James Montier needs no introduction to the readers of Investment Postcards. Prior to joining as member of GMO’s Asset Allocation Team in 2009, he was co-head of Global Strategy at Société Générale. Montier is the author of several books, including “Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance“, “Value Investing: Tools and Techniques for Intelligent Investment“and“The Little Book of Behavioural Investing“.
Montier has just published a paper titled “In defense of the ‘old always’,” arguing that proponents of the so-called “new normal” seem to draw incorrect conclusion when it comes to investing. The following are some pertinent excerpts:
The concept of the “new normal” abounds in markets these days. It seems I can’t open the Financial Times without at least one headline proclaiming the importance of the new normal. But what does it mean for the way we invest?
According to PIMCO, the coiners of the term, the new normal is also explained as an environment wherein “the snapshot for ‘consensus expectations’ has shifted: from traditional bell-shaped curves – with a high likelihood mean and thin tails (indicating most economists have similar expectations) – to a much flatter distribution of outcomes with fatter tails (where opinion is divided and expectations vary considerably).” That is to say, the distribution of forecasts has become more uniform.
But what concerns me … are some of the implications that proponents of the new normal seem to draw when it comes to investing. For instance, Richard Clarida of PIMCO wrote the following earlier this year, “Positioning for mean reversion will be a less compelling investment theme in a world where realized returns cluster nearer the tails and away from the mean.”
This certainly isn’t the first premature obituary written for mean reversion. During pretty much every “new era”, someone proclaims that the old rules simply don’t apply anymore … who could forget Irving Fisher’s statement that stocks had reached a “permanently high plateau” in 1929? With respect to mean reversion, I can’t help but say, in the spirit of Mark Twain, that reports of its death are premature and greatly exaggerated.
It is also worth noting that in order for mean-reversion-based strategies to work, it is not required that the mean be realized for long periods of time, but that markets continue to behave as they always have, swinging pendulum-like between the depths of despair and irrational exuberance, or, from risk-on to risk-off. As long as markets display such bipolar disorder and switch from periods of mania to periods of depression, then mean reversion should continue to merit worth as an investment strategy.
History is littered with the remains of proclaimed, but unfulfilled, new eras. Exhibit 6 shows the long-run history for the Graham and Dodd P/E for the U.S. market. Over this time, we have witnessed some quite remarkable, and quite appalling, things – the deaths of empires, the births of nations, waves of globalization, periods of deregulation, periods of re-regulation, World Wars, revolutions, plagues, and huge technological and medical advances – and yet one thing has remained true throughout history: none of these events mattered from the perspective of value!
As Ben Graham wrote, “Let me conclude with one of my favorite clichés – the French saying: ‘The more it changes the more it’s the same thing.’ I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of this proverb is the phrase ‘the more it changes.’ The economic world has changed radically and it will change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change. But if my cliché is sound – and a cliché’s only excuse, I suppose, is that it is sound – then the stock market will continue to be essentially what it always was in the past – a place where a big bull market is inevitably followed by a big bear market. In other words, a place where today’s free lunches are paid for doubly tomorrow. In the light of experience, I think the present level of the stock market is an extremely dangerous one.”
I simply couldn’t have put it any better!
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