In their latest Q3 2021 Market Commentary, GMO discusses the frustration of watching your neighbor get rich. Here’s an excerpt from the letter:
The end of the quarter is also a time to breathe and take stock more broadly of the “mood” of the markets and our clients. While we were encouraged by the outperformance of Value in the first six months of the year, this quarter’s reversal of the reversal, especially in July and August, was disappointing.
We understand the frustration. We feel it too. It has been a long, hard road for all valuation-sensitive managers, and 2020 (the worst year in history for Value’s underperformance of Growth) added insult to injury; 2021, indeed, offered powerful glimmers of hope. Still, some fear it may be too little too late.
To be sure, frustration is even more poignant on the way up. It’s hard to be a valuation-based manager from a psychological perspective given our tendency to lag during up markets and lose less during down markets. In the long term, it is a wonderful way to compound wealth. But in the short-to-intermediate term, it can feel unsatisfying.
Truth be told, the real pain is the lagging on the upside – particularly during higher-than-average market run-ups. And it is really hard to focus on valuation when entering the speculative phase of that run-up. Nothing is more frustrating, as Jeremy Grantham has pointed out, than watching your neighbor get rich. Again, we understand and appreciate this painful phenomenon.
It is worth noting that this multi-year U.S rally has been primarily about multiple expansion, not fundamentals. That is not a good thing. In fact, the last 7 years has seen mean-aversion, not mean re-version. In 2014, the cyclically adjusted price-to-earnings (CAPE) ratio stood at a heady 26 (close to the levels of the market top of October 2007), putting it in the 92nd percentile of expensiveness.
It would have been reasonable back then to think that U.S. stocks were looking pricey. Since then, however, they have defied mean reversion’s gravitational pull by going up even further and blowing past 2007 and 1929 levels. Today, the CAPE ratio stands at 38, which is in the 99th percentile.
During this same time frame, the U.S economy grew at a measly 1.9% real. Sales for the S&P 500 grew a miserly 1.9% real, and EPS for the S&P 500 grew at 4.5% real, which is nice, but hardly spectacular (and frankly driven more by stock buybacks than true earnings growth). We acknowledge the earnings growth from the depths of the Covid-induced lock-down beat expectations and has recovered to pre-pandemic levels. The problem is that overall long-term growth has been OK at best while price movement has been exuberant.
But we have seen this movie before. In fact, it is eerily reminiscent of the late 90s’ lead-up to the TMT Bubble. All through 1997, 1998, and 1999, clients and consultants were losing patience with our performance. This late 90s experience at GMO – that gnawing, pit-in-the-stomach fear that perhaps Value was dead – has even been memorialized at the Harvard Business School. GMO is literally a case study due to our ability to hang on to our forecasts and stay disciplined in the face of second-guessing.
We mention this, of course, because ultimately mean reversion occurred. Maybe not on time, maybe a bit too late for some – but it nevertheless arrived. And it did so with a vengeance. The Russell 1000 Value Index went on to beat the Russell 1000 Growth by over 14% per year for the next 7 years. Again, there is no guarantee that Value’s dominance will repeat in the same time frame or by the same magnitude; but we believe with equal vigor that it deserves to.
You can read the entire letter here:
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