gmo april06

8/2/2019 GMO April06

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Global liquidity, without too much fanfare, has moved

slowly and steadily from massive, and seemingly exces-

sive, to increasingly moderate. This decreasing liquidity

is an arrow aimed at what had become a global liquidity

bubble that was driving global asset prices higher.

Anglo-Saxon housing markets are apparently topping

out after having played a strong role in over stimulating

consumption. Yet the U.K. market, particularly London,

has made a teasing several-month recovery partly under

the impetus in London of a large city financial bonus

year. But market declines, just like rallies, do not run

smoothly. What is remarkable, though, is the complete

faith expressed in the press that the tiny little weakness is

over and a new bull market rules. Importantly, though, it

is noted that last year had the lowest percentage of first

time buyers for 25 years. That is what breaks all housingmarkets. The idle rich can keep markets going for a while

on second homes and buying to let, or rent, but in the

end, you need new buyers. Inventories of unsold houses

in general have been rising in the U.S., and sales in gen-

eral have been declining. Prices in bubble cities are off a

little. If it is not the beginning of the end, then at least we

can see it from here.

The dollar looks increasingly suspect as the future for

rate increases looks stronger abroad than here. Given the

past rise in rates here, and the average U.S. rate advantage

last year, indeed, the 10% to 15% dollar rally does notseem that impressive in hindsight. As relative rates look

less attractive here, the dollar might well fall and make

investing in the U.S. market less attractive. (Not to men-

tion almost the trade deficit going on $900 billion a

year and, what is really shocking, that our total imports

are almost 60% bigger than our total exports.)

The Epic 23-Year Credit Cycle from 1982 is still the

backdrop. Inflation and rates cannot decline much;

For all I know they are still making Road Runner car-

toons in which his admirably persistent assailant, Wile E.

Coyote, is still racing off the end of the road, over the

cliff, and half way out across the chasm as Road Runner

hides behind the tree. But however narrow the chasm,coyote never makes it more than half way across before

he looks down and realizes the ugly truth and, losing

heart, falls like a stone. This is what todays market feels

like to me, although it lacks Wile E.s frenzy. Its as if the

coyote this time is strolling out across the bottomless pit

without a care in the world, whistling and looking up at

the birds.

To a degree I have never seen before, todays U.S. equity

market appears completely unimpressed with the grow-

ing list of negatives. There have been plenty of over-

priced markets where everything appears to be just fineand you can just about sympathize with that main group

of bulls The Extrapolaters! saying everything is

great and therefore the market should keep going up.

But, this time, one by one, the negatives have fallen into

place, and Wile E. Market couldnt care less.

Let Us Count the Negatives

Interest rates have steadily risen at the short end, and the

conundrum of low longer rates is disappearing as they

also rise steadily, now to within 0.5% or so of long-term

fair value on consensus inflation estimates. And for infla-

tion fearers, the TIPS look even better. It is already easyto hold some cash, and it is becoming easier all the time

to overweight bonds over stocks.

Oil and commodities prices have surged under the pres-

sure of global demand. Recently they have also felt some

effect from the increasingly socialist and nationalistic

policies in South America and from terrorists in Nigeria.

These rising prices must put pressure on inflation, con-

sumption, and profits.

GMOQUARTERLY LETTER

April 2006

Jeremy Grantham

The Wile E. Coyote Market

plusLetters to the Investment Committee VII


2/11

2GMO Quarterly Letter April 2006

increases in debt, especially mortgage debt, cannot con-

tinue at the recent rates; credit cannot stay so available;

and risk premiums cannot narrow much further, unless

you want Brazilian debt trading through U.S. govern-

ments. But the long, favorable cycle has done a great job

in producing a state of permanent confidence in which

risk is barely seen to exist.

Very, very high profit margins around the world, butparticularly in the U.S., absolutely cannot continue.

Exhibit 1 shows the U.S. picture. If global high profit

margins cannot produce offsetting increased investment

and competition, something very odd must have hap-

pened to capitalism. Look at Exhibit 1 and make your

own guess about the timing of a decline, but now looks

good to me.

Chinese labor, cheap and plentiful, has been said to be a

reason for high profit margins, but surely Econ 101 would

say that any resource equally available to everybody will

pass through the usual competitive system that ends witha fair return on capital and no more. Only if cheap

Chinese labor helped us and no one else could it be a per-

manent contributor to our high profit margins.

The Presidential Cycle effect aint what it used to be, at

least not recently: last years market was not strong, but

unexpectedly up a little rather than down, helped perhaps

by Greenspans retirement. Now, though, Bernanke has

an opportunity to behave in a Presidential Cycle way. If

I were he, and wanted to stay in good standing with the

administration, I would go for one or two extra quarter

points this year so I could cut rates more next year.

Remember, only increases in employment in the last 2

years move the vote. If he does this, it will help the infa-

mous year 2 market to be weak, and year 3 to recover abit, as nature intended.

The savings rate has declined year by year for a decade,

often unexpectedly. This has created an equally unexpect-

ed series of strong consumer years that are in turn so good

for profit margins. Under the influence of some of the fac-

tors discussed above, and particularly rising rates and

stalling house prices, surely savings will rise a little, caus-

ing consumption and profits to be a little less than expect-

ed. Surely then Wile E. Coyote will finally look down.

Recent Forecasts

Absolutely nothing changed last quarter, indeed, the mar-

ket seems stuck in a groove. So, once again, our forecast

of quality stocks outperforming and the U.S. equity mar-

ket being weak was completely wrong, and, once again,

our faith that should the U.S. market hang in, then emerg-

ing market equity would beat it by a lot, and developed

3%

4%

5%

6%

7%

8%

9%

47 49 51 53 5 5 57 59 6 1 63 65 6 7 69 71 73 7 5 77 79 8 1 83 85 8 7 89 91 93 9 5 97 99 0 1 03 05

Exhibit 1

Profit Margins in the U.S.

Source: GMO, BEA As of 12/31/05

Profit Margins: Corporate profits after tax with IVA and CCAdj as a percentage of final sales of domestic product


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3 Quarterly Letter April 2006 GMO

foreign markets (EAFE) would at least beat it was com-

pletely justified. Overweighting fixed income was mod-

erately expensive, but lowering duration was right. Other

bets like the anti-dollar bet did not really matter.

Junks Revenge

The drain that the outperformance of speculative stocks

puts on our performance, particularly in the U.S., is get-

ting tiresome to us and no doubt to clients. I try to con-sole myself by remembering that every big win we have

had has been preceded by pain as we increase our weights

in factors that are falling and getting cheaper. (Thats a

complicated way of saying that we always seem to be

early.) But high quality versus junk in the U.S. is now

almost a bona fide 2-sigma event (a 40-year outlier), and

I think high quality could beat the market by 20% or

more, depending on what happens to the relative profit of

quality companies.

Exhibit 2 shows the relative value of the highest quality

25% of the market cap compared to the S&P 500. Over40 years it has had one blow-off in the Nifty Fifty era of

the late 1960s. The Nifty Fifty, uniquely, was more of a

quality, or Great Franchise market, than a growth mar-

ket. Now junk has had a heyday, not just in U.S. stocks,

but everywhere else, and the quality stocks are as cheap

as they have ever been. And even this measure does not

fully capture the potential for quality stocks that could

also benefit from a major swing in favor of their profit

margins. Exhibit 3 shows the long-term ebb and flow of

relative margins between high and low quality compa-

nies. Once before, around 1980, the great companies got

outmaneuvered by inflation, and the lower grade, more

desperate companies marked their prices up for inflation

more rapidly in order to survive, and the profitability gapalmost disappeared. Now, although the margins of high

quality companies are just fine, those for low quality

companies have moved up dramatically, under the impe-

tus of a very strong global economy and the consequent

greater need for secondary or marginal capacity. Once

again, the gap between the two groups is extremely nar-

row. The real money will be made by us when high qual-

ity companies once again sell at a relatively overpriced

level on above average profit margins. Right now,

though, I would be happy to settle for a normal relative

evaluation on a normal margin premium. Yes, please.

As a footnote, there is a rather unpleasant line of logic I

can torture myself with. Small caps were at their second

lowest relative level in March 2000, and price/book was

actually at its all-time relative low. Being believers in

mean reversion, we, not surprisingly, predicted a dramatic

Exhibit 2

Valuation of High Quality Stocks

Relative to the S&P 500

0.8

0.9

1.0

1.1

1.2

1.3

65 68 71 74 77 80 83 86 89 92 95 98 01 04

RelativeValuationofQualityStocks

(Qu

alityEquity/S&P500)

Dec-

Source: GMO, Standard & Poors As of 3/31/06

Nifty-Fifty

Exhibit 3

Relative Profitability of Quality vs. Junk Stocks

1.03

1.05

1.07

1.09

1.11

1.13

1.15

1.17

1.19

70 73 76 79 82 85 88 91 94 97 00 03

RelativeProfitabilityofQualityvs.

JunkStocks

Dec-

Source: GMO As of 3/31/06


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4

move in their relative performance that would take them

back to normal. This happily worked according to Hoyle,

but as historians we also know that dramatically

depressed assets always overcorrect through fair value as

by then they have developed momentum and crowd

pleasing qualities. Small cap stocks and price/book have

both done precisely that, and are now substantially over-

priced, but no more so than factors usually over run,

and less than these particular factors over ran on theupside by 1982 after their legendary 1974 low. So if you

expect small caps and price/book to over run normally,

how could quality not exactly concentrated in small

caps and price/book hope to do well? This is often the

mistake of value managers like us: to get out of over-

priced sectors like size, value, and quality too soon, and

to assume that now that their opposites are cheap they

will turn obediently on a dime. However, I believe we are

in the ballpark for changes in the relative strength in all

these parameters: small, book, and quality. I keep

reminding myself, though, how painful it can be when on

the wrong side of the last few months of a blow-off.

GMO Performance

The combination of the market rally and exceptional

strength in junk in the U.S. has caused a difficult environ-

ment for our quality-tilted, slightly bear market oriented

approach in the U.S. for over 3 years. The 3 years before

that of a falling, high quality dominated market gave us

the reverse strong performance. Foreign (EAFE) mar-

kets had a substantially less hostile spin for us in the last

3 years, although somewhat so, and our three very strong

bear market years were happily followed by 3 years ofmodest outperformance. Emerging, also with a dilute

version of the U.S. problems, had two strong years, and a

weak one in the last 3 years, and is behind in the first

quarter. We typically but unfortunately not always

can really show our paces in a sustained bear market with

a high quality bias, and this meshes completely with our

current forecast. Now if

For the quarter, U.S. and emerging performance was

poor, and our EAFE accounts were slightly ahead. Our

bond strategies were mixed except, once again, emerging

debt, which had a strong gain. Our hedge strategies con-tinued to be very low volatile, reflecting the markets with

only modest positive return on average. In our asset allo-

cation accounts, our heavy overweight in emerging equi-

ty compensated once again for other errors, notably an

overweight in high quality, and they managed to pull

ahead in the first quarter in a year that, if up, would be our

seventh consecutive up year. I hope the emerging equity

stone has not lost all its blood, and that our other big bets

pro-quality and anti-U.S. equity will soon kick in.

Postscript: Silly Bull Case #212

Lets compare the P/E reciprocal (earnings yield) of

stocks to the least attractive, most overpriced fixed

income security to prove how cheap stocks are.Recently the Financial Times enthusiastically quoted a

money manager justifying U.S. stock prices by comparing

earnings yield to U.S. 10-year TIPS. This raises a series

of interesting points:

1. As always boring, boring fair price for equities in

aggregate should equal replacement cost (Tobins Q).

However hard this may be to calculate, it is easy to

agree with the principle and to realize that replace-

ment cost cannot jump around with rate changes.

2. And what about the principle of using a yardstick that

itself is influenced enormously by the usual, flaky

behavior of investors? We efficient U.S. investors,

for example, recently sent the long TIPS from 4.4%

yield in 2000 to 1.5% recently. Some yardstick! A

fixed yardstick is surely better, and we prefer the

long-term return requirements that investors have for

equities and bonds, apparently around 5.7% and 2.9%

real, respectively.

3. The use of silly, overpriced fixed income yardsticks

brings to mind two extremes. First, in the U.K., why

not use their 50-year government TIPS, in some ways

a very senior dignified security? It recently hit a low

yield of 0.35%. (Fama and French, by the way, no

doubt thought this was a perfect reflection of the total

lack of all future risk, etc.) Used as a yardstick, the

50-year TIPS would certainly have justified U.K.

P/Es of 50 to 100 depending on the technique used. In

fact, the extreme argument is that in the long run,

stocks are not risky enough to justify any premium

over bonds at all (see Dow 36,000) which, therefore,

could justify a stock market with an earnings yield of

less than 0.35% or a P/E of about 280 times! This

would be about 20 times replacement cost. Second, itis fun to remember the hit squad sent out in 1989 by

Salomon Brothers that toured U.S. investment houses

arguing that with Japanese bond rates so low the

Japanese market, then 65 times, was a bargain that

should have been 125 times. Cross my heart, its true!

Disclaimer: The foregoing does not constitute an offer of any securities for sale. Past performance is not indicative of future results. The views expressed

herein are those of Jeremy Grantham and GMO and are not intended as investment advice.

Copyright 2006 by GMO LLC. All rights reserved.

GMO Quarterly Letter April 2006


5/11

long-term trend of about +3.5% a year real. This trend is

stable because the economy is mean reverting, and bad

times (like the 1930s) that produce spare capacity in both

labor and capital are followed by strong times as theeconomy works to use up its excess resources. This ultra

Huge Behavioral Risk versus

Small Fundamental Risk

Exhibit 1, the Exhibit of the Quarter, shows the incred-

ibly low volatility of the U.S. GDP, which two-thirds ofthe time has a volatility that is a mere 1% around its

GMOSPECIAL TOPIC

April 2006

Jeremy Grantham

Letters to the Investment Committee VII*

Risk Management in Investing (Part Two)

Risk and the Passage of Time:The Extreme Importance of a Long Time Horizon

* The Letters to the Investment Committee series is designed for a very focused market: members of institutional committees who are well informed but non-

investment professionals.

8.0

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18821886

18901894

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191419181922

19261930

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194219461950

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19821986

19901994

19982002

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icesan

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inLogS

pace

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RealGDP

inLogSpace

S&P Real Price

S&P Fair Value

GDP

Volatility:2/3 of the Time Prices 19%

2/3 of the Time Fair Value 1%

2/3 of the Time GDP 1%

Exhibit 1

S&P Prices Relative to Fair Value and GDP

Source: GMO, Standard & Poors, Federal Reserve As of 12/31/05


6/11

2GMO

stable GDP engine can be thought of as the engine driv-

ing corporate profits and dividends. They in turn,

although far less stable at a yearly level, follow the GDP

in its mean reverting tendency towards a normal level.

Because of this, if you were clairvoyant in 1882 about the

entire actual stream of corporate earnings and dividends

until today, and used your clairvoyance to calculate a fair

value, and then did the same for 1883 and so on for every

year, it would produce a very stable trend of stock marketfair value, as first revealed by Robert Shiller 18 or so

years ago. Perhaps, not surprisingly, the volatility of this

fair market value also stays within 1% of its long-term

trend two-thirds of the time. But what a contrast these

two series are to the actual stock market, which manages

to spend two-thirds of its time within only 19% of fair

value. This means that the market is 19 times as volatile

as the underlying fundamentals would seem to justify!

Understanding this 19 to 1 discrepancy would put us a

long way along the road to understanding risk.

The Real Risk in Investing:Career and Business Risk

The key to understanding this unnecessary volatility is

behavioralism, a nice academic way of defining ineffi-

cient or irrational behavior at least inefficient and irra-

tional in its approach to profit maximizing. For those

interested in a simple story, the main driver in risk man-

agement for most investors is, unfortunately, career and

business risk. This means that controlling short-term

benchmark risk dominates, and not the risk of the actual

client not the committee, but the actual client losing

real money. This problem is now referred to often asagency riskmeaning its the other suckers money. Our

ultimate job description is to keep our jobs, and in 1936

Keynes explained in Chapter 12 ofThe General Theory

that you do this by never, ever being wrong on your own.

If you stay with the pack, but ideally execute quicker and

slicker than the next investor, your career will never be in

danger. This attempt by investors and firms to limit career

and business risk creates momentum (or herding), which

from time to time pushes prices far away from fair price.

(See Letters to the Investment Committee I, 3Q 2004.) But

how do you deal with an uncertain future? If all managers

and firms produce their own estimates, pretty soon you willbe in a chaotic world of very different estimates and mass-

es of career risk. Borrowing a little from Keynes, the

answer to this conundrum is extrapolation. If we all agree

to extrapolate the current conditions, all career risk has

been removed and we are all betting on the same numbers.

(Keynes said that extrapolation was the convention we

adopt to deal with an uncertain world, even though we

know from personal experience that it is not the case.) But

extrapolation causes the extreme market volatility relative

to the stable fundamentals that we observe.

Exhibit 2 shows long-term changes in profit margins and

P/Es. As mentioned in Letters to the Investment

Committee II (1Q 2005), serious bedrock value is

replacement cost and this is arrived at by multiplying low

profit margins in a depressed economy by high P/Es and

vice versa. The perfect correlation would be -1. Exhibit2 shows the extent of behavioralism. We collectively

cannot even get the sign right and the actual correlation is

+32%. We actually multiply high margins by high P/Es,

particularly at market peaks, and vice versa at market

troughs, where exactly the reverse would be particularly

helpful! This double counting is a large part of the Shiller

effect. There are other behavioral twitches deviations

from the rational behavior of the assumed economic man

of Modern Portfolio Theory (MPT) fantasy but behav-

ior designed to minimize career risk does the heavy lift-

ing in driving prices away from fair value.

The Market Really Is a Tiny Bit Efficient

Assume for a while that the argument above is correct.

What it suggests is that the more you ignore the short-

term, career driven, almost hysterical-looking volatility,

the closer you will get to the much more stable long-term

fundamentals. To help us, the market is not completely

inefficient, but is like a stopped clock, efficient every 6 or

7 years as it passes through fair value, usually on its way

to another substantial mispricing. This occasional effi-

cient pricing is necessarily the case, for in the long

run, fair value is arbitrageable. In an overpriced mar-ket, corporations will build more plants, sell them in the

market at twice price, and finally drive the margins down

until we sell once again at replacement cost or fair value.

(See Letters to the Investment Committee II.) Value,

therefore, is like a mild, but very steady gravitational pull

towards fair value or efficiency. Every 1% of the time or

so the market is efficiently priced and 99% of the time it

is inefficient. This might be thought of as the very, very,

very mild form of market efficiency. Of course, the case

for calling it the Inefficient Market Hypothesis (IMH)

could be argued to be 99 times stronger!

Reducing Volatility in a Mean Reverting World

A major difference between the risk that would be

involved in an efficient market and the real mean revert-

ing world is the way volatility changes with time. In an

efficient market all mean reverting tendencies in the econ-

omy would be recognized and discounted, providing a

much lower relative stock price series than actually exists.

Only the truly unknowable aspects of the future would be

Letters to the Investment Committee VII, April 2006


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3 GMO

left out of the price, and they would produce a series of

truly random effects and a normal distribution of prices

(the familiar bell shaped curve). In a random, or effi-

cient series like this, volatility increases with the square

root of time, that is to say, the volatility over periods of 16

days (or years) is four times greater than for 1 day (oryear). In real life, though, the mean reverting tendency of

economies and markets works to reduce the volatility

below the random level of the efficient market. The outer

band or cone in Exhibit 3 (taken from Andrew Smithers)

shows how the level of volatility that would contain 90%

of all occurrences grows with time in a normal distribu-

tion. The inner cone shows the actual historical increase.

As you can see, at 3 years there is no important difference,

but at 15 years there is an important difference. It is at 30-

year horizons, though, that the differences become truly

dramatic: the actual deviations around trend are only half

in our real mean reverting world of what they would berandomly in an MPT world! (Trend, or approximately

6.9% real 2.8% compared to 6.9% 5.8%.) It should

also be remembered that a 30-year horizon is purely arbi-

trary and that beyond 30 years the ratio of real risk to the

theoretical risk continues to improve.

So, capitalist instincts extra returns attract extra invest-

ment cause the economy and profits to always move

back to average or mean revert. This is absolutely not

anticipated efficiently in the stock market, but exaggerat-

ed through the working of career risk and extrapolation.

This in turn creates a world in which mean reversion in

equity prices is so strong that real risk in equities

reduces steadily with time. The equity risk premium the reward for holding stocks instead of risk free cash

has always looked high to academics. It is very high rel-

ative to the risk of the long-term holder, but reasonable

for the risks of the short-term holder exposed to extreme

and technically unnecessary volatility.

The Importance of Extreme Events

The previous point deals with how the 90% range around

trend narrows because of mean reversion. However, the

extreme 10% this analysis misses is particularly impor-

tant. For 90 or 95 percent of the time, all you have to do

is show up for work and keep your nose clean. It doesntreally matter what you do since assets are reasonably

priced relative to their risk and each other. But once or

twice in a career there are major aberrations and it

absolutely matters what you do. It is the time to use some

of your career risk units and try to make a difference.

Mandelbrot has weighed in on this point with his book

The (Mis)Behavior of Markets, which contains one of my

favorite quotes: Economics has not truly come to

0

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26 29 32 35 38 41 44 47 50 53 56 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04Dec-

Record

Margins High PE

Depressed Margins Low P/E

Record

Margins High PE

Record

Margins

High PE

Depressed Margins Low P/E

P/E Ratio of U.S. Stock Market

Actual correlation between profit margins and P/Es is +32%

Exhibit 2

P/Es and Profit Margins

Source: GMO, Standard & Poors As of 12/31/05

Letters to the Investment Committee VII, April 2006


8/11

4

grips with the main difficulty, which is the inordinate

practical importance of a few extreme events.

Most financial analysis, which would include MPT, real-

ly assumes a normal bell curve distribution (known to

academics as a Gaussian distribution), but many aspects

of the real world and the stock market are power laws thatform what are known as Paretan distributions.

Mandelbrot and Taleb recently wrote an excellent article

for the Financial Times that dealt with these two different

types of uncertainty distributions. My favorite tidbit

from the article (altered slightly by me) is that a normal

distribution could be demonstrated by looking at the

weight distribution in the Super Bowl and how it is

affected by adding a gigantic 500 pound man: the average

weight goes up by a tenth of an ounce. If, however, you

were studying the distribution of wealth and you added

Bill Gates, the average wealth would move from $50,000

to $550,000! That is a power law or Paretan distribution,and much of the market is more like that: the real action

is contained in the last few outlying points. In contrast,

the dominant academic view of the period between 1975

and 1995 was almost 100% concerned with normal distri-

butions. Perhaps partly in consequence, there has been a

strong and painful tendency to underweight the signifi-

cance and probability of new and potentially terrible out-

lying events. This, ironically, has been the case at least as

much for heavyweight quants as for traditional investors,

and the list of sufferers has famously included a couple of

Nobel Prize winners in economics.

Time Reduces Even the Risk of Extreme Events

What Im particularly interested in here though is the

effect of time on these important outliers. Exhibit 4shows the distribution of a daily price series compared to

a normal distribution. It appears oddly and interestingly

to have a very large number of very small changes, more

than you would expect. But the real action is with the

outliers. 1987 was an 18-sigma event; the sun would

have to cool down completely before you would expect to

see one of those based randomly on the distribution of the

other 99.9% of all days. These outliers have enormous

implications for decisions such as leveraging and selling

options. You take home a nice profit year after year, and

over 10 years it can look riskless, and then, bang

youre dead. Some hedge funds have an element of thisselling insurance imbedded in them, so caveat emptor.

Exhibit 5 shows a distribution of yearly returns. Now we

only have to deal with a measly one in 3,000 year ran-

dom event in 1931 and note that the other end is 1932

not a complete accident and enough to materially narrow

the distribution of 2-year returns, but space does not

allow an extra exhibit. Exhibit 6 shows the 30-year dis-

tribution and it is now a normal distribution! From the

Malkiel is right

5 15 2510 20 300

Trend:+6.9%

0

1

10

100

10 20 30

Number of Years You Stay in Stocks

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If stock returns were random, returns on stocks,

over different horizons, should lie in this range 90% of the time.

log scale

Trend:+6.9%

Because values are mean reverting,

they have stayed within this significantly narrower range.

5 15 2510 20 300

Malkiel is right

5 15 2510 20 300

Trend:+6.9%

0

1

10

100

10 20 30

Number of Years You Stay in Stocks

Rea

lva

lueo

f$1inves

teda

ts

tar

to

fperio

d,

withre

inves

teddividen

ds.

If stock returns were random, returns on stocks,

over different horizons, should lie in this range 90% of the time.

log scale

Trend:+6.9%

Because values are mean reverting,

they have stayed within this significantly narrower range.

5 15 2510 20 300

Exhibit 3

Distribution of Real Returns from Investing in the S&P 500: 18712005

Source: Smithers & Co. Ltd.

GMO Letters to the Investment Committee VII, April 2006


9/11

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-4%

-3%

-2%

-1% 0% 1% 2% 4%5% 6%7% 8%10

%11%

12%

14%

15%

16%

Market Returns in Logs

Frequency

18 std.dev. event

Oct. 19, 1987

11 std.dev. event

Oct. 28, 1929

9 std.dev. event

Oct. 29, 1929

14 std.dev. event

March 15, 1933

NormalDistribution

0

500

1000

1500

2000

2500

3000

3500

4000

4500

-20%

-20%

-19%

-18%

-17%

-16%

-15%

-14%

-13%

-12%

-11%

-10% -9

%-8%

-7%

-6%

-4%

-3%

-2%

-1% 0% 1% 2% 4%5% 6%7% 8%10

%11%

12%

14%

15%

16%

Market Returns in Logs

Frequency

18 std.dev. event

Oct. 19, 1987

11 std.dev. event

Oct. 28, 1929

9 std.dev. event

Oct. 29, 1929

14 std.dev. event

March 15, 1933

NormalDistribution

Exhibit 4

Distribution of Daily S&P 500 Returns (1928 Present)

Source: Standard & Poors, Global Financial Data

0

10

20

30

40

50

60

70

-64%

-61%

-58%

-54%

-50%

-46%

-41%

-36%

-31%

-25%

-19%

-12% -4

% 4% 13%

23%

33%

45%

57%

71%

85%

101%

118%

137%

157%

Natural Log of Real Returns

Frequency

3.4 std. dev. event

1 in 3,000 year event (1931) 1932

NormalDistribution

0

10

20

30

40

50

60

70

-64%

-61%

-58%

-54%

-50%

-46%

-41%

-36%

-31%

-25%

-19%

-12% -4

% 4% 13%

23%

33%

45%

57%

71%

85%

101%

118%

137%

157%


Frequency

3.4 std. dev. event

1 in 3,000 year event (1931) 1932

0

10

20

30

40

50

60

70

-64%

-61%

-58%

-54%

-50%

-46%

-41%

-36%

-31%

-25%

-19%

-12% -4

% 4% 13%

23%

33%

45%

57%

71%

85%

101%

118%

137%

157%


Frequency

3.4 std. dev. event

1 in 3,000 year event (1931) 1932

NormalDistribution

Exhibit 5

Distribution of Yearly S&P 500 Returns (1900 Present)


GMOLetters to the Investment Committee VII, April 2006


10/11

6

last point we covered on mean reversion, we know that it

has half the range that would have been expected from

the daily volatility, but it is still a normal distribution.

And one in which all the outliers have disappeared.

Our Past May Have Been a Lucky One

It must also be remembered that although all the outlier

events disappeared in these 30-year holding periods in the

last 80 years, the actual experience may well have beenlucky for the U.S., the U.K., Denmark, and a few others.

For Czarist Russia the market risk did not work out so

well. Germany also took its licks both in hyperinflation

in the 1920s and in World War II. We have only one flight

path in history to study, and it could have been a much

less successful one. The safest procedure is to take all rel-

evant examples, not just the U.S., as a measure of future

outliers. Having said that, the overwhelming majority of

event risk was reduced by the passage of time and mean

reversion. The U.S. recovered from the depression as if

it had never occurred. Japan caught up, and Germanyrecaught up with Europe after the destruction of WWII.

Only when irreversible, permanent loss of market value

occurs (e.g., 1919 Russia), can mean reversion not work

its magic. It is hard to mean revert from zero. This point,

importantly I think, always argues for being more conser-

vative than would be justified by historical data only.

Some Implications of Risk Reducing with Time

A) Leverage

Enough leverage can undo all the best efforts of mean

reversion to reduce long-term risk because under the

pressure of a severe decline exaggerated by leverage, the

investor can be forced by margin calls or pure panic to

sell before prices have time to move back up. This is par-

ticularly the case since short-term outlier risks are typi-

cally underestimated. Such underestimation is a forgiv-

able crime for long-term unleveraged investors, but often

a terminal error for short-term leveraged investors. This

is especially relevant today when leverage and risk

assumption have never been higher.

B) Holding Periods

Ironically, most of the risk to long-term investors in equi-

ties comes from panicking in the short term and closing

out positions that then mean revert. (Classic examples ofthis would be institutions firing value managers and hiring

growth managers in 1999 because they couldnt stand the

underperformance, and a whole generation of investors in

the 1930s moving permanently out of equities.) Selling

in declines throws away the powerful risk reduction effect

0

5

10

15

20

25

30

35

40

45

50

-5%

-4%

-4%

-3%

-3%

-2%

-2%

-1%0%0%1% 1%2%3%3%4% 4%5%6%6%7%8%8%9%10

%10%

11%

11%

12%

13%

13%

14%

15%

16%

16%


Frequency

NormalDistribution

0

5

10

15

20

25

30

35

40

45

50

-5%

-4%

-4%

-3%

-3%

-2%

-2%

-1%0%0%1% 1%2%3%3%4% 4%5%6%6%7%8%8%9%10

%10%

11%

11%

12%

13%

13%

14%

15%

16%

16%


Frequency

NormalDistribution

Exhibit 6

Distribution of 30-Year S&P 500 Returns (1875 Present)


GMO Letters to the Investment Committee VII, April 2006


11/11

7

Disclaimer: The foregoing does not constitute an offer of any securities for sale. Past performance is not indicative of future results. The views expressed

herein are those of Jeremy Grantham and GMO and are not intended as investment advice.

Copyright 2006 by GMO LLC. All rights reserved.

of mean reversion. Most investors would be better off if

they had a hard rule that everything they bought had to be

held for 30 years or longer. Even more certainly, they

would benefit if the rule only allowed the selling of an

asset class at a price well above its long-term trend.

C) Stocks versus Bonds

In my opinion, the risk premium for stocks appears to be

set by short horizon investors with their unnecessarilyhigh stock risk. (Equities seem to give a type of illiquid-

ity premium in the form of risk reduction for long-term

holders who give up the normal advantages of liquidity

frequent selling.) The long horizon argument for a much

lower risk premium is strengthened by two further points.

First, bond volatility does not appear to reduce at long

horizons as that for stock does, and it may even widen a

little. And second, traditional or nominal bonds have the

outlier event from hell the pain from which definitely

never mean reverts unexpected, rapid inflation.

Hyperinflation knocked 98% off German stock values,but they then bounced back because they were real assets.

German bonds lost 92%, but lost it forever. Long U.S.

bonds in the 1970s lost an accumulated 50% of their buy-

ing power to inflation (from 1967 to 1981). Inflation

rates might mean revert, but the real asset value of bond

holders during the inflation is eroded permanently.

Conclusions?

A) Long-Term Holders

Does this leave me recommending 100% stocks and 0%

bonds? Not quite. In a world in which selling stocks is

not allowed for 30 years and you always start at fair valueand have volatilities that look like the last 80 years, the

optimal return does indeed come from 100% stocks.

Even if you rebalance yearly and assume a more modern

risk premium of stocks over bonds of only 2.8%, this is

still the case.

There are several reasons, though, for owning bonds,

especially a mix of nominal and real or inflation protect-

ed bonds. An annually rebalanced 80/20 stock/bond port-

folio only reduces return by 0.22% from the 100% equi-

ty portfolio if the last 80 years of data are adjusted to give

a modern 2.8% risk premium, yet it reduces short-termvolatility or risk by about 20%. This is a real bargain if

we allow for even a small possibility of some outlying

catastrophe specific to some organization the college

burns down and the treasurer forgot to pay the insurance

premium or more likely some general equity setback of

a hitherto unrecorded sort like a 20-year Japanese-type

mini depression. But the most potent reason to own

bonds, even for 30-year horizon investors, is mispricing.

If stocks are badly overpriced and bonds are not, the

mean reverting nature of mispricing means it is just silly

to ride out the considerable, and unnecessary, pain of hav-

ing the markets move back to fair price. This is the mostimportant topic for next quarter, which covers the risk of

mispricing and problems with volatility and value at risk

(VAR), even in the short term.

B) The Real World

Very long time horizons are fine in theory, but commit-

tees in real life typically have to deal with an investment

pain tolerance of about 3 years, far too short to receive the

main risk reduction benefits of mean reversion.

Committees still generally respond to pain by moving

away from it and, that being the case, stocks are muchriskier than they have to be and outlier events like the

1929 crash pack their full enormous punch. In the future,

time horizons will probably lengthen, and if they do insti-

tutions will really benefit. The irony for now is that most

institutions have been given the glorious, natural advan-

tage of a long horizon and choose in most cases not to use

it. Only a handful of institutions deliberately set out to

sell liquidity or be paid for being illiquid, and illiquidity

at any horizon is a market characteristic that is irrational-

ly feared and therefore heavily paid for. In the meantime

(simplifying the case to a two asset class world of stocks

and bonds that are both fairly priced), institutions face thetheoretically unnecessary task of optimizing portfolios

using much higher 3-year risk or volatility, which calls

for optimal portfolios of 35% to 40% in real and nominal

bonds with a consequent substantial reduction in long-

term return.

A Final Caveat

The worst of all possible worlds but unfortunately one

that is common enough is one in which committees

assume they and their successors will be able to stand

short-term pain and therefore can sensibly have a very

equity-heavy portfolio only to find out the hard way thatit was simply not the case. Rapidly changing committee

membership and a lack of institutional memory more

common than not make this an easy trap to fall into.

GMOLetters to the Investment Committee VII, April 2006

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