The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is ﬁrst and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the ﬂow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefﬁciencies in market pricing, but this is by far the largest. It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in “fair value” for the stock market. This difference is massive – two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1% of its long-term trend as shown in Exhibit 1. The market’s actual price – brought to us by the workings of wild and wooly individuals – is within plus or minus 19% two-thirds of the time. Thus, the market moves 19 times more than is justiﬁed by the underlying engines! This incredible demonstration of the behavioral dominating the rational and the “efﬁcient” was ﬁrst noticed by Robert Shiller over 20 years ago and was countered by some of the most tortured logic that the rational expectations crowd could offer, which is a very high hurdle indeed.Read the rest at GMO Quarterly New Letter
My Sister’s Pension Assets and Agency Problems
(The Tension between Protecting Your Job or Your Clients’ Money)
by Jeremy Grantham
Grantham explains why managers and traders are much more interested in price momentum and relative strength than underlying fundamentals.