Key Takeaways
- GMO, founded by veteran value investor Jeremy Grantham builds investment strategies on the premise that all asset classes eventually revert to their historical means.
- Co-head of asset allocation John Thorndike says investors don’t need to “hide out,” but should avoid the most expensive parts of the global market.
Last week’s action in stocks illustrated investor worries about high valuations. Those worries are reasons for restraint, a fund manager told Investopedia, but not alarm.
“High valuations offer both lower expected returns and higher risk than fairly valued or cheap markets,” said John Thorndike, a portfolio manager at GMO, in an interview with Investopedia. “Although valuation is not a great short-term predictor of market moves, it’s no surprise that an expensive market can decline with the slightest whiff of investor concern.”
One way to deal with valuation anxiety, and the growing chorus of investment professionals warning of a potential market pullback, is to invest away from richly priced stocks. The GMO Dynamic Allocation ETF (GMOD), an actively-managed strategy that shifts into asset classes that present relatively higher returns as suggested by their valuations, aims to make that easier.
The October-launched fund is the latest from GMO, co-founded by veteran value investor Jeremy Grantham, who predicted both the Dotcom crash and the 2008 financial crisis. Grantham’s investment wisdom—that all asset classes eventually revert to their historical means—underpins the strategy through the firm’s asset class forecasts, which projects potential real returns over a seven-year horizon.
For example, U.S. large- and small-cap stocks were projected to deliver negative returns as of the end of September.That explains the fund’s underweighting in U.S. stocks.
Why This Matters to Investors
The way an investor divides their investments across assets—stocks, bond, commodities, alternatives and cash—largely determines results. The default is a 60/40 portfolio, though different versions of that allocation can work better in some periods over others.
Thorndike, who manages the fund with Ben Inker, says the fund has about 60% of its assets parked in stocks and 40% in bonds. Right now, it’s biased toward quality and value stocks, both in U.S. and non-U.S. stocks, and overweight Japan, emerging markets excluding China, and intermediate-term bonds.
An edited transcript of Investopedia’s interview with Thorndike follows.
Q: What is GMO’s view of the market now?
Thorndike: This [market] isn’t like 2007, or 2008 when everything was expensive and you needed to hide out in the safest assets. Today, you just need to avoid the most expensive part of the market, but otherwise can be fully invested.
In the U.S., growth stocks and certainly some of the AI-related comes with very high valuations and expectations. That’s the part of the market worth avoiding, or at least underweighting depending on your risk tolerance, while value stocks in the U.S. trade at a discount almost as wide as we’ve ever seen. We see opportunities both in the U.S. and outside of the U.S.—outside of the U.S. is where we see the highest expected returns.
Q: Is there anything that happened this year that gives you conviction that relatively undervalued, or quality stocks will outperform in spite of the current junk-fueled rally?
A: The Magnificent Six [GMO says “Tesla doesn’t make the cut on Magnifence”] has continued to generate fantastic fundamental returns, and their ability to do that has really delivered for investors.
What’s changed? These companies were often considered capital-light. They had great free cash flow. They didn’t have to make a ton of investments back into their business. Now they are all investing a lot of money in real-world investments, building out data centers, etc. That capex is going to have to earn a great return to justify their valuations, and that’s a change in what you need to believe about those stocks from here, relative to what they’ve delivered over the past few years.
Q: Has there been any sort of allocation recommendation shifts around the expectation of the Federal Reserve’s lowering rates?
A: It hasn’t been a big driver of portfolio changes this year. The job of fixed income is to earn you some income and to help protect you in a bad economic event where you expect equities to go down. The higher the yield, the better chance fixed income has in doing those jobs.
Today, you’ve got a real yield on the 10-year [Treasury] that’s somewhere between 1.5% and 2%—that’s perfectly acceptable. If the Fed cuts rates to the point where you no longer get that yield, then fixed income becomes less attractive. Remember when the 10-year yield was trading at 60 basis points nominal? Well, that basically gives you no income, and it had no chance of appreciating. In that environment, we held no fixed income duration, whereas today we have a couple years worth.
Q: Looks like GMOD is split 60% stocks and 40% bonds. That reads neutral on stock exposure given the ETF can own as little as 40% or as much as 80% in stocks.
A: Because our equity book looks markedly different than a cap-weighted index, we are comfortable owning a normal weight in equities. The equities we own offer an attractive risk premium over bonds, unlike the expensive parts of the U.S. equity market.
Q: What corners of the global stock markets look the most attractive right now?
A: Japan is particularly cheap and we have quite a bit of our portfolio invested there. It’s a market that a lot of investors ignore, or at least shy away from, given it produced very poor returns on capital for a very long time. They’ve seen improving returns on capital and shareholder friendliness from both management teams and policymakers And of course, as a U.S. investor, you can buy into the Japanese market at a very attractive exchange rate.
Q: So the dollar’s decline makes non-U.S. stocks more attractive?
A: Not so much with the dollar’s decline, but the dollar’s valuation. An expensive dollar tends to make non U.S. equities look more attractive for U.S. investors for one of two reasons—either a currency appreciates [against the dollar] so you get that windfall, or the companies benefit from the competitive currency and see faster earnings growth.
The fact that the U.S. dollar is quite expensive relative to almost any other currency should be [a] tailwind for non U.S. equities, and the fact that the dollar has weakened over the course of this year has helped returns for non U.S. stocks, but it’s the valuation that determines the forecast.
Q: What would happen in the event that U.S. equity markets fell significantly—not asking for a prediction, but if the 7-year forecast completely changes its recommendation, does the fund have the ability to change its entire portfolio?
A: So not a prediction, but—if equity markets fell significantly, we would also expect fixed-income yields to fall, especially in Treasurys. That would bring their prospective returns down. Meanwhile, your equities’—as long we we’re talking something like a recession but not a depression—fundamental intrinsic value wouldn’t have gone down that much, and their prices would have gone down a lot. Equities would look a lot cheaper, and fixed income less attractive.
GMOD has the ability to be as much as 80% in equities, okay? I can’t tell you exactly what we would do, because we don’t know how [a downturn] would manifest. We like to buy things that look cheap and sell things that look expensive.
