Swedroe: Debunking Grantham’s Concerns

July 18, 2014

Grantham says the market is overvalued, but has he been good at exploiting the opportunities he sees?

“For some months now, Jeremy Grantham, a respected market strategist with GMO, an institutional asset management company, has been railing about the efficient market hypothesis.”

So began a June 6, 2009, New York Times article by Joe Nocera. He went on to note: “While Grantham was an early advocate of index funds for unsophisticated investors he believes that professionals should do better precisely because the market is full of major league inefficiencies.”

One of my favorite hobbies is collecting opinions such as Grantham’s and saving them for review at a later date. I saved this one because Grantham is one of the market’s most respected value investors, and his views often receive wide media coverage. Grantham has been “railing” for some time now about the market being vastly overvalued.

He points to currently high price-to-earnings ratios and to record-high profit margins, and believes that we should expect to see a big market correction. For example, in the quarterly newsletter that he released in February 2013, Grantham wrote: “All global assets are once again becoming overpriced.”

He added that domestic companies—other than “quality” stocks backed by stable earnings and low debt—and most global growth equities are “brutally overpriced.” Do his forecasts, and the forecasts of others like him, have value? It’s an important question for investors to ask.

To test Grantham’s ability to add value based on his unique insights, we’ll check Morningstar’s database to find GMO stock funds that have at least a 15-year track record and are either international or domestic funds, as opposed to global funds.

Using the latest data available, the following table presents returns for five GMO stock funds that meet our criteria. Since GMO is a value manager, we’ll then compare their returns to the returns of similar funds managed by Dimensional Fund Advisors (DFA). (Full disclosure: My firm, Buckingham, recommends Dimensional funds in constructing client portfolios.)

15_Yr_GMO_Vs_DFA_Returns

So that we can include additional funds in our analysis, we’ll now consider other GMO funds that have at least a 10-year history. We’ll once again compare GMO’s international large value funds against DFA’s international large value fund. And, for consistency purposes, we’ll compare GMO’s domestic large blend fund against DFA’s large company portfolio.

 

10_Yr_GMO_Vs_DFA_Returns

There certainly doesn’t seem to be any evidence of Grantham’s ability to exploit the supposed inefficiencies he is railing about. Thus, even if the market does exhibit inefficiencies, it seems Grantham and his investors would be better off investing as if there weren’t any.

Further evidence on the wisdom of this advice comes from the study “Behavioral Finance: Are the Disciples Profiting from the Doctrine?Behavioral finance is the study of human behavior and how that behavior leads to investment errors, including the mispricing of assets.

The authors identified 16 self-proclaimed or media-identified behavioral mutual funds that practice some form of behavioral finance in their investment strategies. The study concluded that behavioral funds were really nothing more than value funds, and that after adjusting for risk, there were no “abnormal returns.”

Putting Your Money Where Your Mouth Is

I don’t think I could come up with a more appropriate conclusion than the following, which I took from an interview with one of the leading behavioral finance theorists, Professor Richard Thaler of the University of Chicago. “[Thaler] concedes that most of his retirement assets are held in index funds. And despite his research on market inefficiencies, he also concedes that: ‘It is not easy to beat the market, and most people don’t.’”


Larry Swedroe is the director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

 

 

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