Sunday, January 23, 2011

The Old Always

The thing that hath been, it is that which shall be; and that which is done is that which shall be done; and there is no new thing under the sun.
Ecclesiastes 1:9

Last month, James Montier of GMO wrote a piece, In Defense of the “Old Always", questioning the concept of the "new normal" and what it means for the way we invest these days.  Perhaps not surprisingly for a value investor, his conclusion was that there is nothing new under the sun and that "old always" value investing principles still apply.  I especially liked his observation that the value investing concept of mean reversion still applies, contrary to what some "new normal" proponents have proposed.
What Is the "New Normal"?
Discussing the "new normal" is complicated by the variety of meanings that different writers have attached to the term.  Perhaps the most common interpretation is that the "new normal" refers to the current period of low economic growth in the developed world and the likelihood that this period will continue for years. This interpretation makes a lot of sense, because low growth seems likely to be with us for years, thanks to the unsustainably high levels of debt in the private and public spheres. Indeed, the growing convergence of the developed and developing worlds makes it unlikely that the "old normal" economic proposition will return.
Is the "New Normal" in Investing Returns?
To other observers the "new normal" refers to a shift in investing returns from a distribution with thin tails and more likely outcomes close to the middle to a more uniform distribution with fat tails, or more frequent extreme outcomes.  Bill Gross of PIMCO offered this interpretation in one of his monthly commentaries last year. 
I find this "fat tail" interpretation very hard to give credibility to, because the world has experienced high variance outcomes in the financial markets historically and with a frequency that is much higher than has generally been appreciated.  Bubbles, bankruptcies, and the ruin of old regimes have been fairly frequent companions of financial markets for centuries.  With samples taken over long enough periods of time or across enough kinds of  markets, financial returns have always looked non-normal with fat tails.
                              Joan Miro, Red Sun
Is the "New Normal" in Mean Reversion?
Another PIMCO manager, Richard Clarida, went even further and attacked the very basis of value investing, which is that one buys when a thing is cheap and sells when it is dear.  Clarida wrote, “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.” 
Come on now, who could really believe that mean reversion is dead?  Not only does this statement ignore the historical fact that extreme outcomes are not that rare, but it also makes the logical mistake of saying that high variance is inconsistent with the mean reversion.  When markets go to extremes, they eventually revert to the mean and beyond, and patient value investors will profit if they wait for the bubble to burst.  This increases the chances for profit when reversion occurs.
Mean Reversion Is Alive and Well
I have to agree with Montier when he says "the concept of the new normal confuses the distribution of economic outcomes (and forecasts thereof) with the distribution of asset markets ... From the perspective of mean reversion, fat tails help to create some of the best opportunities."  Montier's letter also included a chart that illustrates his point very graphically.
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!

No One Says That It Is Going to Be Easy
None of this means that it is EASY to apply value principles to mean reversion.  No one can predict the future, which means that no one knows when the top or the bottom will occur. You have to understand the investing  world, and you need to apply valuation metrics, but is this possible today?  Zero Hedge suggested that the metrics have changed:
Yet in a universe in which true asset fair value can no longer be derived, and all valuations are wrapped in the enigma of trillions of monetary and fiscal stimuli, whose stripping is virtually impossible in a world in which everything is centrally planned, we just may have entered... the non-"old always" zone. 
I agree that it isn't easy to apply familiar valuation metrics when the Fed has flooded the market with liquidity, but I don't think that it is impossible.  You just have to adjust your metrics so that they reflect the determining forces at work in a debt-laden world.  If the government assumes private debt to attain financial stability, you need to attend to the political risks as well as the industry fundamentals.  But mainly you need patience.  I'll let Montier answer in his own words. 
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 pendulumlike 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.