GMO's Ben Inker: Your Gal Ain't Doodly-Squat
Board: Macro Economics
Jeremy Grantham’s firm, GMO, has issued its latest quarterly letter, featuring an article by Mr. Grantham (perhaps to be discussed at another time) and a nuts-and-bolts macroeconomic article by GMO’s hotshot Young Turk, Ben Inker, entitled Breaking News! U.S. Equity Market Overvalued! Both articles can be accessed at this site following free registration:
Mr. Inker also spoke with Barron’s in an interview published on November 16, 2013:
Although I greatly admire Mr. Grantham, his article mostly consists of calumny and riposte, which is admirable but does not advance our shared desire to master all things macroeconomic. So, at least for now, let us put Mr. Grantham aside and set our sights squarely on the redoubtable Mr. Inker.
To steal ideas from one person is plagiarism; to steal from many is research.
What do we know about Mr. Inker? Your correspondent, after exhaustive research effort, can tell you this:
Mr. Inker is co-head of GMO’s Asset Allocation team and a member of the GMO Board of Directors. He joined GMO in 1992 following the completion of his B.A. in Economics from Yale University. In his years at GMO, Mr. Inker has [done a lot of stuff].
Mr. Inker is also a member of the Yale Corporation Investment Committee, which is an honour given by Yale to wealthy alumni whom it hopes will donate a lot of money to Yale:
From his photograph, it appears that Mr. Inker is young, slender, and of funereal demeanor, reminiscent of the early public appearances of Paul Ryan, the acknowledged modern master of the funeral home countenance and posture:
(but possibly I digress).
Before we leave this meticulously researched background section, perhaps we should talk briefly about GMO. There is a tendency amongst the confident young denizens of these boards to characterize GMO and Grantham as perma-bears, essentially lumping them together with, e.g., John Hussman, a permanent Nervous Nellie.
What happens if you get scared half to death twice?
But this characterization is inaccurate; Grantham and GMO are much more than that – they are justly labeled as legendary investors, and they have generally been correct and balanced in their major calls.
For example, in addition to calling all of the recent bubbles correctly, albeit early, Grantham also made a strong “buy” call in early 2009. Furthermore, unlike a true perma-bear such as Hussman, GMO currently advocates a balance of approximately 50% in equities, 20% in bonds, and 30% in cash and “other.” This is far different from Hussman’s fully hedged approach, and shows that GMO is more balanced -- capable of making dismal forecasts (almost always very accurate over the long term) and yet choosing a sensible path to optimize returns under that forecast.
So, although you guys are of course fully entitled to ignore GMO, or dismiss it with the contemptuous label of “perma-bear,” you might . . . well, I guess I have never understood how average people leading average lives can be so confident that they know more than people widely regarded as being among the world’s leading experts.
Half the people you know are below average.
It is possible that you know more than GMO, and have better insights -- and that for some cruel reason the world and Fate have not rewarded you commensurately with your talent – but is it also possible that there is another explanation for the fact that GMO manages billions of dollars and you manage many orders of magnitude less? At some point, one would hope that strongly held belief would intersect with observable facts . . . .
All those who believe in psychokinesis raise my hand.
Recognizing my own numerous flaws and weaknesses, I try to read a variety of expert sources with an open mind, but other approaches may work for you. As Grantham says in his part of the quarterly letter, Your call. We of course are making our call.
One gets the sense that he is not exactly waiting with bated breath to hear your opinion -- but then, he is Jeremy Grantham and you are not!
OK, now that we have a handle on Mr. Inker and GMO, and have probably (without fully intending to do so) offended many people, let us examine what Mr. Inker has to say.
He begins his quarterly letter by noting that GMO has developed a new forecast methodology which suggests that fair value for the S&P 500 is about 1100 and the expected return is -1.3% per year for the next seven years after inflation. This is quite a conclusion, one that has galvanized the crack macroeconomic team here at the headquarters of the ADD Worldwide Investing Hegemony (i.e., my daughter Sammie) into near-action.
But before we get into the macroeconomic details, there is an important side trail that we must follow.
Mr. Inker generously says that GMO’s new model involved work by a large number of people, although Martin Tarlie of our global equity team did a disproportionate amount of the heavy lifting.
As you read this, what thoughts occur to you? Are you thinking, “Gee, Mr. Inker is a nice guy to give credit like that!” and “Wow, that fellow Tarlie must be brilliant”?
Well, there is no need to be ashamed; it takes an old silvertip to understand the true backstory here.
Let me illustrate it with a true story, one that occurred many years ago.
I was a Young Turk myself back then, a member of the inner circle of a very famous CEO, and my duties were in part to evaluate the performance of our sub-C-level officers and managers and recommend action where necessary.
(My introduction to this position was brutal – on my first day, the CEO took me on a walking tour through a company that we had just acquired. We chatted amiably with many workers scattered throughout the large building and then met with the management team of the acquired business. The CEO began the meeting by instructing me to lead management in a forced ranking of the business’s employees – the bottom 10% would be riffed and the top 10% would be promoted. He was galactically uninterested in hearing arguments to the contrary – as only a CEO or a judge can be uninterested -- so we did it. I cannot tell you how much I hated that process.)
Anyway, the day came when I had to report to the CEO that one of our VPs was simply over his head – he was basically incompetent, and there was no chance that he could ever do his job adequately. In the CEO’s delicate parlance, he was a “bozo,” and he was building a “pocket of bozos” below him – some people are just not destined for success.
I met this wonderful girl at Macy's. She was buying clothes and I was putting Slinkies on the escalator.
So the VP had to be pruned, even though our industry was competitive and growing rapidly, and it was very difficult to find qualified junior executives.
I recommended firing him, and the CEO looked at me and said, “Daisy, you are doing your job at a pedestrian level; I need more from you.”
I did not see what he was driving at, and he was (and is) by no means a patient man; he just told me peremptorily to give a couple of interviews to local reporters, anonymously, praising the VP and attributing our great recent successes to his inspired vision and leadership. Per his instructions, I also arranged numerous speaking and public appearance opportunities for the VP in question – always well-scripted and carefully monitored. Finally, again per instructions, I called several headhunters and told them, confidentially, that the VP in question was highly valued but was showing signs of dissatisfaction since we could not advance him as quickly as he deserved, so we were beginning to look for a replacement as a precautionary measure.
To be honest, I just assumed that the CEO saw something in the VP that I did not, and that we were doing our best to work with him to eliminate his weak areas.
Several months later, the VP was hired away from us, at a higher level, by one of our chief competitors. The CEO called me in and said, “Do you strive for an acceptable outcome or do you strive for the best outcome?”
I said, “You saw this coming all the way – you made it happen.”
He said, “The most important thing that we do is find the best spots for our people. In [VP’s] case, well, his highest and best use is to work for the competition.”
Then the cold-hearted old ******* looked at me and said, “I did your job for you; do you realize that?”
And I did realize that, and also heard very clearly the ominous undertones of his comment. And I also understood something – namely, that I did not want to have what it takes to do what this eminent CEO had done. So I did something different . . . .
99 percent of lawyers give the rest a bad name.
which is neither here nor there. Returning to Mr. Tarlie at GMO – well, I leave it to you as to how best to interpret Mr. Inker’s favorable comments. Are his comments genuine, or is he using what my CEO used to call the “My gal is red hot; your gal ain’t doodleysquat” strategy?
Back to Mr. Inker’s macroeconomics:
GMO is famous for basing its analyses on the assumption that stuff will revert to the mean, but critics are often a bit fuzzy as to what it is, exactly, that GMO believes will revert to the mean. Stock prices? Hardly – GMO knows full well they have been appreciating steadily for decades? P/E? Probably – but if we listen to Mr. Inker, he puts a somewhat different spin on things:
[W]e want our process to adhere as closely as possible to our basic beliefs that stocks should sell at replacement cost and that the return on capital and cost of capital need to be in equilibrium in the long run.
So, ultimately, perhaps GMO’s emphasis on regression to the mean has become more of an emphasis on reversion to equilibrium under the above assumptions – the reversion target is not a constant (an unchanging mean) but an evolving value based on, essentially, an equation. Of course, without access to the inner chambers of GMO’s model, we cannot be sure of its mechanisms and assumptions.
If a word in the dictionary were misspelled, how would we know?
Mr. Inker goes on to state that there are basically two ways in which GMO’s model could be wrong. The first way would be if the US were about to embark on a golden age of corporate investment and economic growth, which is unlikely because corporate investment has been on a downward trend for more than 40 years. And austerity does not solve the problem of meager growth . . . .
Smoking cures weight problems...eventually
The second, less pleasant way GMO could be wrong would be if 5.7% real is no longer a reasonable guess at an equilibrium return for U.S. equities. If equity returns for the next hundred years were only going to be 3.5% real or so, today’s prices are about right. We would be wrong about how overvalued the U.S. stock market is, but every pension fund, foundation, and endowment – not to mention every individual saving for retirement – would be in dire straits . . . .
Mr. Inker then points to a recent article by William Bernstein supporting this “lower-return” view, referring to it as one of the most quietly depressing pieces I have ever come across (and this is coming from someone who has spent the last 21 years reading Jeremy Grantham’s letters!).
Obviously, this was a must-read, so I found a workable link to an expanded version of the piece to which Mr. Inker refers:
Here are Mr. Bernstein’s conclusions in a nutshell (condensed from 19 laborious pages) . . .
And let me just say that this was about the most boring, dull thing I have ever read. It makes one appreciate Mr. Hussman’s feeble, extraterrestrial efforts at anecdotal humor; it even makes one question one’s deep and abiding commitment to the pursuit of macroeconomic knowledge! I definitely took one for the team here . . . .
OK, here goes my summary:
. . . both theory and long-run empirical data support the notion that economic growth lowers security returns . . . .
Wealthy societies do consume more capital than poor ones, but . . . [a bunch of stuff discussed above] suggests that as societies get richer, the supply/demand equation shifts in favor of capital’s consumers.
[Lots of boring data] suggest a rough reciprocal relationship between real investment return (R) and societal per capita energy consumption (C), in kcal/person/day:
R ~ 5/C
This equation yields a theoretical real investment return of 125% in prehistoric periods, 20% in the early medieval period, and 2% today, which roughly approximates the historical data.
* * * * * * * * *
OK, so what's the speed of dark?
Mr. Inker kind of sets this argument aside for further consideration, but FWIW I do not – in fact, I think that as long as the Fed is artificially suppressing the entire interest rate curve, the result is almost necessarily a suppressed return for investment assets across the board.
Why? Because such returns are ultimately derived from the risk-free rate of return – the rate that the Fed has directly suppressed. And when the expected return from an asset is lowered while its future stream of cash flows is unaltered, its price is increased as a mathematical necessity. But that is JMO, and I am nobody important, so let’s return to Mr. Inker.
In a very non-enthusiastic way, Mr. Inker recommends European and emerging equities and, to an even lesser extent, US high quality stocks:
we don’t consider non-U.S. equity markets a screaming buy. But as value managers listening for any assets, anywhere, that are screaming to be bought, the world currently sounds a deathly quiet place. The hoarse whisper of “buy me” coming from European and emerging equities (as well as the polite cough for attention coming from U.S. high quality stocks) comes through loud and clear.
OK, now I know this post is really long, but we are not talking about the weather here. If we want to understand macroeconomics at its deepest levels, it is going to take seven or even eight pages. To complete our investigation, we need to look at Mr. Inker’s comments in his Barron’s interview – they add some important color to his quarterly letter. (Remember the citation is up near the beginning of this post.)
Inker notes that there are no cheap assets . . . . There is definitely stuff to do; there are assets which are OK and assets which are not.
GMO’s investments are allocated as follows:
-- . . . a little bit more than half . . . in stocks spread across . . . U.S. quality stocks, EAFE [Europe, Australasia, Far East] value stocks . . ., and emerging-market value stocks . . . . There is no reason to own international growth stocks or U.S. small-caps. . . . Stocks are all priced more expensively than we've seen, on average, in history. . . [they] may be more dangerous than normal.
-- About 20% is in fixed income . . . about 10% in TIPS [Treasury Inflation-Protected Securities] . . . about 4% in emerging-country debt . . . about 5% or 6% in asset-backed securities.
-- . . . a little under 30% . . . dry-powder assets, which include a little cash, and
-- . . . [a small amount in] a couple of absolute-return strategies we run.
GMO’s problem with the stock market – at a time when bond returns are dismayingly low – is that the S&P 500 is up this year about 25% or 26% on earnings that are up 3%. . . . So we have a market that is trading at an increasingly high P/E at a time when profit margins are already as good as we have ever seen . . . the likelihood of strong profit growth from here is pretty dim. That's a lousy market . . . .
A conclusion is the place where you got tired of thinking.
Put it all together and you have – for one reason or another – an expectation for muted returns for many years coupled with a reluctant belief that it is best to be largely invested (at least 70%) in stocks and bonds of the type identified above.
Strangely, the actual investing strategy of GMO is not all that different from that of many bullish investors – it is just the expression one wears as he or she invests (a frown instead of a happy grin) that seems to differ.
And in the end, what does it all mean?
Two babies were born on the same day at the same hospital. They lay there and looked at each other. Their families came and took them away. Eighty years later, by a bizarre coincidence, they lay in the same hospital, on their deathbeds, next to each other. One of them looked at the other and said, "So. What did you think?"
A Drumlin Daisy