GMO’s Quarterly Letter – Q2 2013

This month’s quarterly letter consisted of two separate essays authored by Ben Inker and James Montier.  Jeremy Grantham, GMO’s usual commentator, decided to have one less summer deadline and put his efforts into taking on a “tougher topic” for a later letter – can’t wait to see what that will be.  Anyway, below are some elements of the letters that resonated with me…

Ben Inker – What the *&%! Just Happened?

• Since 2009 it has been difficult to avoid making money in the financial markets. Nominal bonds, inflation linked bonds, commodities, credit, equities, real estate – everything – has  been bid up as a consequence of the very low expected returns of cash. And this gives today’s markets a vulnerability that has not existed through most of history. Today’s valuations only make sense in light of low expected cash rates. Remove that expectation, and pretty much every asset across the board is vulnerable to a fall in price, as the rising real discount rate plays no favorites. [emphasis is Inker’s not mine]
• Under normal circumstances, a rising real discount rate would probably come on the back of rising inflation or stronger than expected growth, which are diversifiable risks in a portfolio. But May’s shock to the real discount rate came not because inflation was unexpectedly high or because growth will be so strong as to lift earnings expectations for equities and other owners of real assets, but because the Fed signaled that there was likely to be an end to financial repression in the next few years. And because financial repression has pushed up the prices of assets across the board and around the world, there is unlikely to be a safe harbor from the fallout, other than cash itself.
• I would like to say that having warned investors of this problem, we were able to spare our clients losses in this environment. But most of the reason we have been complaining about this issue as loudly and continuously as we have is that there is no good way out

James Montier – The Purgatory of Low Return

• Finds nearly every asset class expensive, calling this a “‘foie gras’ bubble as investors are being force-fed higher risk assets at low prices”.  He even cites Brian Sack of the New York Fed: A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel.
• “… if you don’t know what is going to happen, don’t structure your portfolio as though you do!”
• The only scenario under which treasuries do “well” is one with outright deflation! In essence, in the
  absence of a strong view on deflation, you neither want to be long, nor short, treasuries. You just don’t want to own any.
• Ultimately, if you own bonds as insurance you must ask yourself how much you are
  paying for that insurance, because insurance is as much a valuation-driven proposition as anything else in investing
• Remember that leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one (by forcing you to sell at just the wrong point in time).
• Be Patient. This is the approach we favour. It combines the mindset of the concentration “solution” – we are simply looking for the best risk-adjusted20 returns available, with a willingness to acknowledge that the opportunity set is far from compelling and thus one shouldn’t be fully invested. Ergo, you should keep some “powder dry” to allow you to take advantage of shifts in the opportunity set over time. Holding cash has the advantage that as it moves to “fair value” it doesn’t impair your capital at all.
  Of course, this last approach presupposes that the opportunity set will shift at some point in the future. This seems like a reasonable hypothesis to us because when assets are priced for perfection (as they generally seem to be now), it doesn’t take a lot to generate a disappointment and thus a re-pricing (witness the market moves in the last month). Put another way, as long as human nature remains as it has done for the last 150,000 years or so, and we swing between
  the depths of despair and irrational exuberance, then we are likely to see shifts in the opportunity set that we hope will allow us to “out-compound” this low-return environment. As my grandmother used to chide me, “Good things come to those who wait.”