GMO co-founder Jeremy Grantham.

In his second-quarter letter to investors, GMO Chief Investment Strategist Jeremy Grantham admits he may have been “over-intellectualizing the working of the market for a few decades.”

Why would he ever do that? “I have had too strong a belief that investors would at least be influenced by past data in a sensible way,” Grantham explained.

“The market, however, appears not to care at all about the past or to learn much from it,” he added.

This model “for sure” has been “a coincident indicator of superficially appealing variables that in a strict economic sense have been inappropriate, and that have caused spectacular and unnecessary market volatility,” the investment guru states.

The model, he points out, seems to reflect human nature.

Of all the factors influencing the market, human nature, “as economically inefficient and unsophisticated it may be, seems the least likely to change,” Grantham concludes.

His focus in the latest quarterly newsletter, though, zooms in on discussions of momentum and value and of investment sage Ben Graham’s thinking.

Momentum & Value

If short-term behavior dominates the short-term market levels at a 0.90 correlation, there should be “enough noise” to make room for many individual stocks — at least in the short and intermediate term — to be driven away from fair value by momentum.

Plus, there could be enough noise in the data “for individual stocks and the market to be pulled back toward replacement cost or fair value,” Grantham says.

“Value (like gravity in physics) is a weak force in the short term, but very, very persistent — so it can eventually work its way around the stronger coincident behavioral forces,” he explained.

Value benefits from arbitrage.

Or does it?

More recently, the corporate reflex to expand in favor of stock buybacks has been declining, and that perhaps weakens “the previously reliable game,” Grantham points out.

Back to 1963

Grantham also highlights Ben Graham’s talk “Securities in an Insecure World,” delivered on Nov. 15, 1963.

“The action of the stock market since [1955] would appear to demonstrate that these [other] methods of valuations are ultra-conservative and much too low …”, Graham explained.

With market theory, “… by the time you have had a long enough period to give you sufficient confidence in your form of measurement just then new conditions supersede and the measurement is no longer dependable for the future,” he said in his talk. 

According to Grantham, the total return of the S&P 500 from 1963 until today has been 5.75% real, “exactly what we at GMO assume to be the long-term, normal return,” the GMO leader pointed out.

Back to Graham: “My reason for thinking that we shall have these wide fluctuations — of which we had a taste in 1962, in May particularly — is that I don’t see any change in human nature vis-à-vis the stock market, which is sufficient to establish more restraints in the public behavior than it showed over so many decades in the past.”

Still, he says, it is not impossible “in theory that the market’s high level alone could sooner or later precipitate a collapse without the necessity for these technical weaknesses … to show themselves.”

What would trigger such a collapse? “Some untoward economic or political development,” Graham said.

“But if things do happen that way it will be the first time in market history, I believe, that we would have the end of a bull market without the excesses and abuses of the sort I have mentioned,” he explained.

Investors need to find a rule that “will keep him [or her] out of mischief, and one, I insist, which will always maintain some interest in common stocks regardless of how high the market level goes,” Graham said.

Those out of the market, he adds, might feel ruined “from the standpoint of intelligent investing for the rest of [their lives].”

More Highlights

Grantham provided the following summary on his latest thoughts:

“Contrary to theory, the market P/E level does not primarily reflect future prospects. It reflects current conditions.

The variables it weights heavily are not academically or economically correct, but those that make investors feel comfortable.

High profit margins and stable, low inflation dominate this feel-good list, with stability of GDP growth (as opposed to actual growth) a distant third.

Investors’ extreme preference for comfort, like human nature, has never changed. (Tested back to 1925.) This is unlike financial and economic conditions, which have very substantially changed in the last 20 years.

The ebb and flow of these variables explain previous market peaks and troughs. These comfort factors, for example, have been at an extremely high average level for 20 years (as have P/Es) and remain so today. Thus, today’s high priced market is the completely usual response from investors.

Any shift back to a lower P/E regime must therefore be accompanied by a major sustained fall in margins or a sustained rise in inflation (or both).

And, yes, I do believe these comfort variables will move to be less favorable. But probably not quickly.

My Ph.D. thesis title [for the above] would have been, ‘The Persistent Dominance of Superficially Appealing but Economically Inappropriate Market Influences.’”