Career Risk vs. Portfolio Risk

In markets where investors hand over their money to professionals, the major inefficiency becomes career risk. Everyone’s ultimate job description becomes “keep your job.” Career risk-reduction takes precedence over maximizing the client’s return. Efficient career-risk management means never being wrong on your own, so herding, perhaps for different reasons, also characterizes professional investing. Herding produces momentum in prices, pushing them further away from fair value as people buy because other are buying. That, ladies and gentlemen, is a perfect description of what the professional money-management business has become.

. . . Jeremy Grantham, portfolio manager and co-founder of GMO, a Boston-based money management firm

We recalled these sage words from GMO’s (Grantham, Mayo & Van Otterloo) Jeremy Grantham as we watched the end of the quarter performance gaming and portfolio restructuring late last week. His comments are particularly cogent now that we have entered the month of October, since many money management firms close their fiscal year “books” at the end of this month. Consequently, there is much angst regarding performance risk, bonus risk, and ultimately career risk (loss of job). Indeed, keeping up with the Joneses, that would be the Dow Joneses, has been difficult for portfolio managers this year.

Now we are not so sure this herding trend has “pushed prices further away from fair value” for as we have argued in past missives we don’t think stocks are all that expensive. To wit, given there are more high growth companies in the S&P 500 than ever before, the tectonic shift from tangible assets on corporate balance sheets to intangible assets, and the fact that since 1990 the S&P 500’s average P/E ratio has been over 20 times earnings; but, we digress. Despite these end of the quarter machinations, the more strategic theme is that pension funds, endowment funds, sovereign funds, etc. are figuring out the only way they can ever achieve their targeted annual return of say 7.5% is to increase their exposure to equities. To be sure, there is no way to get to that return in bonds because it is mathematically impossible. So their sole focus is to attempt to get back to a 7.5% annualized return.

To this point, our friend, and perspicacious Dallas-based portfolio manager Frederick “Shad” Rowe (Greenbrier Partners) shared this with us a few years ago:

We’ll look at 20 year [returns] starting in 1965, then 20 years [forward] starting in 1966, and so on. Returns on investments in the S&P 500 stock index for each period have fluctuated between 8% and 12%. Each period contained some bad years, but there were always more good years and they outweighed the bad results for every 20-year stretch. While the actuarially assumed rate of return for most public pension systems is approximately 7.5%, the stock market has managed to climb the proverbial wall of worry and offer superior returns, compared to virtually all available alternatives – if you stayed fully invested in the index for the full 20 years.

As for Andrew and I, we have never wavered since our long-term proprietary model flipped positive in October of 2008 that a new secular bull had begun. While most believe it began in March 2009, the majority of stocks bottomed on October 10, 2008 when 92.6% of all stocks traded on the NYSE made new annual lows. Granted the major indices went lower into March 2009, but that was because the Financials went lower and we were bullish. Since then we have averred the equity markets are in a secular bull market that has years left to run. This first leg of the secular bull market ended in May 2015, which was followed by an upside consolidation until the second leg began in February 2016, which at the time the Royal Bank of Scotland told investors to sell everything but high grade bonds. The second leg of a secular bull market is the longest, and the strongest, being driven by the accommodative Fed monetary policy that produced the first leg, and the transition to an improving economy, and an “earnings driven” secular bull market.