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The dilemma facing asset allocators is especially acute at investment manager Grantham Mayo van Otterloo, which has remained bearish as markets have lifted valuations and clients have decamped for passively managed funds.
The firm’s assets under management have steadied at $77 billion, from their peak of $124 billion in June 2014. But even founder Jeremy Grantham, who famously called the top of the market before the 2000 and 2008 downturns, has asked whether this time may indeed be different. When he muses about that, Grantham reliably encounters pushback from James Montier, the forthright member of the firm’s asset-allocation committee, who often challenges the assumptions of his boss and others around him. Montier, a huge fan of Winnie-the-Pooh (he even got married in Ashdown Forest, where the Hundred Acre Wood is located), likes to quote the bear’s view of “the value of doing nothing,” as well as other precepts of value investing.
Montier, 45, arrived at GMO in 2009, after a stint as a global strategist at Société Générale. He is the author of Behavioral Investing: A Practitioner’s Guide to Applying Behavioral Finance, and Value Investing: Tools and Techniques for Intelligent Investment. In a recent conversation with Barron’s, he shared his views on passive investing, the heresies of Warren Buffett, the foie-gras bubble, and additional subjects. To learn his views, keep reading.
Barron’s: Bonds are expensive, stocks are expensive. What’s an asset allocator to do?
Montier: Things just don’t add up. One group has thrown in the towel and says, “If you can’t beat them, join them. I’m just going passive and be damned.” [Passive investing] is a very strange thing to do at this particular point in time.
The U.S. market is at its second or third most expensive point in history. So people are saying, “I either don’t understand the world anymore, or I don’t think that valuation matters anymore,” which is a really weird thing to say. You’re giving up the one piece of information that you know helps determine your long-term returns. You cannot describe yourself as an investor if you are going passive. You are welcome to call yourself a speculator, but you honestly can’t say you care about expected returns if you are going passive at this time.
For those standing against the tide, there are a couple of challenges. One, how much pain can you take? The U.S. has been an incredibly strong market for a number of years, so going passive is classic returns-chasing behavior. How do you manage the pain? Nothing in the precepts of being a value investor tells you about the path or the timing. It just tells you about the final destination. The light at the end of tunnel is that the more that people buy on the basis of market cap, the greater the opportunity for active managers.
You have also taken Warren Buffett to task.
All these years I have looked to Warren Buffett as a beacon of hope. Two months ago, he said that equities look cheap, relative to interest rates. It seemed like a dreadful thing to say. It might be true only if you believed there was absolutely no mean reversion—in that case you’d be looking at a 3% real return from equities, zero from bonds, and, say, minus 1% or 2% from cash. But here was a man who, using his favorite valuation indicator of market cap to gross domestic product, pointed to the tech bubble of 2000 and said it was insane. Using the same indicator, he pointed out when to buy equities in late 2008, early ’09. Here we are within a hair’s breadth of the levels in 2000, and he is saying equities are cheap. This is an unvaluelike statement, and I don’t think it’s true. There are plenty of reasons why interest rates are not related to performance—very low rates haven’t stopped a 50% decline in Japan. So I’m sticking to dead heroes now—Ben Graham and John Maynard Keynes.
Yet even your colleagues aren’t dismissing the premise that this time is different.
One of the great joys of being at GMO is that conflicting views are tolerated and encouraged. When somebody like Jeremy Grantham says there’s a plausible case that mean reversion might take 20 years, not seven, I’m going to listen, and try to persuade others, including Jeremy, that Jeremy is wrong. Information lies in the divergence of opinion. Jeremy and I arrive at the same terminal point: You end up with low returns. Jeremy says bubbles are best characterized by excellent fundamentals irrationally extrapolated. In the classic manias—the TMTs [the technology, media, and telecom bubble of 2000], the Japanese new era—everybody believes this time it’s different.
Jeremy says we don’t have that, that the world is worried, not euphoric, and therefore this isn’t a bubble. My perspective is that we have a bubble of complacency, and people are acting as if there are no risks, while I see a world full of them, from slowdowns in China to a euro-zone crisis to Fed tightening. And yet pretty much all assets look to be priced for perfection. Effectively, people have just said: “I have no choice but to go and invest.” I call it the foie-gras bubble, where you’re being force-fed risk assets. Jeremy is talking about extrapolation of return. I’m talking about underestimation of risk.
Let’s talk about secular stagnation.
Secular stagnation is a function of the policies that we’ve chosen to pursue.
The first is the rise in shareholder value maximization. Too many corporate leaders are obsessed about it as an objective. The enduring businesses service their customers right. Without that, they wouldn’t exist. In a world in which shareholder value maximization has become the kind of driving engine, business levels of investment have collapsed, dragging down growth. Who owns 80% of the stock market? The top 20% of the population. As the market does well on dividends and share repurchases, the cash flows back to the rich, who don’t spend as much per dollar of income as the poor.
The second policy is the decision taken in the early 1980s, which was to abandon full employment as a policy objective when wage spiral inflation got everyone scared. Central banks decided to target lower inflation and higher unemployment. That deliberately limits the upside of growth. In the 1970s, one in four belonged to a union. Today, it’s less than one in 10. The dynamics are very different.
The third policy is globalization, which sounds like it should be wonderful, but really means lowest-cost products. It takes jobs from people and depresses the labor share, and recycles money back to the wealthy. President Trump was elected because he appealed to the disenfranchised. The idea of a member of the 1% being elected to represent the 99% has a beautiful irony.
The fourth is deregulation, particularly in regard to the labor market and the idea that anything like a minimum wage impedes the fundamental laws of supply and demand. That puts pressure on the labor share of GDP.
Can central banks reverse it?
Monetary policy is relatively powerless in the context of the real economy. It has a lot of influence over asset markets. Monetary policy is really about distribution. It’s about creditors versus debtors. Everybody hangs on Greenspan’s, Bernanke’s, Yellen’s every word, as if they are somehow coming down from the mount with the sermon. They are a bit more like the Wizard of Oz. If you pulled back the curtain, you would be a little ashamed of what is going on.
How do you build a portfolio under these conditions?
You stop trying to build so-called optimal portfolios, which are a very strong statement about your belief in the state of your knowledge—that your expected returns are going to be this, which to me is absurd. You build a robust portfolio that can survive lots of different outcomes—a world where Jeremy is right and it takes 20 years for mean reversion to happen, or one where I’m right and the markets revert considerably faster.
There are four things you could do: First, concentrate your portfolio, own the one thing that will generate returns, which to us are emerging markets, with a strong value tilt. If you are Rip Van Winkle and go to sleep for 30 or 40 years, you will wake up and your portfolio will probably be just fine. But most people have a three-year time horizon. Second, sidestep the problem, look away from listed assets and seek alternatives like private equity, hedge funds. The problem is that alternatives aren’t magic beans with uncorrelated sources of return. They are different ways of owning standard risks. Private-equity returns look very much like public equity, plus or minus leverage, so they’re not really diversifying. Hedge funds in aggregate look like a put-selling strategy. And it is not noncorrelated when equity markets fall apart. Third, use leverage. The problem there is that leverage can never turn a bad investment into a good one, but it has the potential to turn a good investment into a bad one by forcing you to sell at just the wrong point in time. Fourth, to quote Winnie-the-Pooh, never underestimate the value of doing nothing. Patience is a virtue.
What does that translate into?
A sensible portfolio today has a sizable amount of dry powder: T-bills, bonds, TIPS [Treasury inflation-protected securities]. You have to say: “Look, I know cash is giving me a lousy return, but it has an option value that comes in when there are dislocations in markets.” Now, the risk of that strategy is clearly that this time is different and there is no more volatility. Then take your equity risk mainly where you are getting paid the most for it–emerging market value stocks. There are also different ways of owning low standard risk. Merger arbitrage is a way of owning equity that has a very different duration profile. Equity duration can be 25 to 50 years, but merger-arb duration is six to 12 months. If you use leverage, use it sparingly.
Please share your expectations for returns.
For U.S. equities, around -3%, -4% a year, driven by mean reversion. Both price/earnings ratios and profitability are high and will revert to normal over seven years. The Standard & Poor’s 500 is the world’s worst equity market because it has such an appalling return forecast. Europe is about zero, Japan is zero to mildly negative. Then you get good old emerging markets at 4%, and emerging markets value at 6.5% a year for the next seven years, in real terms. Bonds are an appalling investment. The current yield on the U.S. 10-year is 2% and change, and expected inflation over the next 10 years is 2% and change, so I’m expecting a near-zero return. That’s why it’s a difficult time to be an asset allocator, because historically when risk assets are expensive, safe-haven assets provide somewhere to sit and wait. Today, they don’t, because of the way that the central banks have applied their policies.
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