Investing in a World of Overpriced Assets (With a Single Reasonably-Priced Asset)


GMO 3Q17 Quarterly Letter – Career Risk and Stalin’s Pension Fund: Investing in a World of Overpriced Assets (With a Single Reasonably-Priced Asset)

Be as brave as you can on the EM front. Be willing to cash in some career risk units. Bravery counts for so much more when there are very few good or even decent alternatives.

Background: A Rapid Market Fall Back to the Old Trend or a 20-Year Slow Retreat?

  • My view is that the trend line will regress back toward the old normal but at a substantially slower rate than normal because some of the reasons for major differences in the last 20 years are structural and will be slow to change
    • Factors such as an increase in political influence and monopoly power of corporations; style of central bank management, which pushes down on interest rates; aging of the population; great income inequality; slower innovation and lower productivity and GDP growth would be possible examples
    • I argue that even in 20 years, these factors will only be 2/3 of the way back to the old normal of pre-1998. This still leaves returns over the 20-year period significantly sub-par
    • Another sharp drop in prices will not change this outcome in my opinion, as prices will bounce back
  • My assumption of slow regression produces an expectation of a dismal 2.5% real for the S&P and 3.5 to 5% for other global equities over 20 years
    • This upgrades the significance of the positive gap between stocks and cash and downgrades the virtues of cash optionality and long bond havens
  • My conclusion is straightforward: heavily overweight EM equities, own some EAFE, and avoid US equities

What is the point of asset allocation? Making good-sized bets and winning

  • When there are great opportunities, which is all too often not the case, you must make big bets. If you mean only to tickle the allocation with slight moves, you may have a good framework for coffee time conversation with clients but you are not going to make a difference
  • If you are not prepared to put considerable career or business risk units on the table, for example, in a classic equity bubble like 2000, or a classic housing bubble with associated junk mortgage paper in 2007, then you should not offer the service
  • Keynes explained career risk first and still best in Chapter 12 of The General Theory in 1936: Never, ever be wrong on your own. If you are “you will not receive much mercy.” Yet, he also pointed out earlier in 1923 that for advice to be useful it needs to rise above faith in long-run regression to normal. “This long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task, if in tempestuous times they can only tell us that when this storm is past the ocean is flat again”
    • And this unusual tempest of way over old-normal prices has lasted for 20 years and still continues

The Catch 22 of asset allocation: career risk (and clients’ patience)

  • The Catch 22 of trying to give useful asset allocation advice is that you cannot expect to be right all the time. You will make mistakes, mostly in timing, but possibly also in analysis, and you will pay a price
  • Your objective is to be as aggressive as you can be and just not lose too much business
  • Some cycles are well-behaved and sometimes most of us get lucky; but once in a dreaded while opportunities that were already brilliant become incredibly brilliant just as early 1998 broke out above the previous record P/E on the S&P of 21x in 1929 and then went on to 35x
  • Looking back, 1999 seemed to prove that no large investment house felt that it could afford the client loss of exiting the market early
    • The proof of the pudding was in the degree to which the severe 50% losses in 2000-02 and in 2008-09 were avoided or not

Stocks are getting more efficiently priced… asset classes are absolutely not

  • Severe market breaks of 2000 and 2007 showed one thing very clearly: that at the asset class level there was not even a hint of increased efficiency
  • Peak of 2000 offered perhaps the all-time best packet of mispriced asset classes: value and small cap had never been cheaper compared to growth and large cap
    • Small cap looked as if it could rally 70% to catch back up, which it duly did
    • Even more remarkably, US REITs yielded 9.1% at the very top of the market against the all-time low yield on the S&P 500 of 1.5% – all to be justified by a 1%/year faster growth in dividends
    • By the time S&P was down 50%, REIT index was up close to 30%
    • The new long real bonds, or TIPS, yielded 4.3% and regular long bonds yielded 5% or 3.5% real
  • Then more recently in 2007-08 there was the broadest overpricing across all countries, over 1 standard deviation, than there had ever been
  • In contrast to the increased acceptability and lowered career risk that had narrowed the value opportunities at the micro level, there was still nowhere to hide at the asset class level
  • In short, investing at the asset class level remains dangerous to career and profits and is, hence, inefficient, thereby allowing for occasional great opportunities with the old attendant caveats

The inefficiencies today: EM and EAFE vs. US Equities

  • At the recent low in February 2016, the multiple on EM equities was lower than after the crash in 2009. Meanwhile, the multiple on the US had gone from 12 to 22, an almost 100% spread in favor of the US in just 7 years
    • The Emerging index had sold at 38x in late 2007, a very substantial premium by any standard over the 25x of the US index. It had sold again at a premium as recently as 2011 after the crash
    • And early last year, US was at a 120% premium the other way
  • It certainly indicates an old-fashioned level of extreme market inefficiency at the asset class level
  • Developed ex-US is well below its 20-year average and 40% below the US and Emerging is 65% below its high in 2007

Stalin’s pension fund management: the ultimate career risk

  • Joe Stalin has appointed you to a well-paid cushy job looking after his substantial pension fund; conveniently, Stalin has defined a very precise benchmark: 4.5% real for 10 years (4.7% real is considered the “normal” return to a 65% equity / 35% fixed income portfolio)
    • Do badly and you will be shot
  • You have only GMO’s current 7-year forecast with the understanding that:
    • We have had some success in ranking asset returns but have been about 2% on average too low when measured today, although measured at the market low in 2009 we had averaged 1% too high
  • Looking at this data, you now have to make a decision on which your life depends (now that is real risk!)
  • If you invest to keep your normal 2-year career risk under control by doing what normal investors think is normal and produce a typically diversified 65% / 35% portfolio with the 65% in equity divided, say 37% in the US, 17% in EAFE, and 11% in EM and do it on a buy-and-hold basis for 10 years, you will surely die
    • On our numbers, it totals today to a grand cumulative return of 8.2%, or under 1% a year
  • If only the standard asset classes on our list were available to me, I would invest 100% in EM equities, with two-thirds titled to Value, and I would probably get to live
    • From our GMO forecast, the blended annualized real rate over 10 years would be 5.7%
  • Luckily your life does not depend on the outcome of the next 10 years. So, 2-year career management rules the day – as usual – with the need to be normally diversified or superficially “prudent”

Comparison of a big EM bet to a policy of an extreme move to cash

  • The only sound reason to ever hold lots of cash like this at negative real rates would be that you were confident of a crash fairly soon and you were also confident in your abilities to reinvest in a timely way and execute a sound strategy for the remaining time (all of which is not easy)
  • Let’s assume you are not clairvoyant so that you miss a last 18-month gain in the market before it breaks. Then let’s say it takes 2 years to decline and then you miss only 6 months before investing for the final 6 years at the old-normal returns (this set of assumptions requires above-average talent and a bit of good fortune)
    • The bad news is that after this 4-year phase-in, fully investing for only the last 6 years of the 10-year test, in a normal diversified manner and even at pre-1998 average prices and returns, you will not reach a 4.5% average return for the whole 10 years, but just over 3%
  • The return from getting out and back in with skill and experience – say +3% real a year – will very probably beat a typically diversified portfolio but is very likely to fail to beat a portfolio prepared today to invest heavily in a single decent asset class – EM equities with its 5.5% estimated return

Likely performance of EM equities in a down market: relative value also matters

  • Everyone expects that these assets would drop like a stone, worse than their US counterparts
  • But historically that is not how it works. Yes, beta is very important in a bear market or any market when explaining relative performance but so is value
  • When small cap was in its most relative expensive third, these stocks fell on average well over their 1.2 beta. When small was in the best third of being relatively cheap against large caps, they went down less than the market
    • In 2000, they were co-equally the cheapest they had ever been
    • Small cap at the low being down less than 40% of large cap and small cap value actually up absolutely by a nose versus minus 50% for the S&P 500
  • Looking back at the performance of EM equities, they were relatively very expensive in 2008 and fell like a very large stone, probably the most rapid decline of that magnitude for any broad index ever – over 60% in 4 months
    • Back in 2000, although Emerging was absolutely high-priced, it was still considerably cheaper than the US and beat it slightly in the decline
  • In major rapid declines, relative value indeed plays a very large role alongside beta. Thus, today it is possible that EM equities would decline more than the US in a major decline, but I believe it is improbable

Recent relative performance of EM equities and its relevance

  • Since hitting a multi-year low in February last year, at 11x Shiller P/E, the MSCI Emerging index has beaten the US market by 11% in total return when measured in dollars, with the outperformance driven mostly by currency
    • Relative P/E has moved less than 5%
  • It is always irritating to miss the low, but to put this performance in perspective we should look at the relative outperformance in previous cycles
  • From 1968 to 1980 Emerging won by over 300%; next, from 1987 to 1994 it again trounced the US by over 300%, and most recently from 1999 to 2011 it returned 3.6x the US
    • And in between, of course, it loses impressively
  • Investing when Emerging is at a premium is definitely bad for financial health. In the very long run it appears to have won by 0.5% a year, with more than all of this excess return coming from being cheaper and yielding more
  • Recent valuation on Shiller P/E is around 14.5x, suggesting a 5.9% real embedded return
    • On GMO’s adjusted basis, a Shiller P/E is more like 16x, with an earnings yield of 6.25% and, net of 1% slippage, 5.25%
  • GMO also likes to emphasize relative values ex-Banking and Resources, which makes Emerging look less attractive as these markets have substantially larger shares in these two currently cheaper areas
    • My view on Resources is that the cycle has turned, global economies are doing quite well by recent standards, and oil prices are likely to rise for 3 years or so

Image Source: Gerard Minack