Wednesday, December 9, 2015

GMO Quarterly Letter: Just How Bad Is Emerging, and How Good Is the U.S.? and Give Me Only Good News!

GMO's 3Q 2015 Letter includes Ben Inker's "Just How Bad Is Emerging, and How Good Is the U.S.?" and Jeremy Grantham's "Give Me Good News Only!" 
And this leads to the quandary for thinking about the U.S. stock market. We cannot find any convincing evidence that the U.S. is deserving of trading at a premium P/E to the rest of the world. This profitability, however, could be read either of two ways. Either the U.S. has somehow unlocked a secret to permanently higher profitability or this is an extremely dangerous time to be investing in the U.S. U.S. profitability has never looked materially better relative to the rest of the world than it does today. The bull case would be that, for whatever reason, this profitability gap is sustainable and U.S. stocks are only mildly more expensive than the rest of the developed world given U.S. P/Es are only about a point higher.  
But, frankly, we have a hard time believing this bull case. U.S. outperformance in recent years can be readily explained by the better trends in profitability, but that is a long way from saying that outperformance was truly justified. From a macroeconomic perspective, maintaining such high levels of profitability in the face of low investment rates implies ever-increasing wealth inequality in this country, unless taxes were to be raised in a way that seems highly implausible. Generating sufficient end demand in the economy given the inequality would call on either the rich to start spending their wealth at signficantly greater rates than we have seen historically or the rest of households to spend more than 100% of their income, as they did in the housing bubble. It is hard to envision that an economy that relies on those foundations to be a sustainable one.  
And even if the U.S. has somehow managed to unlock the secret to permanently high profits and the economy remains solid, it seems unlikely that the secret will remain an entirely U.S. phenomenon. If we imagine a world in which U.S. profitability is able to remain well above historical levels, we would expect non-U.S. companies to begin to copy their American counterparts, similar to the way profitability converged from the 1970s to the early 2000s. In that scenario, we are being too tough on U.S. stocks, but they are still the worst of the global bunch as our forecasts for other equities are similarly underestimated.  
It takes little experience in the investment business to realize that investors prefer good news. As a bear in the bull market of 1999 I was banned from an institution’s building as being “dangerously persuasive and totally wrong!” The investment industry also has a great incentive to encourage this optimistic bias, for little money would be made if the market ticked slowly upwards. Five steps forward and two back are far more profitable. 
Similarly, we environmentalists were shocked to realize how profoundly the general public preferred to believe good news on our climate, even if it meant disregarding the National Academies of the world. The fossil fuel industry, not surprisingly, encouraged this positive attitude. They had billions of dollars to protect. If the realistic information were to be widely believed, most of their assets would be stranded.  
When dealing with realistic limits to growth it is also obvious how reluctant everyone is to accept the natural mathematical limits: There simply cannot be compound growth in a finite world. A modest 1% growth compounded for the 3,000 years of Ancient Egypt’s population would have multiplied its economic output by nine trillion times! Yet, the improbability of feeding ten billion or so global inhabitants in 50 years is shrugged off with ease. And the entire economic and political system appears eager to encourage optimism on resources for it is completely wedded to the virtues of quantitative growth forever.  
Hard realities in these three fields are inconvenient for vested interests and because the day of reckoning can always be seen as “later,” politicians can always find a way to postpone necessary actions, as can we all:  “Because markets are efficient, these high prices must be reflecting the remarkable potential of the internet”; “the U.S. housing market largely reflects a strong U.S. economy”; “the climate has always changed”; “how could mere mortals change something as immense as the weather”; “we have nearly infinite resources, it is only a question of price”; “the infinite capacity of the human brain will always solve our problems.”

Having realized the seriousness of this bias over the last few decades, I have noticed how hard it is to effectively pass on a warning for the same reason: No one wants to hear this bad news. So a while ago I came up with a list of propositions that are widely accepted by an educated business audience. They are widely accepted but totally wrong. It is my attempt to bring home how extreme is our preference for good news over accurate news. When you have run through this list you may be a little more aware of how dangerous our wishful thinking can be in investing and in the much more important fields of resource (especially food) limitations and the potentially life-threatening risks of climate damage. Wishful thinking and denial of unpleasant facts are simply not survival characteristics.