GMO’s James Montier on Fed-Induced Bubbles, Alpha, and More

James Montier of Grantham Mayo van Otterloo’s (GMO’s) Asset Allocation team spoke with Advisor Perspectives recently about interest rates, behavioral biases, and other key factors affecting markets. He said that unlike the longest-serving Fed governor William McChesney Martin, who said the central bank’s job is to “take the punch bowl away just when the party was getting interesting,” recently the Fed governors “are more like teenagers at prom night . . . spiking the punch bowl and handing out free drinks and hoping to get lucky at the end of the night.” This, he suggested later in the interview, has helped to create “very broad-based overvaluation” that is unlike the past “bubbles in smaller areas,” such as the dot-com bubble. He likened the current overvaluation to the housing bubble, which he said “was a central banks-sponsored bubble.” The current overvaluation, he said, is “the first truly global immersion of that experience” because it involves far more than the U.S. alone. The mechanism, he maintained, is that investors are inspired to believe it is not possible to “take on too much risk because ultimately the Fed will bail them out.” This is particularly important, Montier suggested, because “people get overconfident [and] tend to overestimate return and underestimate risk,” which can be very “dangerous” because “markets are essentially very fragile constructs . . . subject to tipping-point outcomes” in which reassessment of valuation rapidly breeds fear and “the world unravels.” Nonetheless, he noted the opportunity for value investors when such reassessment occurs.

 

Montier also attacked the idea proffered by Larry Swedroe that markets are now more efficient and, therefore, passive portfolios will necessarily outperform active managers. He distinguished between macro and micro efficiency, reasoning that markets are not significantly more efficient in either sense than they used to be. Further, he asserted that “there is always going to be some element of active management in the market that effectively acts as a behavior driver” because “if nobody is actually looking for alpha, then there will be plenty there because everything will become inefficiently priced.” He described an ebb and flow between active management and indexing (including “closet indexers”) in which the active managers reduce alpha and, as they recede, inefficiencies crop up as passive funds gain ground, which then increases opportunities to find alpha.

 

Montier discussed the impact of technological revolutions, including the internet, which he said always have a “good” deflationary effect in that they lower prices and thereby benefit consumers more than producers. On the market volatility thus far in 2016, he said we are simply seeing reassessment of pricing that actually reflects “the same sort of issues that we were certainly grappling with throughout last year and certainly not anything new in the last couple of weeks.”