Prologue: For GMO's asset allocation team, valuations are our first protection against losses. We generally believe that cheaper assets are more resilient against bad economic and financial events, and that if we focus on avoiding the overvalued assets, we should not only achieve higher returns over time, but more often than not do less badly when markets encounter difficulty.
From a valuation perspective, Chinese equities do not, at first glance, look to be a likely candidate for trouble. The PE ratios are either 12 or 15 times on MSCI China, depending on whether you include financials or not, and the market has underperformed MSCI Emerging by about 10% over the last three years (ending December 31, 2012). Neither of these characteristics screams "bubble." And yet, China has been a source of worry for us over the past three years and continues to be one, affecting not merely our behavior with regards to stocks domiciled in China but the entire emerging world, as well as some specific developed market stocks, which we believe are particularly vulnerable should things in China go down the road we fear it might. Continue Reading »