“We really can’t forecast all that well, and yet we pretend that we can, but we really can’t.” – Alan Greenspan
A summary of the commentary accompanying these forecasts:
“The consumer is as badly leveraged as ever, which is to say the worst in history.”
“I thought last April that the market (S&P 500) would scoot up to 1000 to 1100 on a typical relief rally. Now it seems likely to go through 1200 and possibly higher. The market, however is worth only 850 or so; thus, any advance from here will make it once again seriously overpriced, although the high quality component is still relatively cheap.”
“EAFE equities seem a little overpriced, emerging markets more so, and fixed income seems badly overpriced, especially cash, which is awful.”
“The real trap here, and a very old one is to be seduced into buying equities because cash is so painful. Equity markets almost always peak when rates are low, so moving in desperation away from low rates into substantially overpriced equities always ends badly.”
Seven years later, what actually happened?
- The Consumer Discretionary sector (XLY) was by far the best performing sector, more than tripling in value.
- U.S. large/small caps trounced expectations (by 9.8% per year and 11.9% per year respectively).
- U.S. High Quality was stronger than expected, by 6.1% per year.
- International large caps underperformed expectations by 3.3% per year.
- International small caps were the closest to expectations, outperforming by 1% per year.
- Emerging Markets returned less than 1% annualized, underperforming expectations by 6.7% per year.
- U.S. Bonds and TIPS in aggregate did much better than forecasted (1.5% per year higher).
- International bonds posted negative returns, underperforming the forecast by 1.5% per year.
- Emerging Market bonds did well as expected (6.0% per year vs. 5.0% forecasted).
- Short duration Treasuries did nothing as expected (0.8% per year).
The key takeaway: forecasting is a difficult game. GMO has some of the most highly compensated, brightest minds in the business crunching numbers to arrive at these projections. They spend hours upon hours, I am sure, debating the assumptions and methods used. They are trying very hard to get it right.
So when they said U.S. small caps will return 2.3% per year (nominal), and they actually return 14.2% per year, that should tell you just how wide the “margin of error” in this business can be. When they said that U.S. equities are “substantially overpriced” in December 2009 and that the market (S&P 500) is “only worth 850,” and large cap equities return 12.9% annualized going forward, that should tell you how hard valuation analysis can be.
Where did GMO go wrong?
This assumption, contained in the same December 2009 letter, may shed some light:
“In contrast to predicting the impossibly difficult real world, predicting market outcomes is relatively straightforward. Profit margins and P/E ratios always seem to pass through fair value if, and it’s a big if, you can just be patient enough. Normalcy is what we assume in our 7-year forecasts.”
If they blundered at all, it was in assuming “normalcy” and believing that “predicting market outcomes is relatively straightforward.” There is nothing “normal” about the distribution of investment returns and nothing straightforward about arriving at a specific return number (to one decimal place) over a 7-year period. There is a huge difference between valuation and timing, and the range of possible outcomes, particularly within in equities, is enormous.
I say “if they blundered at all” because there is absolutely no evidence to say that anyone else would have been much better in predicting the future 7 years ago. They could very well have been above average in their forecasting ability; we’ll never know because few (if any) consistently publish such forecasts. Perhaps, then, their only known error was in making a specific forecast to begin with, in assuming precision in an investment world that is anything but.
But specific forecasts they will continue to make, for their investment process and business depends on it. And what an incredible business they have built, peaking in assets at $155 billion in 2007. The recent downturn in performance (presumably a result of the wide gap between actual asset class returns and their projections) has predictably led to outflows. “Flows follow performance” is perhaps the greatest truism in the industry and no one is immune to it. The patience of GMO’s investors to wait for profit margins and P/E ratios to “pass through fair value” did not match that of GMO:
To their credit, GMO appears to be sticking to their guns, and resisting the urge to make wholesale changes to their value-oriented process due to short-term underperformance. “The reason you don’t see a lot of money chasing long-term value strategies, particularly strategies like ours, is career risk,” said Ben Inker, GMO’s co-head of asset allocation…
In their June 2016 letter, those “opportunities” seemed much more focused on preserving capital than growing it. GMO’s projected asset class returns (after an assumed 2.2% inflation rate) were substantially lower than 7 years ago, with projections of negative nominal returns for U.S. large cap equities and 0% nominal returns for U.S. bonds.
Will their forecasts prove to be more accurate over the next 7 years?
Only time will tell, but they certainly make a convincing argument (“there are no particularly good investment outcomes”) for lower returns, and it would be difficult to argue with the math behind it. The only problem is that they have been making convincing arguments for lower (albeit higher than today) returns for years (since December 2009), and we now know the market did not care about said arguments. In the end, probabilities are just presenting what is “most probable” using your specific methodology and everyone has a different methodology/probability. There is no certainty when it comes to forecasting or investing.
The good news for the average investor is that they don’t need to have an opinion on the next 7 years in order to invest today. In fact, most would be much better off in simply saying “I don’t know” when asked which asset class will be the top performer. For if they have the humility to admit to those 3 simple words, they will be more inclined to build a diversified portfolio and stick with it over time. If they can do that and nothing else they will beat most of the forecasters and “world-class” investors by default, and can spend the next 7 years worrying about more important things.
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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
You can follow Charlie on twitter here.
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