Think twice before ridding your portfolio of lagging stocks, sectors, and managers — you may regret it later this year.
In two reports published over the past week, investment manager GMO advised investors to avoid growth stocks in both the United States and abroad. It argued that high-flying growth valuations are creating an “equity superbubble” that could be dangerous for the portfolios of those who can’t fight their instinct to keep rolling the dice on market winners.
For the past 20 years, GMO has defined a “bubble” as pricing that is two standard deviations from trend. In January, GMO’s co-founder Jeremy Grantham coined the term “superbubble” to describe situations in which highly inflated assets are priced three standard deviations from trend or higher. “As of January 31, the U.S. equity market is just beyond three standard deviations from fair value, based on a cyclical adjusted price/earnings ratio,” said Catherine LeGraw, portfolio strategist at GMO. She told II that ample evidence — such as increasing retail participation in the markets, strong equity issuance, and the meme-stock euphoria — suggests that current valuations may not be sustainable in the long term.
“It’s natural to feel that any market that has recently done well is less risky and those that have done poorly are riskier, but this turns out not to be the case,” said Ben Inker, co-head of asset allocation at GMO. His team ranked countries by their trailing stock market performance from 1970 to 2021 and found that over a three-year period, the laggards outperformed the average. Specifically, the three-year performance of countries ranked in the bottom third over the past 51 years outran the average by 1 percent, while the highest third lagged by 1.25 percent.
The same logic can be applied to growth and value stocks. According to Matt Kadnar, partner and portfolio manager at GMO, growth stocks — especially U.S. companies that have been fueled over the past decade by the high-flying tech sector — are now too overpriced to offer sustainable long-term returns. “The epicenter of the bubble, both at home and abroad, is concentrated in growth stocks,” he wrote. As of December, the valuation of U.S. value stocks compared to U.S. growth stocks is in the fifth percentile relative to history, according to data from GMO. This means that if value were to go to its historic average versus growth, the former would outperform the latter by 68 percent.
To capitalize on the so-called superbubble, Kadnar suggests investors reduce their equity allocations, focus on non-U.S. value stocks, and expand their alternative strategies. Value stocks in emerging markets and Japan “look very cheap relative to the U.S.,” Kadnar wrote. In addition, small value stocks in Japan “are attractive in absolute terms” because the country has been promoting a shareholder-friendly environment through recent policy reforms.
Part of the reason why managers have been piling into U.S. growth stocks in recent years is that the Chinese government has been clamping down on its tech giants, which “left plenty of investors feeling as if U.S. large growth was both the lowest risk and highest return version of equities,” according to Inker.
He added that investors also tend to select active managers based on their recent return profile, which can be a misleading metric because historical data suggest that periods of underperformance are usually followed by excess returns. In an earlier study, GMO found that active managers fired by institutional investors delivered an average of 4.2 percent excess return after being let go. “You may be tempted to outright fire some value-oriented managers [in an effort to enhance] a growth bias in your portfolio,” Inker wrote. “[But] that looks like an even more dangerous mistake than such a move would normally be.”
Besides value stocks in emerging markets and Japan, LeGraw said that there are a few other areas where global investors can find attractively priced assets. The first is resource stocks, which are “trading at roughly the deepest discount to the global equity markets we’ve ever seen,” she said. The others include quality cyclicals and thematic investing in climate-related stocks.
“There remain significant opportunities to make money and reduce risk in today’s market, just as there were in 1987, 1999, and 2008,” Kadnar concluded. “We know that selling winners and rebalancing into losers is good investment discipline but incredibly difficult to do for a whole host of behavioral reasons. That investment discipline is particularly critical given the equity superbubble we see today.”
