Investors Find It Hard to Stay Course in Strange Winds
(Bloomberg Gadfly) -- Here’s a delicious paradox: Despite easy access to mountains of financial data and vast computing power to process it, investing remains a stubbornly superstitious and emotional pursuit.
Perhaps that’s why the personal attribute that investors prize most -- more than smarts or diligence or trading savvy -- is discipline. Pick an investment philosophy, the saying goes, and stick to it. And if it makes sense, that’s even better.
But that’s easier said than done. The problem is that every style of investing -- no matter how thoughtfully constructed and ably executed -- goes through a long, agonizing period when it doesn’t work. Just ask value investors. The Russell 1000 Growth Index has beaten the Russell 1000 Value Index by 3.4 percentage points annually since 2007 through June, including dividends.
The longer an investing style stumbles, the harder it is to know whether that style is temporarily out of favor or destined for the dustbin. The line between discipline and foolishness becomes increasingly blurry, even to elite investors.
Two years ago, hall-of-fame investor Stanley Druckenmiller recounted how internet stocks seduced him into straying from his investing principles. It was February 1999. Investors went cuckoo for the internet, and tech stocks were absurdly expensive. The S&P 500 Information Technology Index traded at a trailing price-to-earnings ratio of 66. Druckenmiller spotted the madness and decided to short internet stocks.
No one told internet stocks, however, that the party was over. A month later Druckenmiller had lost $600 million and his portfolio was down 15 percent on the year. He had never had a down year.
Frustrated, Druckenmiller sought advice from techies. It’s a new world, they told him. Throw away the old playbook. The technology revolution demands sky-high stock prices. Druckenmiller dumped his shorts and bet big on technology.
He was quickly rewarded. The Nasdaq 100 Index gained 93 percent from March to December 1999. Druckenmiller’s portfolio ended the year up 35 percent and his internet stocks traded at a breathtaking P/E of 104.
Drunk with internet riches, Druckenmiller plowed an additional $6 billion into tech stocks in March 2000. The bubble burst just days later and he lost $3 billion.
When asked what he learned from that experience, Druckenmiller replied, “I didn’t learn anything. I already knew that I wasn’t supposed to do that. I was just an emotional basket case and couldn’t help myself.”
About the same time, another hall of famer was wearily watching internet stocks. But unlike Druckenmiller, Jeremy Grantham, co-founder and Chief Investment Strategist of Grantham Mayo Van Otterloo (GMO), stuck to his playbook.
Grantham was a vocal proponent of mean reversion -- the simple idea that what goes up must come down, and vice versa. In the late 1990s, he was convinced that internet stocks had climbed too high and were poised to fall.
Grantham paid a price for his discipline. GMO’s U.S. Equity Allocation Fund trailed the Nasdaq 100 Index by 29 percentage points annually from 1995 to 1999, which didn’t endear GMO to investors. The firm’s assets under management fell from $26 billion in 1997 to $22 billion by 2001.
Undeterred, Grantham insisted that the dot-com mania would end badly. He was right, of course. In a reversal of fortune, GMO’s fund beat the Nasdaq 100 by 26 percentage points annually from 2000 to 2002. By the end of 2003, the firm’s assets under management had ballooned to $53 billion.
What do stories from the dot-com era have to do with current markets? A lot. Markets haven’t been themselves since the 2008 financial crisis, and some deeply held investment principles are once again being tested.
Value stocks, for example, are supposed to shine during recoveries. They haven’t. Low interest rates are supposed to translate into meager returns from bonds. Not this time. The average 12-month yield for the Bloomberg Barclays U.S. Aggregate Bond Index has been 2.7 percent since 2009 through June, and yet the index has returned 4 percent annually over that time. High stock valuations are meant to augur low returns, but U.S. stocks have continued to rally despite rich valuations.
Markets have been so wacky that even Grantham is having doubts about his trusty mean reversion. He recently wrote that corporate profits -- and by extension stock prices -- could remain elevated.
He isn’t alone. Yale professor Robert Shiller correctly warned during the dot-com and housing bubbles that a high cyclically adjusted P/E, or CAPE, ratio meant trouble. Shiller warned in January that the CAPE ratio is stretched yet again and that U.S. stocks are in a bubble. But in a recent interview with Fortune, Shiller seemed to back away from his previous warning.
It’s a classic test of investment discipline. And this time, I suspect Stanley Druckenmiller won’t be so quick to capitulate.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.