GMO’s 2Q 2014 Letter includes Ben Inker‘s “Is This Purgatory, Or Is It Hell?” and Jeremy Grantham’s “Bubble Watch Update” and “The Beginning of the End of the Fossil Fuel Revolution (From Golden Goose to Cooked Goose)”
s This Purgatory, Or Is It Hell?
GMO is often accused of being a “glass half empty” investor, and I admit that in a year that has seen the S&P 500 rise 8.3%, MSCI All-Country World rise 3.7%, and the Barclays U.S. Aggregate rise 4.1% through the third quarter, the words “Purgatory” and “Hell” are unlikely to come to mind to most investors when opening their brokerage statements. It has been a dull year, perhaps, but certainly not a hellish one. So what is bringing Dante- esque visions of damnation into our slightly warped minds? As is often the case, our moods are driven far less by a look in the rearview mirror and more by what we see through the windshield. A little over a year ago, my colleague James Montier wrote about the current opportunity set for investors and referred to it as the “Purgatory of Low Returns.” He called it Purgatory on the grounds that we assume it is a temporary state and higher returns will be available at some point in the future. But as we look out the windshield ahead of us today, it is becoming clearer that Purgatory is only one of the roads ahead of us. The other one offers less short-term pain, but no prospect of meaningful improvement as far as the eye can see. At the risk of stretching this metaphor further than I should, I need to point out that we are merely passengers in this car, with no more ability to affect the road taken than my toddler when he exclaims that today we should drive to Legoland instead ofpre-school.1 All we can do is shout from the back seat to the financial markets taking us on this ride to “Take the Purgatory exit! Take the Purgatory exit!” and cross our fingers.
And which road we take will be of more than theological interest. The two paths not only differ in their implications for thelong-term returns to financial assets, but also in the appropriate portfolio to hold today and into the future.
To skip to the punchline, if we are in Hell, the traditional 65% stock/35% bond portfolio actually makes a good deal of sense today, although that portfolio should be expected to make several percentage points less than we have all been conditioned to expect. If we are in Purgatory, neither stocks nor bonds are attractive enough to justify those weights, and depending on the breadth of your opportunity set, now is a time to look for some more targeted and/or obscure ways to get paid for taking risk or, failing that, to reduce allocations to both stocks and bonds and raise cash.
Mean Reversion and Fair Value
In this April’s note “In Defense of Risk Aversion” I wrote about how a belief in mean reversion would lead an investor to move his asset weights around by much more than they would in the absence of that belief. Here I’m not going to be talking about the general question “Do asset class prices mean revert?” but rather “What are prices going to mean revert to starting today?” While we use the phrase reversion to the mean a lot in describing our beliefs about financial markets, in reality what we believe is that asset class prices should revert to fair value. Fair value may or may not be approximately equal to the average of historical valuations, but we find it instructive to start with an analysis of historical valuations in trying to understand what fair value might be.
Investors have found themselves doubly disappointed by hedge funds since the onset of the Global Financial Crisis. First, investors were shocked by the extent to which hedge funds fell in sympathy with the stock market in 2008. And ever since, they have been disappointed by the fact that hedge fund strategies have failed to come close to the performance of equities – or in many cases even keep up with the performance of bonds – in the rally since 2009. One way to reconcile this disappointing performance is to recognize that many hedge fund strategies are underwriting the same basic risk as the equity market, but doing so in a fashion that has much less duration. Stafford and Jurek showed a few years ago that most hedge fund strategies can be reasonably modeled as variants on equity put selling. Exhibit 4 shows the performance of a put-selling strategy versus the HFRI fund weighted index of hedge funds.
This isn’t exactly the strategy Stafford and Jurek used in their paper, which was levered and soldout-of-the- money puts. It is a simpler unlevered strategy selling at-the-money puts every month. The reason I’m using this version is that it is nice and straightforward to understand that an at-the-moneyunlevered put-selling strategy is underwriting the same risk as an unlevered equity position – you lose money one-for-one when the equity market falls – but the way you get paid is different, because rather than collecting the gains on equities, you get paid a premium for the option you have sold. This method of payment means that put selling has a much shorter duration than equities do, and would not be expected to keep up in an environment in which a falling discount rate has driven up the price of equities. The performance of the S&P 500, put selling, and the HFRI since 2010 is shown in Exhibit 5.5
The performance of put selling has been one half that of the S&P 500 since 2010, and for hedge funds, one quarter. It is far too facile to say that put selling has half the duration of the stock market and hedge funds one quarter the duration. In fact, I haven’t been able to figure out a sensible way to calculate a duration of either of them given the nature of their cash flows, but it is almost certainly the case that for both of them the duration answer is “a lot less duration than stocks.”6
But if we are in an environment today where we aren’t sure whether stocks are very overvalued or whether they have been repriced to give a lower, but still fair, return, taking equity risk in a fashion that has less duration looks like a pretty good idea. If we are in Purgatory, we’ll do a lot less badly than in stocks (depending on how long mean reversion takes, we might actually make decent money) and if we are in Hell, the tailwind for equities that has made such strategies look uninteresting is probably over and there is no particular reason why they don’t have a decent shot of keeping up with standard equities.