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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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?

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.

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.

snowball777's picture

Suck Prechter's cock, VeloGroid.

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. 

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).

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

fuggetaboutit's picture

not sure why that duped

hugovanderbubble's picture

James Montier is a good analyst.

thepigman's picture

Don't get too excited. I generally agree

with the guy. We got a huge one

time earnings boost laying everyone

off....care  to take a wild guess where the

10 year mean on earnings is? About


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.

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.

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

A Nanny Moose's picture

Especially if deflation really takes hold.

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.

spinone's picture

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

hugolp's picture

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

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


VeloSpade's picture

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

Cheesy Bastard's picture

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

mynhair's picture


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

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

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....


Charlie's picture

So what would you buy at this point?

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.

percolator's picture

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

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

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.

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.

VeloSpade's picture

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

VeloSpade's picture

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

spinone's picture

with no CNS activity, even your involuntary muscles relax.

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?

Don Birnam's picture

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

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.

Cdad's picture

Wow...this whole comment thread...an 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...

Cheesy Bastard's picture

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

VeloSpade's picture

Here is a suggestion worthy of your consideration:

Fuck you, eat shit, and die.

VeloSpade's picture

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

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.

jeff montanye's picture

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

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.


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 math....is....overrated.

Get over it, man.

Cdad drinkin'


Thank the lord for AFV.