GMO

QUARTERLY LETTER
April 2006
Jeremy Grantham

The Wile E. Coyote Market

plus Letters to the Investment Committee VII
For all I know they are still making Road Runner cartoons 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 growing list of negatives. There have been plenty of overpriced markets where everything appears to be just fine and 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

Global liquidity, without too much fanfare, has moved slowly and steadily from massive, and seemingly excessive, 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 housing markets. 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 general 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 not seem 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 mention 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;

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 inflation fearers, the TIPS look even better. It is already easy to hold some cash, and it is becoming easier all the time to overweight bonds over stocks. Oil and commodities prices have surged under the pressure 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, consumption, and profits.

increases in debt, especially mortgage debt, cannot continue 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. governments. 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, but particularly 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 happened 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 with a fair return on capital and no more. Only if cheap Chinese labor helped us and no one else could it be a permanent 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
Exhibit 1 Profit Margins in the U.S.
9%

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 infamous year 2 market to be weak, and year 3 to recover a bit, as nature intended. The savings rate has declined year by year for a decade, often unexpectedly. This has created an equally unexpected series of strong consumer years that are in turn so good for profit margins. Under the influence of some of the factors discussed above, and particularly rising rates and stalling house prices, surely savings will rise a little, causing consumption and profits to be a little less than expected. Surely then Wile E. Coyote will finally look down.
Recent Forecasts

Absolutely nothing changed last quarter, indeed, the market seems stuck in a groove. So, once again, our forecast of quality stocks outperforming and the U.S. equity market being weak was completely wrong, and, once again, our faith that should the U.S. market hang in, then emerging market equity would beat it by a lot, and developed

8%

7%

6%

5%

4%

3% 47 49 51 53 55 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 Profit Margins: Corporate profits after tax with IVA and CCAdj as a percentage of final sales of domestic product
Source: GMO, BEA As of 12/31/05

GMO Quarterly Letter April 2006

foreign markets (EAFE) would at least beat it was completely justified. Overweighting fixed income was moderately 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 getting tiresome to us and no doubt to clients. I try to console 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. Over 40 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 market. Now junk has had a heyday, not just in U.S. stocks, but everywhere else, and the quality stocks are as cheap
Exhibit 2 Valuation of High Quality Stocks Relative to the S&P 500
1.3

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 companies. 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 gap almost disappeared. Now, although the margins of high quality companies are just fine, those for low quality companies have moved up dramatically, under the impetus 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 narrow. The real money will be made by us when high quality 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 3 Relative Profitability of Quality vs. Junk Stocks
1.19 Relative Profitability of Quality vs. Junk Stocks

Nifty-Fifty

1.17

Relative Valuation of Quality Stocks (Quality Equity / S&P 500)

1.2

1.15

1.13

1.1

1.11

1.0

1.09

1.07

0.9

1.05

0.8 Dec-65 68 71 74 77 80 83 86 89 92 95 98 01 04
Source: GMO, Standard & Poors As of 3/31/06

1.03 Dec- 70 73 76 79 82 85 88 91 94 97 00 03
Source: GMO As of 3/31/06

Quarterly Letter April 2006

GMO

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 overpriced, but no more so than factors usually over run, and less than these particular factors over ran on the upside 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 overpriced 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

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 replacement 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, it is 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!

The combination of the market rally and exceptional strength in junk in the U.S. has caused a difficult environment 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) markets 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 of modest 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 continued to be very low volatile, reflecting the markets with only modest positive return on average. In our asset allocation accounts, our heavy overweight in emerging equity compensated once again for other errors, notably an overweight in high quality, and they managed to pull

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

GMO
SPECIAL 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
Huge Behavioral Risk versus Small Fundamental Risk

Exhibit 1, the Exhibit of the Quarter, shows the incredibly low volatility of the U.S. GDP, which two-thirds of the time has a volatility that is a mere 1% around its
Exhibit 1 S&P Prices Relative to Fair Value and GDP
12.5 S&P Real Price 12.0 Real Prices and Fair Value in Log Space S&P Fair Value GDP 11.5 11.0

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 the economy works to use up its excess resources. This ultra

13.5

Volatility:
2/3 of the Time Prices 19% 2/3 of the Time Fair Value 1% 2/3 of the Time GDP 1% 12.5

11.5 Real GDP in Log Space 10.5

10.5 10.0

9.5 8.5

9.5 9.0

7.5 6.5

8.5 8.0
18 8 18 2 8 18 6 9 18 0 9 18 4 9 19 8 0 19 2 0 19 6 1 19 0 1 19 4 1 19 8 2 19 2 2 19 6 3 19 0 3 19 4 3 19 8 4 19 2 4 19 6 5 19 0 5 19 4 5 19 8 6 19 2 6 19 6 7 19 0 7 19 4 7 19 8 8 19 2 8 19 6 9 19 0 9 19 4 9 20 8 02

5.5 4.5

Source: GMO, Standard & Poors, Federal Reserve

As of 12/31/05

* 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.

stable GDP engine can be thought of as the engine driving 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 market fair 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

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. Exhibit 2 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 behavior designed to minimize career risk does the heavy lifting in driving prices away from fair value.
The Market Really Is a Tiny Bit Efficient

The key to understanding this unnecessary volatility is behavioralism, a nice academic way of defining inefficient or irrational behavior at least inefficient and irrational in its approach to profit maximizing. For those interested in a simple story, the main driver in risk management 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 as agency risk meaning its the other suckers money. Our ultimate job description is to keep our jobs, and in 1936 Keynes explained in Chapter 12 of The 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 will be in a chaotic world of very different estimates and masses 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

Assume for a while that the argument above is correct. What it suggests is that the more you ignore the shortterm, 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 efficient pricing is necessarily the case, for in the long run, fair value is arbitrageable. In an overpriced market, 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 reverting world is the way volatility changes with time. In an efficient market all mean reverting tendencies in the economy 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
2 Letters to the Investment Committee VII, April 2006

GMO

Exhibit 2 P/Es and Profit Margins

40 35 30 25 20 15 10 5

P/E Ratio of U.S. Stock Market Record Margins High PE Record Margins High PE Record Margins High PE

Depressed Margins Low P/E

0

Depressed Margins Low P/E

Dec-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 04

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

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

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 efficient 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 (or year). 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 distribution. 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 30year 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 be randomly 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 arbitrary and that beyond 30 years the ratio of real risk to the theoretical risk continues to improve. So, capitalist instincts extra returns attract extra investment cause the economy and profits to always move
Letters to the Investment Committee VII, April 2006

back to average or mean revert. This is absolutely not anticipated efficiently in the stock market, but exaggerated 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 relative 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 important. For 90 or 95 percent of the time, all you have to do is show up for work and keep your nose clean. It doesnt really 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

GMO

Exhibit 3 Distribution of Real Returns from Investing in the S&P 500: 18712005
log scale 100

Real value of $1 invested at start of period, with reinvested dividends.

If stock returns were random, returns on stocks, over different horizons, should lie in this range 90% of the time.

10

Malkiel is right

% +6.9% Trrend: +6.9 Ten

Because values are mean reverting, they have stayed within this significantly narrower range.
0 0 0 5 5

10 10

15 15
Number of Years You Stay in Stocks

20 20 20

25 25

30 30 30

Source: Smithers & Co. Ltd.

grips with the main difficulty, which is the inordinate practical importance of a few extreme events. Most financial analysis, which would include MPT, really 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 that form 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 distributions. Perhaps partly in consequence, there has been a strong and painful tendency to underweight the significance and probability of new and potentially terrible outlying 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 4 shows 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 this selling 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 random 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 distribution and it is now a normal distribution! From the
4 Letters to the Investment Committee VII, April 2006

GMO

Exhibit 4 Distribution of Daily S&P 500 Returns (1928 Present)

4500 4000 3500 3000 Frequency 2500 2000 1500 1000 500 0
-2 0% -2 0% -1 9% -1 8% -1 7% -1 6% -1 5% -1 4% -1 3% -1 2% -1 1% -1 0% -9 % -8 % -7 % -6 % -4 % -3 % -2 % -1 % 8% 10 % 11 % 12 % 14 % 15 % 16 % 2% 0% 5% 1% 4% 6% 7%

Normal Distribution 11 std. dev. event Oct. 28, 1929 18 std. dev. event Oct. 19, 1987 9 std. dev. event Oct. 29, 1929 14 std. dev. event March 15, 1933

Market Returns in Logs

Source: Standard & Poors, Global Financial Data

Exhibit 5 Distribution of Yearly S&P 500 Returns (1900 Present)

70

60

50

Normal Distribution

Frequency

40

30

20

3.4 std. dev. event 1 in 3,000 year event (1931)

10

1932

0
4% 13 % 23 % 33 % 45 % 57 % 71 % 85 % 10 1% 11 8% 13 7% 15 7%
Source: Standard & Poors, Global Financial Data

% -1 2% -4 %

% -3 1

-6 1

-5 8

-4 6

-2 5

-6 4

-5 4

-5 0

-4 1

-3 6

-1 9

Natural Log of Real Returns

Letters to the Investment Committee VII, April 2006

GMO

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

vative than would be justified by historical data only.

Some Implications of Risk Reducing with Time

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 been lucky 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 relevant 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 Germany recaught 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-

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 particularly the case since short-term outlier risks are typically underestimated. Such underestimation is a forgivable 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 equities comes from panicking in the short term and closing out positions that then mean revert. (Classic examples of this 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

Exhibit 6 Distribution of 30-Year S&P 500 Returns (1875 Present)

50 45 40 35 30 25 20 15 10 5 0
-5 % -4 % -4 % -3 % -3 % -2 % -2 % -1 % 0% 0% 9% 10 % 10 % 11 % 11 % 12 % 13 % 13 % 14 % 15 % 16 % 16 %
Source: Standard & Poors, Global Financial Data

Normal Distribution

Frequency

5%

6%

4%

6%

1%

1%

2%

3%

3%

4%

7%

8%

Natural Log of Real Returns

GMO

8%

Letters to the Investment Committee VII, April 2006

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 unnecessarily high stock risk. (Equities seem to give a type of illiquidity 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 buying 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?

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 having the markets move back to fair price. This is the most important 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 committees 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 much riskier 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 institutions will really benefit. The irony for now is that most institutions have been given the glorious, natural advantage 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 irrationally 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 the theoretically 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 longterm return.
A Final Caveat

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 value and 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 protected bonds. An annually rebalanced 80/20 stock/bond portfolio only reduces return by 0.22% from the 100% equity portfolio if the last 80 years of data are adjusted to give a modern 2.8% risk premium, yet it reduces short-term volatility 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

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 that it 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.

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.

Letters to the Investment Committee VII, April 2006

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