One of the interesting collateral effects of the internet has been to kill off or terribly diminish publications of record and sources of generally recognized authority and objectivity. For investors, this has meant a move away from daily perusal of the Wall Street Journal, a Saturday morning rush to look at Barron's, and regular reference to publications like Forbes. We have lots more information these days, some of it better than before, but we have little in the way of generally recognized and vetted conventional wisdom. For this reason, a voice of authority with a track record is a rare treasure. One of these voices is GMO, a very large money manager (over 100 billion in AUM) whose leader, Jeremy Grantham, has gone on record with quarterly letters for at least two decades. These comments have often been accompanied by detailed quantitative work and periodically by GMO estimates of the return on various asset classes over seven year periods. Used as buy and sell advice - which they don't pretend to be - they have tended to be early suggesting major changes in trend, but their long-term estimates of returns have been quite accurate and have always provided implied advice which would have been profitable or at least saved longer-term investors from grief. Their view on equities in the 4th Quarter 2013 Letter just published is to sell slowly, steadily, in slices, throughout 2014. The ultimate target from their perspective is one's minimum equity allocation. The basis of their call is simple: valuation.
Jeremy Grantham seems to have more or less kicked himself upstairs to a height from which he provides a capitalist's reasoned perspective on issues like climate change and global shortages of resources. His current essay, "Year-End Odds and Ends," talks about Tesla (he likes it) and some possible consequences of more efficient electric cars. He opens a discussion of future peak demand in oil, versus peak supply. He worries about several aspects of fracking, including release of methane. He is most concerned, however, about running out of minerals needed for agriculture, especially phosphorus, for which the only cheap supplies are controlled by Morocco. He is concerned that Morocco is at the edge of a bad neighborhood, a concern which troubles me somewhat less than it troubles Grantham because of reports from my smart Arabic-speaking stepson who just spent a college term abroad there. Moroccan Arabic may yet prove to be a skill with some market value.
As for Grantham's views on the environment and investments, I know that it sounds a bit like Al Gore's "stranded assets" argument, but once again this year I made my annual New Year's resolution to be more open to new and alien ideas even if they originate from strange sources. Grantham gave a little cover of gray eminence to Gore's pop-offs. I'll weigh his argument against my deep conviction that the boys at Exxon (NYSE:XOM) know what they are doing.
The more immediately actionable part of the GMO Letter was written by Ben Inker, an analyst who is co-overseer with Grantham of GMO's asset allocation strategy and would appear to be Grantham's probable successor as chief spokesman for the firm. Inker's pieces in the GMO quarterly letter have evolved over the years into the sort of global investment overviews which Grantham did so brilliantly. His February piece is quite subtle and is grounded in the balance and detail which are central to GMO methodology.
Sell - But With Calculation
Inker's piece, entitled "Divesting When Discomfited," first looks at several ways of adjusting asset allocation to reflect changes in relative value of equities versus fixed income. First with back studies and then by actual strategic moves GMO has explored the counter-intuitive premise that investing in stocks that were the cheapest one year in the past (a strategy Inker calls lagging) outperforms the strategy of investing in the currently cheapest stocks (which he calls spot). He notes that this strategy also worked for country selection in back studies, though less so in recent real world practice. He is troubled by his inability to account for this fully. He is impressed, however, by the persistence of the strategy's effectiveness.
It occurred to me that the reason this strategy works may be related to the methods described in James O'Shaughnessy's What Works on Wall Street, which generally involve buying classes of stocks first screened for value (PB, PS, PE, PCF, etc., individually or in combinations), but then buying the ones screened for greatest positive rate of change over one year (or sometimes shorter periods). It amounts to a combination of value and momentum with value coming first. Again, you do not buy at the lowest valuation - far from it - but you buy value while avoiding stocks which have been permanently damaged. At least this is one plausible explanation. Not having access to GMO's precise methodology, I can't say how closely it may resemble this approach.
Inker does not stop at that point. He goes on to say that GMO's strategy was to reduce its equity position in slices. Slicing, as they call this strategy, involves taking value snapshots at intervals and adjusting one's allocation in stages, always using data with a one-year lag. Starting around the market top in 2007, GMO used this strategy to move from their highest equity allocation to the lowest permitted within their rules. As the market cratered and value reappeared in GMO's calculations (in the latter part of 2008) they ramped the equity allocation back up in slices. Inker presents a table showing that both lagging and slicing strategies soundly beat both a neutral 65-35 equity/fixed split and also the strategy of buying value at spot (the cheapest at present moment). He explains that the slicing approach not only involves avoidance of whipsaws but also avoids trying to explain peculiar in and out movements both to clients and to oneself. Any experienced investor, certainly of other people's money, knows exactly what he is talking about.
But then Inker says an even more interesting (and astonishingly honest) thing which many of us, myself included, will recognize. Having moved in exactly the right direction as the market sank to the bottom, GMO's value strategy froze a couple of months after March 2009. They just found it too difficult to invest aggressively in a market which was suddenly 20% more expensive by April 2009. If you did something like this yourself, open your window and howl and see how many echoes you hear. The table Inker provides thus includes an outcome called sliced but frozen, which also beat 65/35 and spot, but trailed both lagged and sliced when executed without freezing. Hooray for a money manager who admits an error without any effort at spurious exculpation! Inker is saying, simply: we did pretty well, but being human, we made a mistake and are trying to avoid it in the future. How often do you hear anything like that?
(1) So what is GMO doing now? It's very simple. GMO sees the market as overvalued. GMO is selling. They are doing it in an admirably disciplined way, but they are taking their equity allocation down toward their minimum unless the market falls far enough and fast enough that value reemerges in their models. They are happy to tell you that they plan to do their selling in periodic slices over 9 to 12 months. This, readers, is a policy grounded in data and discipline, and it is rendered with rare transparency. Inker says, in fact, that he is putting it in writing in part to lock himself into doing it. When it comes to your personal equity allocation, make of it what you will, bearing in mind personal situation, personal market view, and taxes, but pay it attention.
(2) GMO thought the equity risk premium was about right at the beginning of 2013, but that this depended highly on the ultra-low rates available at that time in fixed income. Rising rates over the year then pulled the risk premium for equities down to the sell point, and they are now selling. This has been their solution to the problem presented by abnormally low rates which could not last forever, but which were bound to change at some indeterminate future time.
(3) Looking at the outcomes of the various strategies, the one that achieved the highest return over the full cycle of market collapse and recovery was the strategy that involved moving decisively to buy the cheapest stocks from one year in the past - the lagging strategy. It succeeded not by having the biggest pop in the recovery but by having the smallest decline in the collapse. For seekers of alpha, this is an important point to consider.
(4) Knowing the behavioral weaknesses that afflict not only their clients but themselves, GMO chooses not the optimal strategy but the one they are most likely to execute and be allowed to execute without pushing client patience over the edge. They lash themselves to the mast against their own emotions and those of their clients. This, too, strikes me as a very underrated factor in long-term investment success.
(5) Every smart investor should make the quarterly GMO essays regular reading. They are offered for free on the GMO website. This link is to the website rather than the Letter itself as you are asked to sign in. You will not be troubled by emails.