This time is really different
Perhaps the four most dangerous words in investing are; this time is different. History shows however that it is never different, and the belief that today we are more educated, experienced or advanced than ‘last time’, or that conditions have permanently changed, perpetuates the behaviour that is causing the problem. A sign that we might be near the end is the preponderance of died-in-the-wool value investors who simply give up plying their trade and join the momentum.
Thirty-six years of declining global interest rates and a more recent flattening of the yield curve, thanks to unprecedented central bank bond buying, has made investors pawns in a great global game of monetary policy chess. Of course, record prices, and associated paper-wealth, have accrued to those who have purchased anything from low digit number plates, to wine, art and inner city apartments, but paper gains that are the result of a global tide of cheap money is not the same as investing wisdom nor a sign of genius.
Some investors however are regarded as talented and their utterances respected. So what to make of the investment genius that declares this time is indeed different? That’s the question I am confronted with as I read the latest GMO Quarterly Letter by esteemed investor and co-founder Jeremy Grantham. How you respond will also determine your returns for the next decade so a lot is riding on the answer.
Grantham argues that three of the most important inputs in equity markets have changed, and they are prices, profit margins and interest rates.
With respect to prices, Grantham plots a ‘trend’ P/E ratio for the S&P500 and defines a trend as “a level below which half the time is spent”. You might recognise this definition as simply ‘the average’. Grantham then explains that since 1997 the highest P/E ratio achieved (during the Tech Boom) and the lows achieved shortly afterwards were both much higher than previously recorded booms and busts. He note,s “the failure of the market in 2002 to go below ‘trend’ even for a minute should have whispered that something was different.” Grantham then observes that even in 2009 – the depths of the GFC – the market P/E “went below trend for only six months.” Therefore in the last 25 years the market P/E has only been below trend for six months.
This time is therefore different, and Grantham believes the market now oscillates normally enough but around a much higher P/E.
In 1927, John Maynard Keynes pronounced, “We will not have any more crashes in our time.” Eighty eight years ago economist Irving Fisher, posthumously declared by Harvard economist Milton Friedman as “the greatest economist the United States has ever produced”, said “Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months.” It was October 1929. The great Crash commenced days later and plunged the world into the Great Depression.
I couldn’t help but compare Grantham’s new, higher trend P/E to Fishers ‘permanently high plateau’.
Next, Grantham examines corporate profit as a share of GDP. This is the ratio that in 1999, Warren Buffett declared, “In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there’s a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems—and in my view a major reslicing of the pie just isn’t going to happen.”
I would argue that corporate profits, in particular profitability as measured by returns in incremental equity is the most important factor in determining an equity investors long term return.
Grantham, who used to call profit margins “the most dependable mean reverting series in finance” makes the observation that between 1970 and 1997 the average or ‘trend’ profit/GDP ratio was 3.8%, but since 1996 the average has been 4.5%. He then asks the question “why did they stop mean reverting around the old trend?”, perhaps unwittingly declaring another permanently high plateau.
Split the difference between these two numbers and you get 4.15%. So what? And what is so significant about 1997? Why should the new average be calculated from that date onwards? Don’t get me wrong, I hope he’s right but I dare say he, like many other forecasters, won’t be, and in 100 years time, investors will be calculating a completely different average. That future-past average will be the average of what happens next, and what happens next is what we are all interested in discerning.
More directly Grantham points out that globalisation, which has made brands more valuable, steadily increasing corporate power and influence – consummated through the Supreme Court’s Citizens United decision, Justice Department inertia with respect to anti trust matters, a decline in capital spending as a percentage of GDP, and cheap money failing to spur competition, suggests profit margins will remain elevated for some time.
On the subject of interest rates – remembering their decline has provided the helium for elevated asset prices – Grantham concludes that any change to the dominant and “deeply entrenched” central bank policy, over the last twenty years, of using lower rates to stimulate asset prices, is difficult and unlikely to change any time soon.
I cannot say whether the market will correct anytime soon. I do know however when a genius value investor throws in the towel, hangs up the tools or takes his bat and ball home, joins the bullish bandwagon, eight years after it commenced, its worth being cautious. Of Jeremy Grantham, Irving Fisher may yet be proud.