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June 10, 2020, 1:40 p.m. EDT

‘You should be nervous!’—legendary money manager slashes stock market exposure from 55% to 25%

Stocks are expensive and the economy is terrible

By Brett Arends, MarketWatch


Courtesy Everett Collection
Are investors ‘lining up to become a hot lunch’? Murray Hamilton, Roy Scheider, Richard Dreyfuss in Jaws, 1975

As investors we should always get nervous when we start making too much money too easily. As a foolish youth I once ignored that rule while speculating on interest rate futures, and got my fingers slammed in the door very quickly and very hard.

Even before Friday’s jobs report, which sent the stock market skyrocketing yet again, investors’ cups have been running over. Our stocks and mutual funds and 401(k) balances have been going vertical for more than two months. So it’s probably a good moment for a bucket of cold water. And who better to provide it than Wall Street’s best known cold-water merchants, Ben Inker and Jeremy Grantham at Boston fund company GMO ?

“Uncertainty has seldom been higher…oddly, neither has the stock market,” warns Inker, the firm’s head of asset allocation, adding that GMO slashed its stock exposure in its flagship Benchmark-Free Allocation Strategy from 55% in March to just 25% by the end of April.

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“We are in the top 10% of historical price earnings ratio[s] for the S&P on prior earnings and simultaneously are in the worst 10% of economic situations, arguably even the worst 1%!” adds Grantham, the company’s co-founder. The coronavirus pandemic is unlike past economic disasters, he says. “It is totally new and there can be no near certainties, merely strong possibilities. This is why Ben…is nervous and this is why you are nervous, or should be.”

After the trauma of the last few months the economic risks hardly need much repeating, but as markets soar they are at least worth remembering. Among them: Mass unemployment, major corporate bankruptcies, a prolonged economic slump, civil unrest, a quest for a vaccine that takes much longer than people hope, or which is less successful than people hope. As Grantham adds: “But most viruses have never had a useful vaccine and most useful vaccines have taken well over five years to develop and when developed have been only partially successful.”

Grantham adds that even before the crisis hit the economy was dealing with longer term problems, including climate change, slowing population growth in the developed world, slowing productivity gains, and, in the U.S., record public and corporate debt levels.

None of this would matter so much if stock prices were cheap and offered investors a good margin of safety, they add. But they aren’t. Since the market lows in late March, the S&P 500 (S&P:SPX) has rocketed 38% and the Russell 2000 index (USA:RUT)  of small U.S. stocks 43%. Major overseas indexes, such as the MSCI EAFE (MSCI:XX:990300) developed market index and MSCI Emerging Markets (MSCI:XX:891800) , are up by about a third.

Cue the Alfred E. Neuman market. “What, me worry?”

Investors have enjoyed the equivalent of several years’ good returns in the stock market in a matter of weeks, GMO notes. By late April most stock markets were offering dismal seven-year returns, they calculate. It’s worth adding they ran the numbers over a month ago. The markets have carried on rising since then—meaning markets today offer even more grounds for caution.

It’s easy to dismiss GMO as doomsayers. My late friend Dan Bunting, a British money manager for many decades, used to say that the problem with all economic forecasts was “the economic fundamentals always look awful.” Critics note that GMO has been generally very cautious on stock markets, especially in the U.S., in recent decades. They also note its Global Asset Allocation and Benchmark Free Asset Allocation strategies, two key guides to in-house thinking, have underperformed their target rates of return over the past decade.

On the other hand, GMO’s quarterly updates remain required reading on Wall Street, even among those who are always 100% invested in stocks and 100% bullish. The analysis is not foolish. And GMO has had some spectacular successes in the past: Such as anticipating the dot-com bust of 2000-2003 and the global financial crisis of 2007-2009, and turning bullish at the depths of the markets in 2008-2009.

It is at least a reminder not to give in too heavily to euphoric animal spirits after stock markets have boomed. Retail investors, in particular, are prone to the twin risks of getting too bullish when stocks have risen and too bearish when they are down.

Meanwhile for those wondering where a cautious skeptic should invest, GMO notes that so-called “value” stocks are comparatively cheap everywhere, and that emerging market stocks as a group are cheap by any reasonable measure. (And best of all, naturally: Emerging market value stocks). Oh, and they note that while many countries in the emerging or developing world may struggle with the coronavirus crisis and its fallout, some of the biggest members of the MSCI Emerging Markets index—think Taiwan and South Korea—seem to have coped with it better than the so-called “developed” world .

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