our head of Asset Allocation, has tried hard to make our clients’ portfolios relatively robust to either a very bad medium-term outcome (the James scenario) or a relatively benign outcome (my scenario). I am going to attempt something much simpler here – some might say oversimplified, but I hope not – of asking which investments are appealing in all three outcomes, but particularly the 7-year and 20-year versions. My conclusion is straightforward: heavily overweight EM equities, own some EAFE, and avoid US equities. The next question is how brave to be in this type of situation, where there is only one asset that is reasonably priced in a generally very high-priced world. This is the topic I want to emphasize this quarter....MUCH MORE, including Ben Inker on inflation. (22 page PDF)
HT: Paul Murphy at FT Alphaville's Further Reading Post.