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Thursday, April 19, 2012 5:07 AM


Huge Dilemma: Do You Protect Your Job or Your Clients’ Money?


Every day I face the question: Do You Protect Your Job or Your Clients’ Money?

The above link points to an 11 page PDF by Jeremy Grantham in his latest GMO quarterly newsletter. Here are a few excerpts.

Jeremy Grantham

The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money.

Missing a big move, however unjustified it may be by fundamentals, is to take a very high risk of being fi red. Career risk and the resulting herding it creates are likely to always dominate investing. The short term will always be exaggerated, and the fact that a corporation’s future value stretches far into the future will be ignored. As GMO’s Ben Inker has written,2 two-thirds of all corporate value lies out beyond 20 years. Yet the market often trades as if all value lies within the next 5 years, and sometimes 5 months.

Ridiculous as our market volatility might seem to an intelligent Martian, it is our reality and everyone loves to trot out the “quote” attributed to Keynes (but never documented): “The market can stay irrational longer than the investor can stay solvent.” For us agents, he might better have said “The market can stay irrational longer than the client can stay patient.”

Over the years, our estimate of “standard client patience time,” to coin a phrase, has been 3.0 years in normal conditions. Patience can be up to a year shorter than that in extreme cases where relationships and the timing of their start-ups have proven to be unfortunate. For example, 2.5 years of bad performance after 5 good ones is usually tolerable, but 2.5 bad years from start-up, even though your previous 5 good years are well known but helped someone else, is absolutely not the same thing!
Please consider that last paragraph closely. It precisely matches my own experiences.

My clients that came on board in 2007 or 2008 and thus avoided the huge initial decline have hardly said a peep. However, my clients that came on in 2010 or later have been generally frustrated.

Grantham continues ...
You apparently can survive betting against bull market irrationality if you meet three conditions. 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. In my personal opinion (and with the benefit of hindsight, you might add), although we in asset allocation felt exceptionally and painfully patient at the time, we did not in the past always hold our fire long enough or be patient enough. It is the classic failing of value managers (and poker players for that matter) to get impatient and bet too hard too soon. In addition, GMO was not always optimally diversified. We are generally more cautious (or, if you prefer, “more experienced”) now than in 1998 with respect to, for example, both patience and diversification, and at least we in asset allocation always stayed away from leverage.3 The U.S. growth and technology bubble of 2000 was by far the biggest market outlier event in U.S. market history; we had previously survived the 65 P/E market in Japan, which was perhaps the greatest outlier in all important equity markets anywhere and at any time. These were the most stringent tests for managers, and we were 2 to 3 years early in our calls in both cases. Yet we survived, although not without some battle scars, with the great help that we did, in the end, win these bets and by a lot.
My own personal experience with leverage years ago - following initial success - has been disastrous. Arguably the worst thing that can happen to those who use leverage is to be successful the first time.

I now calmly state "don't do it" (and we don't).

Yet, at the same time I point out that incentives to use leverage are massive. The typical hedge fund collects 2% up front plus 20% of gains. Blow up, start again. Win big and 20% of the gains go to the manager. These models encourage speculation and risk-taking and it is the rare firm (the exception) who avoids the risk and thus underperforms on moves higher.

Grantham continues ...
Career and business risk is not at all evenly spread across all investment levels. Career risk is very modest, for example, when you are picking insurance stocks; it is therefore hard to lose your job. It will usually take 4 or 5 years before it becomes reasonably clear that your selections are far from stellar and by then, with any luck, the research director will have changed once or twice and your deficiencies will have been lost in history.

Picking oil, say, versus insurance is much more visible and therefore more dangerous. Picking cash or “conservatism” against a roaring bull market probably lies beyond the pain threshold of any publicly traded enterprise.

Remember, expensive markets can continue on to become obscenely expensive 2 or 3 years later, as Japan and the tech bubble proved.
That is the state I face now. That is the state John Hussman at Hussman Funds faces now and that is the state Grantham faces now.

Moreover, the longer this rally lasts, the more likely it is that value investors throw in the towel at precisely the wrong time.

Fed Force

Grantham continues ...
Over the years, we at GMO have certainly done our share of Fed bashing. Most of our complaints have centered on the way in which overly accommodative monetary policy and a refusal to see the dangers of, or even the existence of, asset bubbles can lead to economic problems. We’re about to pile on the Fed again, but this time it’s personal.

Our major complaint about Fed policy is not about the risks today’s ultra-loose monetary policy imposes on the global economy (which are considerable), but rather the fact that Fed policy makes it tricky for us to know whether we are doing the right thing on behalf of our clients.

One thing that we can say about the 2000 and 2007 asset bubbles is that, while they may have done significant damage to the economy and investors’ wealth, it was at least simple for us to know what to do with our portfolios.

If we avoided the overvalued assets (which in 2007 was pretty much everything risky) we knew we were doing the right thing. Of course, even when investing is simple, it isn’t necessarily easy. In both episodes, but particularly 2000, the conservative portfolios we were running underperformed until the bubbles burst, causing plenty of consternation for our clients in the process.

Today, the Fed has engineered a situation in which the really unattractive asset classes are the ones we have always thought of as low risk: government bonds and cash. And unlike the internet and housing bubbles, this time it isn’t a quasi-inadvertent side effect of Fed policies, but a basic aim of them. The Fed has repeatedly said that a central part of the goal of low rates and quantitative easing is the creation of a wealth effect by pushing up the price of risky assets. By keeping rates very low and taking government bonds out of circulation, the Fed is trying to entice investors into buying risky assets. The question we are grappling with today is whether we should take the bait.
Question of Timeframe

This post primarily pertains to investors and those holding stocks for longer terms. If you are a day-trader or seek to hold stocks for a couple of weeks in a swing trade, much of what I said above is of little use.

Problems arise when people trade outside their normal timeframes. For example, day-traders should not be holding stocks for weeks.  Likewise, value investors should not be chasing short-term liquidity moves by the Fed and ECB.

Take the Bait?

On page nine of his post, Jeremy Grantham says "the question we are grappling with today is whether we should take the bait."

Indeed that has been the question for at least a year. Without a doubt the market has reacted to every hint of financial stimulus (real or imagined)  for  two years.

At some point the market will react in a hugely negative fashion to the idea that still more stimulus is needed. However, in light of overwhelming "don't fight the Fed" sentiment, my suggestion may seem silly, perhaps even foolish, but I assure you it is no different than my claims in 2005 that the housing bubble would burst in spectacular fashion. I also point out that the "don't fight the Fed" mantra was completely useless in 2008.

All I can say for certain is the "fiscal stimulus" rubber band continues to be stretched and the longer this lasts, the greater the snapback. Markets do not mean revert, they invert.

Broken Record

I feel like a broken record. Jeremy Grantham, John Hussman, and Lance Roberts of Streettalk Live surely feel the same way.

Please see Lance Roberts' latest post 10 More Years of Low Returns

I have been preaching the "low returns for a decade" concept for quite some time as noted by the following:




Clearly that is a consistent message, and equally clearly the market has had other ideas.

I was in a similar situation in 2006, calling for a recession when the yield curve inverted, waiting an agonizingly long time for it to arrive.

It is very tough preaching caution, when caution is routinely tossed to the winds. Yet history has proven time and time again, that such times are precisely when caution is warranted, even though timing the precise moment is simply impossible.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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