GMO just issued another quarterly letter titled, "Is Investing Starting to Get Difficult Again?" penned by Ben Inker. GMO is widely considered to be one of the best concerning asset allocation and I eagerly read their reports to learn more about this aspect of investing. Lately they are rather cautious, and this letter is no exception. He starts out cheerfully describing the current situation:
"Not only have markets given strong returns, but the apparent riskiness of both individual assets and overall portfolios has been low. It has not simply been the lack of giant, horrifying market dislocations that gives the impression of low risk, but the combination of very low general market volatility and an extremely friendly correlation structure such that stocks and bonds have been wonderfully diversifying. For most investors, this has been a happy combination."
But as you might have guessed, it is only a precursor before describing the dour future that's ahead of us.
In the graph included below you can see GMO's asset allocation forecasts (they have a good reputation regarding these):
This is a very strange forecast graph because there is almost nothing that is attractive. There is only TIPS (Treasury inflation protected securities). These are Treasuries that are protected from inflation as measured by the CPI. Almost all the other asset classes display a lot of volatility and remarkably low future returns. Perhaps cash is somewhat attractive as a coponent to a portfolio.
Not too long ago, GMO's Jeremy Grantham (Trades, Portfolio) was still very bullish about emerging markets, but in this graph even those look pretty horribe, although they've had a good run.
Inker explains the graph as follows (emphasis mine):
"The slope of the line should be positive – riskier assets should be priced to deliver higher returns. But the Great Moderation changed investor perceptions of risk such that the slope went strongly negative. The financial crisis obviously came as a horrible shock to that mindset, but the rapid recovery in corporate cash flow in the aftermath and the consequent lower levels of distress than previous cycles experienced have served to assuage investors’ economic concerns. The passage of time has also dimmed the memories of the pain of the crisis, such that most investors seem to believe they would stay the course through another such crisis, whether or not they held their nerve last time."
But will they? I'm not so sure and that includes myself. Although I hold some short positions that help to hedge some of my market risk, I'm still long biased while not all that sure I'd ride out a deep drawdown without reducing exposure at exactly the wrong time. The lack of volatility quietly lulls you to sleep and before you know it, you're running more risk than you wanted to.
Inker then dived into the problems the volatility-free environment created due to the prolification of risk parity and volatility selling strategies:
"Stability breeds instability, as Hyman Minsky pointed out 40 years ago. Statistically, we should expect to get periods of relative calm in any natural (or randomly generated) system, and those periods end. But beyond that, the calm itself encourages behaviors that eventually lead to highly volatile outcomes. The very existence of risk parity and volatility targeting strategies creates fragility in the markets in the form of feedback loops. At first, a period of calm will lead to increased leverage, which creates net buying to support markets. But a rise in volatility or shift in correlations can lead to deleveraging and selling pressure just when markets are already shaky."
The whole not culminates into the following point:
"In other words, after years of very low volatility and strongly negative correlations, last quarter looked a lot more like the average conditions investors have experienced over the last 150 years. In that world, historically normal risk premia make a lot of sense, and all of our collective investment goals rely on those risk premia. remaining similar to historical levels. The trouble is that markets today, particularly US markets, aren’t priced for that world, so if current conditions persist, I believe valuations are likely to fall."
Inker thinks that if we are now coming to the close of the volatility-free ride we've had for nine years, we will see markets re-rate downwards because investors require higher returns to hold on through such an environment. Food for thought.
GuruFocus tracks Jeremy Grantham's U.S. stock portfolio, and it doesn't exactly jive with this note, containing a lot of the big U.S. tech stocks and emerging market exposure. But 13-Fs don't reveal how many TIPS a fund is holding:
Disclosure: No position.
