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.
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).
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!