Investors shouldn’t get lulled by the stock market rally in the first half of the year, according to GMO.
The asset manager believes that investors should in fact brace themselves for another potential downturn and construct their portfolios to mitigate downside risk. GMO has been warning of a selloff in markets,
In a paper published Wednesday, James Montier, a member of GMO’s asset allocation team, said he believes that the “massive buildup of private sector debt” could lead to the next market downturn. While the timing of such an event is unpredictable, investors should start thinking about ways to protect themselves against a major market drawdown.
“We seem to live in an era of rolling financial crisis,” Montier wrote in the paper. “I suspect this is the result of a massive buildup of private sector debt.” He cited research showing that the economy becomes unstable when the debt-to-GDP ratio surpasses 150 percent. The U.S. has hovered at or above this threshold for most of the past 20 years, he noted.
Montier suggests three strategies that can help investors protect themselves from tail risks. The easiest way is to hold cash. “As we move to higher rates, the opportunity cost of holding cash is reduced, and its appeal may rise once again,” he wrote. “However, while this is an excellent hedge, it has been a truly terrible store of value (which in turn erodes its ability to be a hedge when we are faced with timing uncertainty).”
The next choice is to go long with stocks that are characterized by stable earnings growth and strong financial health — so-called “quality stocks” — and short those that lack these traits. According to the paper, a long quality-short junk portfolio produced an annualized return of about 4 percent from 2005 to 2021. Meanwhile, a long volatility strategy, which is designed to generate positive returns amid down markets, “has proved to be an unmitigated disaster over the long term.”
“[A] simple long quality-short junk portfolio had very similar insurance properties to a long volatility position but came with the added benefit of positive expected return,” Montier wrote. But he warned that the premiums of quality stocks over junk stocks are currently at their highest since the early 1980s. “This poses potential issues for its long-term store of value characteristic,” he said.
The last strategy that investors can use to protect themselves against market drawdowns is to go long value stocks and short growth equities. From 1929 to 2022, the long value-short growth strategy generated an average return of 10.5 percent during market downturns, according to the paper. While that’s lower than the average return generated by the long quality-short junk strategy in the same situations (20.7 percent), the strategy is more favorable given the valuation appeal of value over growth, Montier said.
“I present three alternatives to long volatility strategies,” he concluded. “All three can be priced relatively easily and all three generally pay off in the event of an equity market drawdown. To me, these seem to offer the best way to create robust portfolios. For the valuation-conscious investor, cash and deep value have the edge given today’s valuations.”
