Jeremy Grantham: How to “Survive Betting Against Bull Market Irrationality”

Thursday, April 19th, 2012

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

– Jeremy Grantham

Here without further comment is an opening excerpt from Grantham’s latest letter. You can read/download the whole letter in the slidedeck below.

Jeremy Grantham – Letter to Investors Q1 2012

My Sister’s Pension Assets and Agency Problems
(The Tension between Protecting Your Job or Your Clients’ Money)

The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes¹ knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest. It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in “fair value” for the stock market. This difference is massive – two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1% of its long-term trend as shown in Exhibit 1. The market’s actual price – brought to us by the workings of wild and wooly individuals – is within plus or minus 19% two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines!

This incredible demonstration of the behavioral dominating the rational and the “efficient” was first noticed by Robert Shiller over 20 years ago and was countered by some of the most tortured logic that the rational expectations crowd could offer, which is a very high hurdle indeed. Shiller’s “fair value” for this purpose used clairvoyance. He “knew” the future flight path of all future dividends, from each starting position of 1917, 1961, and all the way forward. The resulting theoretical value was always stable (it barely twitched even in the Great Depression), but this data was widely ignored as irrelevant. And ignoring it may be the correct response on the part of most market players, for ignoring the volatile up-and-down market moves and attempting to focus on the slower burning long-term reality is simply too dangerous in career terms. Missing a big move, however unjustified it may be by fundamentals, is to take a very high risk of being fired. Career risk and the resulting herding it creates are likely to always dominate investing. The short term will always be exaggerated, and the fact that a corporation’s future value stretches far into the future will be ignored. As GMO’s Ben Inker has written,2 two-thirds of all corporate value lies out beyond 20 years. Yet the market often trades as if all value lies within the next 5 years, and sometimes 5 months.

Ridiculous as our market volatility might seem to an intelligent Martian, it is our reality and everyone loves to trot out the “quote” attributed to Keynes (but never documented): “The market can stay irrational longer than the investor can stay solvent.” For us agents, he might better have said “The market can stay irrational longer than the client can stay patient.” Over the years, our estimate of “standard client patience time,” to coin a phrase, has been 3.0 years in normal conditions. Patience can be up to a year shorter than that in extreme cases where relationships and the timing of their start-ups have proven to be unfortunate. For example, 2.5 years of bad performance after 5 good ones is usually tolerable, but 2.5 bad years from start-up, even though your previous 5 good years are well-known but helped someone else, is absolutely not the same thing! With good luck on starting time, good personal relationships, and decent relative performance, a client’s patience can be a year longer than 3.0 years, or even 2 years longer in exceptional cases. I like to say that good client management is about earning your firm an incremental year of patience. The extra year is very important with any investment product, but in asset allocation, where mistakes are obvious, it is absolutely huge and usually enough.

What Keynes definitely did say in the famous chapter 12 of his General Theory is that “the long-term investor, he who most promotes the public interest … will in practice come in for the most criticism whenever investment funds are managed by committees or boards.” He, the long-term investor, will be perceived as “eccentric, unconventional and rash in the eyes of average opinion … and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.” (Emphasis added.) Reviewing our experiences of being early in several extreme outlying events makes Keynes’s actual quote look painfully accurate in that “mercy” sometimes was as limited as it was at a bad day at the Coliseum, with a sea of thumbs down. But his attribution, in contrast, has proven too severe: we appear to have survived.

Jgletter All 4-12

Tags: Calamity, Central Truth, Clairvoyance, Discrepancy, Flight Path, GDP, GDP Growth, Inefficiencies, Investment Behavior, Investment Business, Investment Outlook, Irrationality, Jeremy Grantham, Keynes, Market Volatility, Martian, Pension Assets, Prime Directive, Professional Investment, Professional Investors, Rational Expectations, Robert Shiller, Stable Growth, Term Trend, Volatile Stock Market
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Infrastucture is India’s Achilles Heel

Thursday, September 2nd, 2010

Poor infrastructure continues to be an Achilles heel for India—if it were better, analysts say, the country could add 1-2 percentage points to its annual economic growth rate of around 8 percent.

India spends $17 per capita annually on infrastructure and capital investment—by comparison, China spends $116. With millions of people moving to India’s cities each year, McKinsey says the country will have to spend $1.2 trillion on infrastructure just to meet basic needs. This works out to $134 per person, or about eight times current levels.

The Delhi government has a plan to spend $500 billion on infrastructure by 2012 and twice that amount in the subsequent five years. But there’s a big difference between plans and execution—India is scheduled to host the Commonwealth Games in just a few weeks, but many of the venues are still not ready due to corruption and inefficiencies.

Eight miles of new roads are being built each day, but the official target is 12 miles per day. Desperate for more electricity, the Indian government turned to a failed Enron project that had been dormant for a decade.

One reason for lagging infrastructure is a lack of qualified engineers. A New York Times article this week said many of the best and brightest are going into the high-tech sector rather than the less glamorous (and less lucrative) world of roads and bridges.

Despite the challenges, Morgan Stanley analysts think India’s economy could begin growing faster than China’s as early as 2013. MS says this is because India’s ratio of working age population to dependents is improving while China’s is declining. Their government has been successful at creating jobs and the country has a strong footing in the lucrative global services export market.

But for India to overtake China’s growth pace, it’s vital that the country get better at executing on its ambitious infrastructure vision.

Tags: Achilles Heel, Age Population, China, Commonwealth Games, Delhi Government, Economic Growth Rate, Eight Miles, Enron Project, Export Market, Growth Pace, India, Indian Government, Inefficiencies, Infrastructure Vision, Lucrative World, Morgan Stanley, New Roads, New York Times, Poor Infrastructure, Roads And Bridges, Target, York Times Article
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China and India: Those Two Big Outliers

Thursday, August 26th, 2010

Why have China and India been able to grow so quickly? This column argues that while the industrial policies pursued by both countries up until the 1980s led to gross mistakes and inefficiencies, China and India would not be where they are now without them. Their export baskets are far more sophisticated and diversified than expected given their income per capita.

The emergence of China and India on the world stage has aroused much interest. As in many other areas of (policy) economics, just how these countries “did it” and the lessons for other countries is something economists either do not know, do not agree on, or both.

In the case of China, the literature seems to agree that capital accumulation, industrialisation, and export-led growth were key factors after 1979. Economists like Gregory Chow (1993) or World Bank chief economist Justin Lin, argue that, before 1979, Chinese central planning was a failure, economic performance was poor, and “haste made waste” (Lin 2010).ⁱ

In the case of India, its poor performance during the 1960s and 1970s, referred to as “Hindu growth”, has often been attributed to, among other things, poor planning, and the license-permit Raj (Bhagwati and Desai 1970). Yet economists such as Bardhan (2006) and Nagaraj (2010) argue that infrastructure bottlenecks and demand–side constraints have been neglected in the discussion of India’s industrial performance.

Built-up capability

In two recent papers and using a data set covering almost 800 products (Felipe et al 2010a and 2010b), we examine the evolution of the export basket of the two countries. We argue that the capabilities that both China and India accumulated before reforms started are vital to understanding their growth later on. While we agree that planning led to mistakes, inefficiencies, and to the misallocation of resources in both countries, we argue that, given their income per capita, China’s and India’s export baskets are more sophisticated – as measured by the income content of the export basket – and diversified – as measured by the number of products exported with revealed comparative advantage – than might otherwise be expected. Both are far ahead of countries at similar levels of development. This could have been achieved only through planning, industrial policy, and sector targeting.

The objective of the development strategies of both countries during the 1950s and 1960s was to achieve industrialisation. Both favoured the capital-intensive route, to a large extent as part of an import-substitution strategy that aimed at avoiding foreign dependence, although with significant differences between the two. The important point is that both countries developed a broad industrial base during the planning period that helped them accumulate capabilities that are now allowing them to grow (see Hidalgo 2009 and the footnote for further discussion).ⁱⁱ

Tags: Bardhan, Bhagwati, Capital Accumulation, China, Commodities, Desai, Economic Performance, Emergence Of China, energy, Gregory Chow, Income Per Capita, India, Industrial Performance, Industrial Policies, Industrialisation, Inefficiencies, Justin Lin, Misallocation, Nagaraj, Natural Resources, Outliers, Policy Economics, Poor Performance, Side Constraints, World Bank Chief Economist
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The dark side of “Productivity Enhancing Tools”

Tuesday, August 24th, 2010

This article is a guest contribution by Dan Ariely, author of Predictably Irrational.

Email, Facebook, and Twitter have greatly enhanced the ways we communicate. These handy modes of communication allow us to stay in touch with people all over the world without the restrictions of snail mail (too slow) or the telephone (is it too late/early to call?). As great as these communication tools are, they can also be major time-sinks. And even those of us who recognize their inefficiencies still fall into their trap. Why is this?

I think it has something to do with what the behavioral psychologist B. F. Skinner called “schedules of reinforcement.” Skinner used this phrase to describe the relationship between actions (in his case, a hungry rat pressing a lever in a so-called Skinner box) and their associated rewards (pellets of food). In particular, Skinner distinguished between fixed-ratio schedules of reinforcement and variable-ratio schedules of reinforcement. Under a fixed schedule, a rat received a reward of food after it pressed the lever a fixed number of times—say 100 times. Under the variable schedule, the rat earned the food pellet after it pressed the lever a random number of times. Sometimes it would receive the food after pressing 10 times, and sometimes after pressing 200 times.

Thus, under the variable schedule of reinforcement, the arrival of the reward is unpredictable. On the face of it, one might expect that the fixed schedules of reinforcement would be more motivating and rewarding because the rat can learn to predict the outcome of his work. Instead, Skinner found that the variable schedules were actually more motivating. The most telling result was that when the rewards ceased, the rats that were under the fixed schedules stopped working almost immediately, but those under the variable schedules kept working for a very long time.

So, what do food pellets have to do with e-mail? If you think about it, e-mail is very much like trying to get the pellet rewards. Most of it is junk and the equivalent to pulling the lever and getting nothing in return, but every so often we receive a message that we really want. Maybe it contains good news about a job, a bit of gossip, a note from someone we haven’t heard from in a long time, or some important piece of information. We are so happy to receive the unexpected e-mail (pellet) that we become addicted to checking, hoping for more such surprises. We just keep pressing that lever, over and over again, until we get our reward.

This explanation gives me a better understanding of my own e-mail addiction, and more important, it might suggest a few means of escape from this Skinner box and its variable schedule of reinforcement. One helpful approach I’ve discovered is to turn off the automatic e-mail-checking feature. This action doesn’t eliminate my checking email too often, but it reduces the frequency with which my computer notifies me that I have new e-mail waiting (some of it, I would think to myself, must be interesting, urgent, or relevant). Another way I am trying to wean myself from continuously checking email (a tendency that only got worse for me when I got an iPhone), is by only checking email during specific blocks of time.  If we understand the hold that a random schedule of reinforcement has on our email behavior, maybe, just maybe we can outsmart our own nature.

Even Skinner had a trick to counterbalance daily distractions: As soon as he arrived at his office, he would write 800 words on whatever research project he happened to be working on—and he did this before doing anything else. Granted, 800 words is not a lot in the scheme of things but if you think about writing 800 words each day you would realize how this small output can add up over time.  I am also quite certain that if Skinner had email he would similarly not have checked it before putting in a few hours of productive work.  Now if we could only learn something from one of the world’s experts on learning….

Copyright (c) Dan Ariely, Predictably Irrational

Tags: B F Skinner, Behavioral Psychologist, Communication Tools, E Mail, Facebook, Fixed Ratio, Fixed Schedules, Food Pellet, Food Pellets, Hungry Rat, Inefficiencies, Modes Of Communication, Random Number, Schedule Of Reinforcement, Schedules Of Reinforcement, Skinner Box, Snail Mail, Twitter, Variable Ratio, Variable Schedule
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