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James Montier In Defense Of Mean Reversion, And Why Economist Predictions Are For Idiots

Tyler Durden's picture


In his latest letter, "In Defense of the 'Old Always'" GMO's James Montier takes PIMCO's trademark "New Normal" to task, and argues that the "Old Always" with its ever trusty mean reversion strategies work as well now as they always did. Summarizing his disagreement with what the investment implications of the New Normal are, Montier says: "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? Mean reversion is in some august company in being well enough to read its own obituary." The key defense for mean reversion Montier says, is the market itself: "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!" Which means: is this time really different? Have we passed some rubicon at which time not even the otherwise spot on observations of traditionally sensible analysts like Montier make sense? The answer is so far elusive. 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.

From Montier:

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?

Part of the difficulty in answering that question is the plethora of meanings that have become associated with the term “new normal.” For some, it is an environment of subdued growth in the developed markets (the result of ongoing deleveraging – similar in essence to the “seven lean years” that Jeremy Grantham, among others, has previously described). For others, it encapsulates a prolonged period of high volatility (in either economies or asset markets).

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).”2 That is to say, the distribution of forecasts has become more uniform (as per Exhibit 1).

Montier then goes on to butcher all those who believe that that hard earned Pd.D. in economics is actually worth its weight in feces:

Why do I think that mean reversion is still very much alive and well? First, I fear that the concept of the new normal confuses the distribution of economic outcomes (and forecasts thereof) with the distribution of asset markets. As I pointed out above, for some (although not all) economic variables the new normal offers a good description of the current state of play. So, perhaps the world of forecasts will be characterized by a flatter distribution with fatter tails.

However, attempting to invest on the back of economic forecasts is an exercise in extreme folly, even in normal times. Economists are probably the one group who make astrologers look like professionals when it comes to telling the future. Even a cursory glance at Exhibit 4 reveals that economists are simply useless when it comes to forecasting. They have missed every recession in the last four decades! And it isn’t just growth that economists can’t forecast: it’s also inflation, bond yields, and pretty much everything else.

Which brings us back to Nassim Taleb's favorite topic: fat tails investing.

If we add greater uncertainty, as reflected by the distribution of the new normal, to the mix, then the difficulty of investing based upon economic forecasts is likely to be squared!

In contrast, we have long known of the existence of fat tails in asset markets. Mandelbrot was writing about the presence of fat tails in the 1960s. From the perspective of mean reversion, fat tails help to create some of the best opportunities. That is to say, fat tails often create fat pitches.

For instance, a sequence of “good” fat tail returns often results in extreme overvaluation (witness Exhibit 5, with TMT stocks trading at over 100x 10-year trailing earnings in the late 1990s and Japan trading at over 90x 10-year trailing earnings almost exactly a decade earlier), whilst a series of “bad” fat tail returns can result in severe undervaluation (see Exhibit 6, with the U.S. market trading at 5x 10-year trailing earnings in 1932).

In conclusion:

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.

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 favourite 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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Mon, 01/10/2011 - 16:28 | 826977 Clapham Junction
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Thu, 12/23/2010 - 17:28 | 826979 MeTarzanUjane
MeTarzanUjane's picture

Nassim Taleb, Rosenberg, etc... All produce economic predictions.

Now you endorse them all as idiots?

Is ZH dipping into too much eggnogs?

Thu, 12/23/2010 - 21:47 | 827383 rocker
rocker's picture

ZH is Very Fine.  If you want real garbage try Prechter's EWave garbage predictions for 2010.  All Wrong. But he has ten books, twenty DVD's, and hours of newsletter garbage to sell you. He has a program for his every thought which only a ponzi scam could accomplish. He can sell you 100 ways to tell you what you already know.  The American Dream for most is over.  The most he talks about can not afford to buy his garbage.  Will You ?  I hope not.  ZH provides you with great knowledge.  You choose to use it or not.

Thu, 12/23/2010 - 22:18 | 827426 VeloSpade
VeloSpade's picture

Well, for someone who admonishes everything and anything on his website (that you are intimateley familiar with), we now know who Prechter's biggest fan is.....YOU.

jeez..f'n idiot.

Fri, 12/24/2010 - 10:28 | 827897 snowball777
snowball777's picture

Suck Prechter's cock, VeloGroid.

Fri, 12/24/2010 - 14:39 | 828205 rocker
rocker's picture

+2  Thanks Snowball. I get his FREE newsletter. He is the ultimate contrary indicator. Bought his Shit once. Never Again.  Although, I know others who still pay homage to his Fear Selling Shit.  He keeps the "Rinse and Repeat" Alive. 

Mon, 12/27/2010 - 04:53 | 831333 VeloSpade
VeloSpade's picture

What's most revealing about you two winners is that through your own admission you read and/or follow Prechter even though you denounce him.  Hence both of you win the idiotic full fucking retard award (IFFRA).

Oh, I almost forgot, you can both suck my cock you fucking filthy faggots (FFF).

Thu, 12/23/2010 - 17:29 | 826991 fuggetaboutit
fuggetaboutit's picture

without a doubt the most idiotic part of any equity argument right now is the "hey if i just put 15x on whatever invented eps number i choose embedding euphoric consumption conditions and peak margins ad infinitem, well, hey, stocks are cheap"

leave the earnings side out of it for a sec, what do ppl think is going to happen to the rate at which earngins are capitalized when the levee finally breaks here and interest rates rip to where they would be if credit markets were left to debate things like black hole budget deficits and sky rocketing input costs without the constant application of morphine via money that doesnt exist printed and distributed by a man no one elected?

if ppl think multiples arent gonna come crashing down they are either nuts or work for goldman or both

Thu, 12/23/2010 - 17:30 | 826992 fuggetaboutit
fuggetaboutit's picture

not sure why that duped

Thu, 12/23/2010 - 17:37 | 827002 hugovanderbubble
hugovanderbubble's picture

James Montier is a good analyst.

Thu, 12/23/2010 - 17:37 | 827005 thepigman
thepigman's picture

Don't get too excited. I generally agree

with the guy. We got a huge one

time earnings boost laying everyone  to take a wild guess where the

10 year mean on earnings is? About


Thu, 12/23/2010 - 17:41 | 827010 thepigman
thepigman's picture

Point being...earnings are non linear...

they revert to the mean and the mean

is far lower than where we are now. And, there

is no one left to lay off.

Thu, 12/23/2010 - 17:39 | 827008 Stuck on Zero
Stuck on Zero's picture

Sometimes there is no "reversion to the mean".  For example, Cisco, Microsoft, Google, Apple etc. have no "mean" because they are new paradigms.  Housing is moved by demographics more than anything else.  No mean there.  Coal, steel, land, and utilities probably reflect a reversion to mean strategy.  Big money will be made by anticipating fads, however.  Fads drive everything way beyond any reasonable consideration.  In this case there will never be a reversion to the mean.  There will simply be a collapse after "irrational exuberance".  All in all "reversion to the mean" implies nothing more than watching for ridiculous deviations.

Thu, 12/23/2010 - 17:55 | 827033 bronzie
bronzie's picture

"Housing is moved by demographics more than anything else.  No mean there."

Two points I would make:

1. the current real estate market was a bubble that peaked in 05/06/07 - the real estate market was several deviations above any reasonable "norm" you care to choose - it is in the process of mean-reverting now and it is very likely to overshoot the mean to the downside

2. the Boomer generation was a bubble in the demographics curve and their is no comparable demographic group coming behind them - the assets that the Boomer need to sell (ie, real estate) will depress the markets because they will provide more supply than demand can absorb

Thu, 12/23/2010 - 18:06 | 827053 Cheesy Bastard
Cheesy Bastard's picture

Then it appears we still have a way to go yet.

Thu, 12/23/2010 - 20:34 | 827269 A Nanny Moose
A Nanny Moose's picture

Especially if deflation really takes hold.

Thu, 12/23/2010 - 22:47 | 827457 jeff montanye
jeff montanye's picture

check the dallas fed article on residential real estate coauthored by dimartino booth.  good chart of mean reversion in real estate indices from 1890 to 2010, reprinted last night or so on zh.

Thu, 12/23/2010 - 18:18 | 827068 thepigman
thepigman's picture

good points...

Thu, 12/23/2010 - 18:45 | 827105 Missiondweller
Missiondweller's picture

Excellent point

Thu, 12/23/2010 - 18:59 | 827121 spinone
spinone's picture

Housing is moved by interest rates more than enything else, kiddo

Thu, 12/23/2010 - 17:45 | 827019 hugolp
hugolp's picture

I agree with what he is saying, but not all economists think like that.

Thu, 12/23/2010 - 17:51 | 827029 thepigman
thepigman's picture

The funny part is he's right just in time

to be wrong. The pendulum is already

swinging back toward Taleb, Rosie and


Thu, 12/23/2010 - 18:39 | 827098 gmrpeabody
gmrpeabody's picture


Thu, 12/23/2010 - 17:56 | 827034 VeloSpade
VeloSpade's picture

That "then/now" pic looks like a before and after pic of my breast implant, without the nipple.

Thu, 12/23/2010 - 18:11 | 827059 Cheesy Bastard
Cheesy Bastard's picture

I hope you didn't go from "then" to "now" on the graph, though.

Thu, 12/23/2010 - 19:13 | 827144 penisouraus erecti
penisouraus erecti's picture


Thu, 12/23/2010 - 17:57 | 827037 mynhair
mynhair's picture


"But what does it mean for the way we invest?"

It means: Buy the fukking dip, u fukking idiot!

Thu, 12/23/2010 - 18:20 | 827051 plocequ1
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Thu, 12/23/2010 - 18:21 | 827074 RobotTrader
RobotTrader's picture

Exactly.  I learned my lesson the hard way back in 2003 and 2004.  Lost a fortune shorting a strong tape because I was listening to all the so-called "experts" and "gurus".

Now I trade like a Robot.

If it's going up, I buy it.

If it's going down, I sell it.

I have some simple methods I use to determine if the market is healthy or deteriorating.

Just follow the trend and you will be OK.

A heck of a lot easier than sports wagering, which is what 90% of my friends are into.  And these guys play with serious money....


Thu, 12/23/2010 - 18:32 | 827086 Charlie
Charlie's picture

So what would you buy at this point?

Thu, 12/23/2010 - 18:39 | 827094 vas deferens
vas deferens's picture

Sports wagering is a good source of income if you can withstand the high veriance.  Sports wagering all you need is some math skills, your control (a sportsbook with correct odds) and sportsbooks with slow updates or allowing correlated wagering.

People wagering on there knowledge of the game will lose everything in the long run.

Thu, 12/23/2010 - 22:30 | 827443 percolator
percolator's picture

I'll add it's a real grind and you need a serious bankroll.

Thu, 12/23/2010 - 19:03 | 827124 ATG
ATG's picture

Only fools eschew the greater fool theory

Also propounded by Cherokee Indian Cowboy folk humorist Will Rogers in the 30s and 40s

Worked a sports book and watched most people lose while a few insiders skimmed

Not terribly different in the market

The house makes the rules

Thu, 12/23/2010 - 21:25 | 827349 prophet
prophet's picture

"If it's going up, I buy it.

If it's going down, I sell it."

and all this time I thought making money was done by buying on the way down and selling on the way up.

Fri, 12/24/2010 - 01:10 | 827596 Al Huxley
Al Huxley's picture

Spot on.  We may be heading for inevitable disaster, but anybody who is in the markets in any way better learn how to follow the tape if they don't want to be donating funds to JPM and GS.

Thu, 12/23/2010 - 19:13 | 827142 VeloSpade
VeloSpade's picture

Does Lucca Brazzi really sleep with the fishes or is that just another conspiracy?

Thu, 12/23/2010 - 19:14 | 827147 VeloSpade
VeloSpade's picture

Did you really shit your pants when the Barzzini's strangled you?

Thu, 12/23/2010 - 19:39 | 827188 spinone
spinone's picture

with no CNS activity, even your involuntary muscles relax.

Thu, 12/23/2010 - 19:52 | 827205 Cheesy Bastard
Cheesy Bastard's picture

Still, he coulda shat just before he went into the bar. So the question still hangs in the air, did you shit your pants, Lucca?

Thu, 12/23/2010 - 20:13 | 827236 Don Birnam
Don Birnam's picture

One of Bruno Tattaglia's soldiers did Luca at the bar. Marone what a load they had to clean up.

Thu, 12/23/2010 - 20:20 | 827244 VeloSpade
VeloSpade's picture

Ah, so it was the Tattaglia's, not the Barzzini's... hmmn, well it was still a good choice to kill em all anyway.  RIP Lucca Brazzi.

Thu, 12/23/2010 - 21:09 | 827319 Cdad
Cdad's picture

Wow...this whole comment exercise in futility.  Some like this kind of thing, I guess...but as that last and brightest bulb on the globe goes dim...perhaps we could rise to greater purpose?

Just a suggestion...

Thu, 12/23/2010 - 21:18 | 827337 Cheesy Bastard
Cheesy Bastard's picture

Sometimes, ya just gotta say "what the fuck".

Thu, 12/23/2010 - 21:19 | 827339 VeloSpade
VeloSpade's picture

Here is a suggestion worthy of your consideration:

Fuck you, eat shit, and die.

Thu, 12/23/2010 - 21:21 | 827345 VeloSpade
VeloSpade's picture

Oh, I almost forgot, buy the fucking dip too, dipshit.

Thu, 12/23/2010 - 21:45 | 827354 Cdad
Cdad's picture

Thank you, Hong Kong, for weighing in instantly.

There you are, folks.  The China effect.  And you thought it was just about China buying Europe all of  a sudden like.

Sweet.  Let the fun carry on then....


Nice hat.

Thu, 12/23/2010 - 22:55 | 827462 jeff montanye
jeff montanye's picture

nice hat, nice talk.  what's not to like?

Thu, 12/23/2010 - 18:30 | 827084 Rockfish
Rockfish's picture

I saw this article briefly on my phone today but had to wait till now to look into it. BOA seems to be the getting the attention it deserves but I am curious why no referrece on ZH.

Do your banking with local banks.

Thu, 12/23/2010 - 19:21 | 827135 Cdad
Cdad's picture


WTF?  WFT are you talking about?  CSWS bankers have declared....stocks up forever...because...Communist China bought Europe...really....really really...and

Get over it, man.

Cdad drinkin'


Thank the lord for AFV.

Thu, 12/23/2010 - 21:38 | 827374 VeloSpade
VeloSpade's picture

Keep drinking cDad

Fri, 12/24/2010 - 10:30 | 827899 snowball777
snowball777's picture

Must have mis-printed the good news in Shanghai.

Thu, 12/23/2010 - 19:55 | 827160 Mercury
Mercury's picture

The key defense for mean reversion Montier says, is the market itself: "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!"

Mean reversion, sure.  I'll buy that.  But the mean you have in mind might be from a timeline that doesn't go far back enough. We will revert to the mean alright (and not just in financial markets).  The question is: where should you peg the beginning of the timeline - 1929? 1913? 1776? 1620? 500 BC?

The mean plight of all persons who have ever lived within the world's advanced civilizations over the last 2500 years or so is pretty grim by Wall-Mart-Man standards.

Thu, 12/23/2010 - 21:57 | 827396 bronzie
bronzie's picture

"The mean plight of all persons who have ever lived within the world's advanced civilizations over the last 2500 years or so is pretty grim by Wall-Mart-Man standards."

yes, most of human history is very brutal in comparison to modern standards

I like to think about bubbles and what happens when they pop - history says financial bubbles always (yes, always) revert to their starting point and usually overshoot to the downside - when applying this idea to the current financial markets I have to ask the question, "which bubble are we unwinding?"

some people say the real estate bubble started in 2001 - some people point out that Greenspan started his monetary pumping in 1987 and we could be unwinding the entire Greenspan bubble - others talk about the 'one-time' exemption of real estate capitals gains as a pumping mechanism (started in 1997 I think - $250K for singles, $500K for couples and you could do it every 2 years) - some people say everything in the financial markets is a bubble (or fraudulent) since 1971 when Nixon closed the gold window - others talk about the GSEs as artificially inflating real estate prices since their inception in the 1960's - or perhaps we are unwinding all the financial fraud that has occurred since the start of the Fed in 1913

it all gets too complicated for me and the bottom line is that nobody really knows where the 'mean' is that we are reverting to - I feel pretty confident, however, that we are nowhere near any sensible mean at this point - that lies somewhere far below us

Fri, 12/24/2010 - 08:42 | 827826 lewy14
lewy14's picture

Yes - "mean reversion" implies a start date - which?

Since variance is large (some might claim it's undbounded), you can prove almost any point you like by picking the right start date to calculate the mean you claim we'll revert to.

IMHO the "New Normal" isn't the least bit inconsistent with mean reversion - it's just that the "post WWII" regime just became inoperative as a reference, and we will revert to a longer period trend... by way of a shorter trend which isn't so fun, and resembles other such "New Normals" in the past... 1870's, for instance...

Fri, 12/24/2010 - 10:05 | 827873 Implicit simplicit
Implicit simplicit's picture

I'd guess that after the 70's when the gold standard was dropped might be a good place to start; considering leverage, margin and debt in general started on its uphill climb in a  more parabolic way at that point- the new abnormal.

Thu, 12/23/2010 - 19:48 | 827202 Don Birnam
Don Birnam's picture

The chaps at Rowe's Wharf are as sharp as tack. Crack analysis, spot-on.

Thu, 12/23/2010 - 20:11 | 827233 tom
tom's picture

It's odd that he doesn't comment on the implications of his argument for P/Es, which as you can see, were still well above the historical mean in March 2009.


Thu, 12/23/2010 - 20:15 | 827240 Cheesy Bastard
Cheesy Bastard's picture

Good suggestion?:

butcher all those who believe that that hard earned Pd.D. in economics is actually worth its weight in feces

Thu, 12/23/2010 - 20:22 | 827246 VeloSpade
VeloSpade's picture


Thu, 12/23/2010 - 21:11 | 827320 Cdad
Cdad's picture

Exactly what I would expect someone with that bad of a hat to say.  Perfect, in fact. 

Thu, 12/23/2010 - 21:20 | 827341 Cheesy Bastard
Cheesy Bastard's picture

Excuse me, but we were just quoting Tyler.  Well taking out of context, actually.

Thu, 12/23/2010 - 21:26 | 827353 VeloSpade
VeloSpade's picture

I would expect that your daughter videotapes herself getting gang raped while whimpering, "Cdaddy, Cdaddy, I'm a good girl, I did this for you."

Thu, 12/23/2010 - 22:18 | 827424 delacroix
delacroix's picture

velo, you are sooo twisted. I kinda like it, but I suspect, there's something very  wrong with me

Thu, 12/23/2010 - 22:23 | 827436 VeloSpade
VeloSpade's picture

Welcome to the club.

Just run to the hills like Iron Maiden says when the shtf.  It might might not.

Thu, 12/23/2010 - 20:48 | 827286 TooBearish
TooBearish's picture

Long term mean reversion is a fast way to go broke....good luk dood.

Fri, 12/24/2010 - 09:59 | 827869 Implicit simplicit
Implicit simplicit's picture

True, from the perspective of the short/mid-term trader on margin; not so much for the patient longer view just using cash.

Fri, 12/24/2010 - 01:55 | 827627 primefool
primefool's picture

Crashes and subsequent recoveries serve to greatly increase investor confidence. Much more so than steady markets. The psychology is obvious. Just wait till the S&P fully recovers from the "worst financial crisis in history" - we are almost there - another 20% will do the trick. Then the sell-side meme will be - look folks who just held on through the worst financial crisis in human history are doing OK now. Compared to all the nervous nellies that sold out during the crash.

This new found confidence will spark a new bull market - after the S&P crosses 1500 or so. I know this is an ou of consensus call - but hey you have to admit there is psychological logic to it. The pooh pooing of "value investors", "Prechtologists", "Deflationist" etc will be deafening as the S&P crosses 1500. The angst of all those sitting by for 3 years as the markets gain 100+% off the 2009 bottom will be unbearable. They will be ripe. They will fuel a new bull run AFTER 1500 on the S&P to god knows what levels of craziness. By then Asian inflation would have rocketed to unimaginable levels and the central banks feeble efforts to contain it will be to no avail. 

Fri, 12/24/2010 - 06:17 | 827775 Snidley Whipsnae
Snidley Whipsnae's picture

Just visiting this planet?

Fri, 12/24/2010 - 10:35 | 827904 snowball777
snowball777's picture

We've been having a flash-crash a day to inspire 'confidence'?

And how's that working out? (34 weeks of outflows and counting)

Fri, 12/24/2010 - 12:00 | 827992 Nathan Hale
Nathan Hale's picture

Whoever quoted Tyler earlier has got to be a shill for TPTB....I have rarely heard such an out of context use of a quote since yesterday on MSM

Fri, 12/24/2010 - 16:23 | 828427 Groty
Groty's picture

The last chart depicting the P/E on the S&P500 going back to 1881 is extremely impressive considering the S&P500 was invented in 1957.

Mon, 12/27/2010 - 18:41 | 832328 pong
pong's picture

For those interested in source data: ie_data.xls - Shiller's Page


Do NOT follow this link or you will be banned from the site!