Comment on: Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt

I have the fun of speaking at the Burridge Center Conference at the University of Colorado at Boulder this week on Friday.  The CFA Society of Colorado is co-sponsoring it.  As a guide, they have asked my panel to comment on this piece  by James Montier of GMO: Was It All Just A Bad Dream? Or, Ten Lessons Not Learnt.  I’m going to comment on each of the ten questions, and show where I agree and disagree.

Lesson 1: Markets aren’t efficient.

“As I have observed previously, the Efficient Market Hypothesis (EMH) is the financial equivalent of Monty Python’s Dead Parrot. No matter how many times you point out that it is dead, believers insist it is just resting.”

I partially disagree.  The EMH is valid as a limiting concept. The markets tend toward efficiency, but there are many disturbances in the market, and some of them are quite big.

The EMH properly understood only means that it is intensely difficult to beat the market, nothing more.  Market prices reveal the current expectations of the market as a knife edge — sharp but thin.  They might be the best estimate of values for the moment, but offer no infallible guide to the future. The crisis tells us nothing about the EMH.

Lesson 2: Relative performance is a dangerous game.

Definitely true.  Those chasing relative performance tend to destabilize markets to the degree that their time horizons are short.  Focusing on short term relative performance leads to an over-emphasis on momentum, and when too many focus on momentum, the markets tend to go nuts — overshooting and falling dramatically, until enough momentum players exit.

Lesson 3: The time is never different.

It’s never different, or it’s always different — which one you choose is a matter of semantics.  The main thing to remember is that human nature never changes.  In aggregate, we don’t learn from market behavior.  We follow trends — we arrive late to the party, and leave the hangover near the nadir.

Most professionals and nonprofessionals tend to chase performance — see lesson 2.  That is a large part of the boom-bust cycle, which no amount of government intervention can repeal.

Here’s some advice: read books on economic history, and avoid current books on how to beat the market.  Learning economic history will help inoculate an investor against greed and panic, and will help the investor understand the guts of the speculation cycle.

Lesson 4: Valuation matters.

You bet it matters.  Excellent long term results stem from buying cheap, among other factors, like margin of safety, earnings quality, and having a sense of the credit cycle, and industry pricing cycles.

Bubble language such as “This time is different,” often appears near the end of booms.  The truth is: it’s never different, or, it’s always different.  Human nature in individual and aggregate, does not change.  Watching valuation is a major way of avoiding getting whipped at extremes, and encourages willingness to invest in the depths of panic.

Lesson 5: Wait for the fat pitch

Also agreed.  One thing that I have focused on in my money management ideas, is to avoid thinking short-term.  There are too many hedge funds, day traders, swing traders, and high-frequency traders out there for me to compete against.  Even mutual funds turn over their positions too rapidly.

I aim to hold investments for three years, but I am not wedded to a time period.  If an investment still looks attractive after five years, compared to the other investments that I hold, I will keep it.  If I find a more  attractive investment than my median idea, I will buy it, and fund it with the proceeds from one of my investments scoring worse than my median idea.

Lesson 6: Sentiment Matters

Yes, sentiment matters, at least until too many people follow it.  I do this in an informal way by following the credit cycle — when risky yields are tight, only own safe stocks.  Volatile stocks rely on sentiment — it is almost a tautology.

Lesson 7: Leverage can’t make a bad investment good, but it can make a good investment bad!

Any investment can be overlevered, and die.  Think of Fannie and Freddie.  They ran on thin capital bases for years, thinking that they could never lose.  So long as housing prices continued to rise, they were right.  And for many, the idea of housing prices falling in aggregate was ridiculous.  Those who suggested that it would happen, like me, were roundly derided.

Yes, leverage can make a good investment bad.

Lesson 8: Over-quantification hides a real risk.

Just because you can quantify it does not mean you understand it.  The Society of Actuaries has a vapid motto quoting John Ruskin: The work of science is to substitute facts for appearances and demonstrations for impressions. Easy to say; hard to do.  Scientists are biased  like everyone else.

Mathematics applied to economics or finance serves to show where assumptions are inaccurate.  Mathematical risk controls are less important than changing the culture of a firm, and setting in place checks and balances.  Toss out VAR, and reduce incentives that would motivate people to take inordinate risks — instead, hire idealists that love the work because they would do it even if they weren’t paid.  That’s how I feel about investing; I just love the game, and wouldn’t want to do anything else.

Lesson 9: Macro matters.

Much as I admire Marty Whitman (and Peter Lynch), I am with Montier and Graham regarding the value of Macro.  Whitman, Pzena, Miller and some others rightfully got their heads handed to them when they neglected the key doctrine of value investing , which is “margin of safety.”  Most of my great mistakes have come from similar neglect.

Particularly when times are unusual, macro factors drive stocks.  But, how well can we predict that?  I’ve done okay over the years, but I am skeptical on being able to do that all of the time.

Lesson 10: Look for sources of cheap insurance.

Again, easy to say, hard to do.  I would like an infinite stream of patsies to soften the blow if I make bad decisions.  In the middle of the 2000s, I felt that shorting credit was nearly a free option, but will there always be bulls making stupid decisions during the bull phase of the market?

On second thought, yes, that should always be true, so where you find cheap insurance, like CDS 2003-2007, buy it.

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So, after all that, aside from point one, I agree with Montier almost entirely.  What a great article he wrote, and what a great article to stimulate the panel that I am on.