Episode #531: GMO’s Catherine LeGraw – Capitalizing on Global Asset Allocation in 2024

Guest: Catherine LeGraw is a member of GMO’s Asset Allocation Team.

Recorded: 4/17/2024  |  Run-Time: 45:15

Summary: In today’s episode, Catherine explains why this is “the best relative asset allocation opportunity we’ve seen in 35 years,” and “we are building portfolios with some of the highest forecasted relative and absolute returns we’ve ever seen.” She explains where she sees opportunity around the world today, why she’s excited about deep value and quality, and how she’s thinking about the Magnificent 7.

Sponsor: Today’s episode is sponsored by YCharts. YCharts enables financial advisors to make smarter investment decisions and better communicate with clients. Visit YCharts to start your free trial and be sure to mention “Meb” for 20% off your subscription (new clients only). View their Economic Update Visual Deck. 

Comments or suggestions? Interested in sponsoring an episode? Email us Feedback@TheMebFaberShow.com

 

Links from the Episode: 

 

Transcript:

Meb:

Catherine, welcome to the show.

Catherine:

Thanks for having me.

Meb:

We’re going to dive into a bunch of things, but you guys had a quote that perked my ears up. You said, “This is the best relative asset allocation opportunity we’ve seen in 35 years.”

Catherine:

Yeah.

Meb:

What do you guys mean by that? That’s quite a statement.

Catherine:

Yeah. So first, important words are relative. So it’s a best relative opportunity in the sense that, hey, we think we can do a lot better than a passive 60/40 stock-bond portfolio. The relative is the ability to outperform. And asset allocation is saying, “We can outperform by picking the right asset classes.”

So why is it the best relative asset allocation opportunity in 35 years? Well, first, when we look across asset classes, we can find assets that we like in every asset class. There are things to buy everywhere. And at GMO, the way we decide that we like something is by looking at its valuation. How attractively priced is this asset today? How much can it deliver on the promise of future returns? In every area, equities, bonds, credit, currencies, we can find things that are cheap and attractive.

Second, we find very wide dispersion across asset classes. We find some asset classes that we like a lot better than other asset classes. So by not holding one, and holding more of the other, you’re getting a good relative opportunity. Areas where we see great relative opportunities today, we prefer non-US stocks relative to US stocks. We see much better valuations there. We prefer value stocks to growth stocks. In fact, we see some of the widest relative opportunity between value and growth that we’ve ever seen historically, and we particularly favor deep value, the very cheapest stocks.

Finally, we see a lot of dispersion in currencies. You’ve got the US dollar close to all-time peak expensiveness, but you’ve got other currencies, the yen, the euro, the pound, looking close to all-time cheapness. So by leaning in to those things that we like a lot, the non-US markets, the value stocks, the cheaper currencies, we think we can outperform a traditional portfolio by quite a lot. We do this quantitatively, by comparing our forecast today for this portfolio focusing on these better relative opportunities, to just a classic passive 60/40 stock-bond portfolio. We measure how good that performance opportunity is. We’ve been looking at this for 35 years, and we see it as the best we’ve seen in 35 years.

Meb:

Well, that’s exciting, but I’m going to play devil’s advocate. Say I’m a listener, and I say, “All right, Catherine, we’ve heard about GMO people on Meb’s podcast before. We’ve heard Meb say not too dissimilar things. And you know what? I’ve just been chilling out in SPY, which since the bottom of the GFC has been printing me money at 15% a year. And you know what? In the last couple of years I said, ‘That’s not enough. I’m moving to the Qs.’ So I put most of my money in NVIDIA and Facebook and Apple, and so I look like I really know what I’m doing. Why should I listen to you guys? Because it seems like my Sharpe ratio of one is cleaning y’all’s clock.” How do you respond to that?

Catherine:

You’ve had a beautiful decade. To this hypothetical investor, that has been a brilliant decade. But my first piece of investing advice is, when you’re looking at what to hold today to find something that’s going to perform for the next 10 years, you shouldn’t really necessarily be focused on what has performed for the prior 10 years. You have to look at the fundamentals of the asset today and the valuation of the asset today.

So two concerns I have about your favorite asset, be it the S&P 500 or the NASDAQ, whichever index you’re liking the best right now. One concern I have is it’s looking really expensive relative to history. So it’s had a brilliant decade, but it’s got to the point where it is pretty expensive. One metric we like to look at for expensiveness is a Shiller P/E ratio, a cyclically adjusted P/E ratio. It smooths out some of the volatility of earnings and fundamentals, and that Shiller P/E ratio, price-earnings ratio for the S&P 500 today is about 34. That’s in the neighborhood of all-time highs, maybe top 1% relative to history. It’s a dangerous time to buy into that asset. The NASDAQ has also recently re-hit close to all-time highs. So both are looking pretty expensive.

The second concern I have beyond valuation is both of those indexes are looking very concentrated. You’ve got the top names in the index taking up a lot of share of the index. One thing investors love about indexes is that they’re a diversified group of stocks, it’s a way to buy the whole market, but today you’re getting a lot of exposure to those stocks that folks have called the Mag Seven, the Magnificent Seven stocks. They’re taking up a lot of share of your index and you’re getting a lot of specific risk for those assets. You’re also buying an index at a point where the concentration has been rising for a full decade. So my advice would be, now’s a good time to take those profits and invest in something that looks cheaper today. Pivot a little bit in your portfolio.

Meb:

One of the big key understandings, I think, for investors is, you don’t have to accept asset classes prepackaged. So when you think of US stocks, it doesn’t have to mean S&P 500, or market cap weight, or SPY. That’s not the only menu on the buffet. When you go to the buffet, hey, you could get the sesame chicken, you could get anything you want. So we did a tweet that was inspired by some of the work y’all did this past week, where we said, “Look, you want a way to beat the S&P[over the last 50 years, all you have to do is take out the top stock, or even the top 10. It doesn’t even really matter. It’s just you move away from this market cap weight, which often is the more expensive things and the heavier things, and you outperform by 30 basis points just for doing that alone.”

You guys had a piece, it’s called Magnificently Concentrated, in the Q-on with Ben and John, and you guys talked about this top-heaviness. Maybe drill in a little bit about this opportunity.

Catherine:

What you just mentioned, we did directly point out in that paper. That over the very long term, but by avoiding the top 10 largest names in the index and owning the other 490, you would’ve outperformed. You would’ve outperformed over a 50-year period. The past decade has been an anomaly, where those top 10 names have outperformed everything else, and that has been because of this rising concentration. The S&P 500 has gotten to the point where it is today magnificently concentrated, because in a stark difference from history, those 10 names just got bigger and bigger throughout the decade.

That means several things. One thing it means is it’s been a really tough time for active managers to outperform. So when you’re in an environment where the very largest stocks in the index are consistently getting larger, active managers, who almost by definition don’t hold those larger names, they’re holding the names that they find most attractive, they’re going to struggle to outperform.

One feature of the decade has been, it’s been a rough decade for active management in US markets. I think going forward it’s going to be a lot more attractive for active management. Another is, at this peak concentration level, you want to think about holding different things. You want to think about things you were just mentioning, Meb. You mentioned quality, value. Both of those I think are brilliant ideas. Quality, we think of that as an assessment of the company’s underlying fundamentals. How profitable? How consistently profitable? How much is this company relying on leverage? We hope not very much. So a high quality company is profitable, consistently profitable, and does not need debt to fuel its profits. That is always a wonderful factor to look for. Consistently it has worked beautifully, and today, you don’t have to pay a premium at all to get a higher quality portfolio. So you absolutely should. You can get a little free downside protection by having a quality portfolio.

Another thing to look for is value. In the US equity market we see value, and in particular, the deep value cohort, the cheapest 20%, as truly dislocated in the equity market. It is close to as cheap as it has ever been, top decile cheap. So try pivoting a little bit toward value. We also see opportunities in small-cap as well. So doing something a little bit different from the S&P 500 today seems to be a great way to play it.

Meb:

The chart of exhibit two in that magnificently correlated piece is such a telling chart. This is the top 10 stocks in the S&P 500 versus the other 490 equally weighted. What this looks to me, you can see that this has underperformed almost 2.5% per year since the 1950s. 2.5% per year would make you the best mutual fund manager in the world if you created that alpha problem. This is why it’s hard, and this is why investing in general is so hard, if you have these face-ripper periods. So you see this chart, and you see, “oh, man, I could totally do that. I could totally invest in this portfolio and garner this alpha juice every year,” but you have these periods.

Look, the entire ’90s looks like a period. You have parts of the ’50s and ’60s, but even more importantly, this last decade, where it says buying the top 10 is outperformed, instead of underperforming, the top 10 is outperformed by 5% a year, which is a monster amount. So every once in a while you get these little face-rippers that cause everyone to get hot and bothered for the big dudes and rinse, repeat before they go back down.

Everyone listening to this is probably going to ask the same question, because I know, because I get it all the time on Twitter. They’re going to say, “Catherine, great. You probably would’ve said this with Meb last year or the year prior. How do I know when this is going to turn?”

Catherine:

Well, you just pointed out two times historically where investors have been punished by loading into the top mega-cap stocks in the index. The ’70s, which we would think of today in hindsight as a nifty 50 stock market bubble, so in the midst of a stock market bubble, and then also the ’90s, which today we call the tech bubble or the dot-com bubble. So if you do look back to history, if you were to pile in to the top winners of the prior decade, either in that mid-70s period or the late ’90s period, it would’ve been disastrous for you in the subsequent period. So I would say in terms of looking at a decision factor, just that alone should guide you that, “Oh, given that we’ve just had a phenomenal decade for these top 10 stocks, I should probably be rotating it away from that today, if history is any guide.”

Now, what’s the catalyst that’s actually going to cause things to turn around? That is an incredibly difficult question. Today we have the benefit of hindsight. We can look through history, we can look at the tech bubble, and even with the benefit of diagnosing with hindsight, can you tell me exactly what was the catalyst that caused that tech bubble to pop in 2000? I really can’t.

Meb:

We love to come up with a narrative after the fact and it becomes obvious perhaps, but sometimes it’s just gravity, and weight, and shift. It feels like some of the narratives are already shifting. We’ll come back to that later. But, agreed, it doesn’t have to be one, at least in real time.

Catherine:

I think what you said about gravity makes a lot of sense. Eventually stocks can’t live up to the amazing promise we expect for them. Investor expectations are just so high that you can’t meet those expectations, and you see those perhaps very good companies just fall under the weight of too high investor expectations.

Meb:

All right. So you guys like value. You like quality. You guys have a particular asterisk next to that, which is interesting because you say not just value, we want deep value, the deepest of all values. What does that mean? And you guys aren’t a small boutique investment manager, you’re a pretty big shop, so it’s not like you’re buying five stocks, but what does deep value mean to you guys? How do you guys think about it or define it, and why is that so much better than just regular old value?

Catherine:

When we think about value, typically we are talking about the cheaper half of the market. And typically when we say growth, we mean the more expensive half of the market. So two halves of the market, value and growth. Well, we’ve started to take a finer comb at this value cycle and say, “Well, what if we looked at smaller, more defined segments of the market?” For example, what if instead of just looking at the cheap half of the market, we look at the cheapest 20% of the market?” Then we’ve got deep value, but there’s still that 30% of value stocks that’s not accounted for in the deep value. We’ve decided to call that shallow value. So you have two components in your value universe, deep value and shallow value. And when we look at those two components in the US, it’s pretty fascinating. If you just look at the value, cheap 50%, it looks cheap in the US. It looks very cheap.

But if you then split it into the deep value, the cheapest 20% of stocks, and the shallow value, the next 30% that completes the universe, that deep value is top decile cheap versus history. It’s only been cheaper a handful of periods than it is today. Whereas those shallow value stocks, they’re actually trading expensive relative to their own history. So a pretty big difference there, as cheap as it’s ever been, versus actually, those shallow value stocks in relative terms, relative to the market, are trading quite expensive relative to history, maybe top 20% relative to history. That’s a pretty big difference, and that’s why we’re so focused on deep value today. We actually think you don’t want to hold those shallow value stocks at all. They’re not really cheap.

Meb:

That’s a great point. My ears perk up anytime I hear the word top fractal of anything, but decile really gets me excited. Means there’s an opportunity. We did a piece last fall called basically, if you’re not going to do value now, you’ll probably never do it, because this is about as stretched… can’t ever say as stretched because things can always get nuttier, but historically, this is about as stretched as it gets.

Now, there’s also an overlapping Venn diagram, maybe the first cousin of value and quality in the US, and that’s our friends outside of the US borders. So foreign stocks, emerging market stocks. Talk to us a little bit about the opportunity there. Can we get away with just buying EFA and EEM, or is it a similar situation where the value opportunity is interesting there in the deep parts of the pool too?

Catherine:

Yeah, I think value is just too cheap to ignore it outside the US. In general, we think markets outside the US are on average cheaper than markets in the US. So already you’re getting a benefit by going outside the US. But pretty much everywhere you look outside the US, value’s pretty dislocated. In the developed markets outside the US on average, such as the UK, Europe, Japan, we’re finding deep value to decile cheap there as well. So that’s an opportunity you do not want to miss.

Now, that shallow value group, the next 30%, that’s pretty cheap as well outside the US, but I’d still get into the deep value. When value wins, deep value always, always wins by more, and value is priced incredibly well. So you should just go for the full deep value punch, both in the US and outside the US.

Meb:

Cinnamon is squishy and narrative’s flows are less squishy, and we’ve been talking about global investing for quite some time, but we started to see a shift, a disturbance in the force, if you may, where people are, A, starting to talk about foreign a little differently. And it feels like this. The quant in me pays no attention to this, but the emotional side of my brain, it feels like there’s been a shift. But particularly when it comes to, say, Japan, it feels like the narrative has really shifted hard. Being at all-time highs again I think probably helps drive that as sentiment tends to follow price.

Do you feel like this is becoming a consensus view at all, or is it just the weirdos, you and I, that may be seeing this opportunity and looking for confirming evidence? How do you feel as you have conversations with some of the world’s largest investors? How’s the conversation? Were they still angry when you brought up foreign and emerging?

Catherine:

Japan is certainly one where I’ve seen a change in sentiment from institutional investors. At GMO, we’ve liked Japan for a long time. The valuations are pretty reasonable. Value has been quite cheap in Japan, so you get a little extra. Today the yen is at an all-time low. There’s a lot of reasons to like going to Japan. Additionally, we think there’s this extra tailwind in Japan as stocks and companies have been becoming a bit more shareholder friendly. They care a little bit more about the return on capital they give to shareholders. They’ve been encouraged by the governments to care about that. So we think there’s this additional tailwind of return and reform there.

I’ve been telling that story to our investors for quite some time. We’ve had an overweight to Japan in our portfolios, and I would say in the past year I’ve seen them perk up and want to engage in the discussion more. What is causing that sentiment to change? I’m not sure, but it certainly doesn’t hurt when Warren Buffett gives something his seal of approval.

Meb:

Oh, you stole my punch line. I was getting ready to say, when Omaha comes to town I feel like that definitely perks people up.

You mentioned currencies, which are hard. You already said the number one worst thing to say earlier, which was CAPE ratio, but now you also mentioned currencies, which I feel like are more confusing than anything for investors. When you guys do your asset class forecasted expected returns chart, which people love to talk about because there’s a pretty wide spread, and at least my pet favorite, emerging value, seems to be one of the leaders in the locker room, you also talk about how currencies may play a role. What do you think about that?

Catherine:

Well, when you look at our 7-year asset class forecast, which we post online, two things to know. One, is they’re done in real terms, so they’re a forecasted return above inflation, and two, local currency. We are showing local currency returns. It’s not from a US dollar investor point of view. Now, normally that’s a wonderful thing, particularly for GMO, or a global investment management firm. So I can be talking to investors in the UK, in Australia, in Canada, in Europe, and these forecasts are equally relevant to everyone. So in the standard view of our forecast, we’re not including any expected return from currency at all.

Typically, I think that is perfectly fine. Generally we don’t have a very high expected return associated with a currency component of your investment in non-US equities, because like you say, there’s a lot of volatility to currencies, and typically you’re not necessarily projecting a very high or low, positive or negative return from the currency component. But we do value currencies in addition to equities, rates, and credits, and we are using a valuation-based approach. So we are expecting over the long term that currencies will revert to some sort of fundamental fair value, a purchasing power parity type fair value, kind of like the Big Mac Index. For most currencies, I’d say the thing that we do differently is we assume a much longer mean reversion horizon for currencies. What we’re trying to say by that is, we think that generally valuation is less powerful for currencies than it is for other asset classes, except at extremes. Once you get to extremes on currency valuations, valuation can be quite powerful.

Today is one of those extremes. The US dollar is close to all-time highs, other currencies are correspondingly cheap. So now is the time you should be considering currencies as you’re making decisions about where to allocate your equity dollars. Because investing outside the US, you can get an additional tailwind from currency return, I’m going to say on the order of two to four percentage points of additional return.

You can earn that in two different ways. One, I would call the easy way, currencies simply appreciate, and as an US dollar-based investor, you would get that additional return. But even if currencies don’t appreciate, you have a second way you can win by investing in companies in cheap currencies. And that is simply that companies in consistently cheap currencies, if the currencies don’t appreciate, tend to have a higher earnings growth. They’re able to take advantage of being the low-cost producer. So two ways to capture that additional tailwind from currencies. And I’d say today, currencies are cheap enough that you should consider it when you’re choosing where to invest your equities.

Meb:

So to frame where I should be traveling in 2024 and 2025, what currencies are most undervalued relative to the purchasing power if the US dollar is up there? Are there any countries that come to mind in general? I think Japan just hit 155?

Catherine:

I would say anyone who doesn’t use the word dollar in describing their currency. I’d skip Canada, I’d skip Australia, I’d skip New Zealand, but every place else is looking cheap. Go to Japan, go to Europe, go to the UK. Go to some emerging market countries, enjoy them all.

Meb:

Most investors, US focused, 60/40. We talked about pivoting towards value. We talked about moving to foreign and emerging in value there. What should investors think about bonds in general? Fixed income? We can even tie in some real assets. You guys don’t talk as much about real assets, but bonds usually mean one thing to investors, in my mind. It means two things in the US. They either do some sort of Treasury ladder, so they put all their money in TIPS, or they buy 10 years, or they just buy the AGG, or something like a bond aggregate, which is half government bonds, a quarter of corporates, and a quarter of agencies, maybe-ish. But the world’s also your oyster when it comes to fixed income. We have 5% all of a sudden again on T-bills. What should people think about that giant bond component now that we’re no longer in the ZURB world?

Catherine:

Thank goodness that bonds are now ownable. For many years we actually thought that bond yields were so bad that they couldn’t give you any of the promises that bonds have in your portfolio. If you roll back to 2021, so pre-2022, and you were considering, should I buy a US 10-year Treasury? Yields got down to 1%, below 1% nominal yield. At that level, the bond can’t give you depression protection because the yield has no place to fall in an economic downturn, and it can’t give you real income, because it is unreasonable to expect inflation to be lower than that over the long term. So for a while, Treasuries were simply unownable, untouchable, and now you can happily buy a 10-year Treasury and hold it in your portfolio. So first of all, traditional government bonds are absolutely ownable in your portfolio.

If you move down the line, you mentioned the Bloomberg Aggregate, and there I would say the next group of assets that you would look at would be the corporate bonds. So bonds of corporations. And corporate credit spreads are really tight. You mentioned things that get you excited, Meb, when it’s top decile relative to history. Well, corporate credit spreads, both investment grade and high yield, are bottom decile relative to history. They’re really quite tight. So I’m not sure that corporate credit is where you want to spend your fixed income dollars. Treasuries are ownable, corporate credit I’m feeling a little bit less excited about.

Then you mentioned agency mortgages, which tends to be our least favorite segment of the structured credit market. What are agency mortgages? They’re mortgages like you and I would have on our house, but they’re guaranteed by the government. And because they’re guaranteed by the government, they typically offer you basically no spread whatsoever, and so they’re not terribly interesting. The spreads on agencies did pop out recently, so they’re actually paying you at some points in the curve something above Treasuries, which is better, but typically our least favorite part of structured credit. I would not ignore structured credit though, you can do so much better than what’s in the aggregate.

There’s a lot of other things to own. There’s non-agency mortgages, there’s commercial mortgages, there’s collateralized loan obligations, there’s asset-backed securities, there’s student loans. That is one of my favorite areas of the credit markets. It offers better spread than corporate credit, and it is an incredibly fragmented marketplace. So those little dislocations that you were just mentioning that you quite like, when things are at extreme relative to history, they pop up in segments of that market all the time and there’s a lot of opportunity to take advantage of it.

So if I had to pick some favorites, all within the US fixed income space, I would say go for Treasuries, have that nice safe piece of your portfolio. And then in credit, I’d say take a broader look at structured credit than just agency mortgages.

Meb:

One you didn’t mention was TIPS. I did a fun poll. I don’t think anyone really understands TIPS, because I asked, “At what point would you sell your stocks and buy TIPS at various real yields?” And most people, I think, said never, or something like 8% real yields.

Catherine:

I would buy them at 8% as well.

Meb:

Jeremy was on a podcast recently where he was talking about TIPS in the late ’90s, after they got introduced, were trading at 4.5 real-

Catherine:

Amazing.

Meb:

… or something like that, which, listeners, today I think it’s maybe 2 1/4, which isn’t bad.

Catherine:

Yeah, which is pretty good because that’s a straight return above inflation. So I’d say TIPS and nominal Treasuries, they’re looking similarly attractive, and definitely be happy to buy the TIPS. They’re not part of the Bloomberg Aggregate Index, which is another reason to ignore that index because there’s many wonderful things to buy in fixing outside of that index.

Another area that’s outside of the Bloomberg Aggregate Index that we’ve liked quite a lot through history, and even today, is Emerging Country Debt. So debt not of the US government, but of non-US countries, emerging market countries. They pay you a really lovely credit spread to bear the risk of default over time, and they’re also on the market with a lot of opportunity for active return. The spreads have gotten a little bit tight, but they’re still pretty attractive in Emerging Country Debt. So another area outside of that Aggregate Index to consider for your portfolio.

Meb:

I was just looking up Chinese bonds, because as we all know, China stocks have gotten pummeled. What are they, down 60% or something? But Chinese bonds have done, to my knowledge, not so bad.

Catherine:

Yeah, I would not advise buying a lot of Chinese debt, just because it doesn’t pay much spread.

Meb:

Where do you go to find the spread?

Catherine:

Probably places that you would not want to go to or you’ve never heard of. So the areas where the Emerging Country Debt team at GMO won by the most last year, some areas where they won a lot, were Argentina and Venezuela. Which is usually not how you start a conversation getting someone excited about something, but they made massive alpha by being in those markets and assessing those risks of those markets that other investors perhaps don’t want to invest in.

Meb:

One of my best angel investments ever was in Venezuela, so the world is your oyster, listeners.

Catherine:

Yep. Go where others fear to tread.

Meb:

All right, so we’ve been cruising around the world. So TIPS is a real asset, but how do you guys think about other real assets? That could be REITs, real estate. Jeremy calls them R-E-I-Ts, by the way, which I’ve never heard before. I say REITs. But so REITs, TIPS, and gold are hitting all-time highs. Anything else in the commodity or commodity equities complex? Are those areas an interesting part of a portfolio or particularly tackily right now?

Catherine:

On those choices, TIPS, definitely yes, we just talked about it. That’s a good place to invest in your portfolio and it’s absolutely a real asset. It’s giving you a real return and it’s well-priced. REITs, I’m less thrilled with as an asset. Their yields have gone up from all-time lows, but still not incredibly attractive. And we’re a little bit cautious about REITs as an asset class at any rate. The only time GMO has ever taken a big bet on REITs is when they were offering double-digit yields. I would say that was in the early 2000s. So it’s pretty rare for us to like REITs, but we’re not close-minded to it. No asset is uninvestable, just you have to find the right price, and the REITs are not offering you the right price today.

As I continue to go, gold I would be a definite no on, at all-time highs. That stock price looks like it’s gone parabolic so far this year. So as a valuation-based investor, you’re more inclined to be short than long. But then your last suggestion, which was something like commodity equities, so resources equity, that’s something we love. Over the long term, commodity equities have given you the diversification of commodities, with the equity risk premium of equities. So that’s a pretty magical asset right there. And they’re awfully well-priced today. There is one place that our Resources Equity team invests in that I think it’s overlooked, and again, like you said, you love a good dislocation. It’s a great dislocation today. That’s clean energy. Clean energy has gotten incredibly cheap. These are effectively growth stocks that are trading at deep value prices.

So all those assets you just offered me, on the safe side, I would buy the TIPS, and on the, “Hey, I’m going for return,” side, I would buy the resources, the commodity equities, and I’d tilt a bit into the clean energy right there. Not as an ESG play, but as a pure, “Hey, I’m going to make a lot of money,” opportunity.

Meb:

I like the sounds of that. I don’t know if anyone’s mentioned something quite like that recently on the pod, so listeners, dig in. What have we left out as we travel around the world? I feel like we’ve covered most general things. You guys do a little bit of shorting, I believe, but are there any other tactics, or things that we’ve skipped over that you guys are thinking about?

Catherine:

We do from time to time use a lot of liquid alternatives, hedge fund type strategies, and those look pretty great today. Hedge fund type strategies often will offer you cash plus return. Cash is looking pretty good. And the plus, which is that relative value opportunity, that’s looking pretty attractive as well today.

So as you can guess from what I’ve said some of my favorite ideas are today, our favorite idea in liquid alternative or hedge fund space is a long deep value, short expensive growth strategy. Getting cash plus a wonderful relative value spread, that’s a wonderful place to be invested. It has the beauty of equity-like return prospects with no correlation to equities.

Meb:

As people try to process everything you’ve been talking about today, which is a lot, what do you think of the big muscle movement, if you’re like, “All right, listen to the end of this podcast. I got to have one takeaway from a traditional 60/40 person.” Is it, hey, lean into value in the US. Does it look foreign? Is it more on the fixed income side? All these things obviously are additive, but if you had to say, “Look, we’ll just pound the table. One thing you got to think about today, Mr. NVIDIA…” What is it?

Catherine:

You can sum everything you just said up in one sentence. Be willing to buy something other than S&P 500.

Meb:

I love it. We got some show note links we’ll add, listeners, a whole host of resources, papers from GMO, as well as some other firms on this topic that I think is pretty interesting.

What’s a belief that you have, and it could be current or it could be timeless, that 75% of your peers don’t agree with or think, what she’s got to say is silly, that doesn’t make any sense?

Catherine:

That’s a pretty easy question for me, actually, because often I’m invited into the room to be the contrarian, to think something different and to do something different. In fact, I’ve had a number of asset class forecast debates where I’m specifically brought in as the person who thinks differently.

In the type of atmosphere you’ve mentioned where, hey, we’re all sitting around chatting and we’re debating, the conversation often moves in the direction of short-term predictions. So, “What do you think is going to happen to inflation this year? How many times is the Federal Reserve going to cut rates? How bad is conflict in the Middle East going to get? Who’s going to win the US presidential election?” And I think the belief I have, or the thing that I would say is contrarian is, “Generally it doesn’t matter and that’s not a good space for me to spend my time.”

Those things are incredibly difficult to predict with consistent accuracy. And even if you can predict these types of things with consistent accuracy, it doesn’t matter at all for long-term asset values and returns, and I’m not even sure it matters that much in the short term. It’s hard to make money that way. So I think a lot of times you’ll find multi-asset managers, macro managers, investors, debating, chatting about these topics, and I don’t think that’s the best use of our time and effort.

Meb:

What a wet blanket. I was hoping you were going to go down the list, tell us who’s going to win the election, tell us what the Fed is going to do.

Catherine:

Yeah, that would make for a good podcast, but I’m just not sure it’s a good investment strategy. So I guess I am contrarian, that sounds like.

Meb:

It’s such a dislocation between what people talk about all day on TV, what people spend most of their time just spinning their wheels about, which is these things, A, they can’t control, B, that are largely unknowable. And if you look at the long history of forecasting things, even by the Fed, of interest rates and the path and direction, they don’t know. So why do we spend all of our time focusing on these narratives and stories?

As you look back at your career, this could be at GMO, could be elsewhere, what’s been your most memorable investment?

Catherine:

I, like you, love weird market events, anomalies, dislocation, bubbles. Bubbles are one of my favorite things. So I’d say memorable investments are always ones that come out of a market dislocation or a bubble. My favorite investment is the one that we’re playing today, which is a long deep value, short expensive growth dislocation strategy. I guess there’s maybe a little recency bias there, but I love this strategy. It was born out of this massive value growth dislocation that we really identified in 2020. Things had gotten out of control. So you’ve got the bubble element there.

The act of designing a strategy around a top-down idea is pretty fascinating. How do you actually put together a portfolio to make money from your investment thesis? That’s great. I also love this investment strategy because it has been equity-like returns, and we think forecasted equity-like returns, with no correlation to equities. Completely different pattern. So value versus growth was up 17% in 2022, when equities were down 17%. You’re getting something different. And finally, it’s got a lot further to run. A memorable place to look for investments is always your big bubbles, your big dislocations.

Meb:

Mine was certainly the late ’90s. I have so many memories, and the podcast listeners have certainly heard me drone on about all the different stories. There’s probably another dozen that I’ve never even told before. 2021 was at the peak of craziness, February. Our old thread wad to the show notes called what in carnation of just all the crazy stuff.

Catherine:

Yeah, meme stocks, 2021.

Meb:

Yeah. I never thought I’d see anything quite like that again, and that was pretty loony tunes. But that’s what creates the opportunity set, and that’s what creates the dislocations of course. Do you see any other crazy bubbles around the world today, or anything that’s particularly nutty, or something we should avoid in that regard?

Catherine:

Well, we mentioned it. You mentioned NVIDIA. AI, artificial intelligence, has gotten a little bit nutty. It seems to be a little bit like the fervor, the fear of missing out that’s a bit like the euphoria, you’ve been mentioning it. That’s a little bit crazy. Also, briefly, you mentioned it where you mentioned the price of gold, but commodity markets are going pretty haywire as well. It’s not just gold, it’s cocoa. Watch the price of your favorite chocolate bar. These things are going through the roof. So you’re definitely seeing weird things across markets.

Meb:

Dandelion chocolates, have you had that? They’re my favorite.

Catherine:

No. But I do love chocolate, so I’m surprised you’re mentioning a chocolate I haven’t eaten.

Meb:

This is the best chocolate, hands down, across the board. I willingly pay 60 bucks, I think… It’s like, once a quarter they send a handful of bars. They’re not cheap, but I think it’s the best chocolate I’ve ever had.

Catherine:

Keep your eye on the price because cocoa has more than doubled year-to-date, so you’re going to be paying more for your-

Meb:

I think it’s more than that, isn’t it? I don’t know where it is. It makes NVIDIA look like a T-bill. But it’s funny because I was talking about this on Twitter. You’ve seen some of these old school trend followers, these managed futures guys. There’s some that have been around since the ’80s, and they’re particularly near and dear to my heart, because as with so much of the investing world, when you get bigger, the temptation to become a closet indexer and collect fees is high. And you guys don’t do that. You guys are willing to be concentrated, weird, and different. But the managed futures folk, which had a very long fallow period post-GFC for probably a decade too, but some of these old school guys are very DGAF, they don’t care. So they still have these highly volatile concentrated weird portfolios.

Two in particular we mentioned on Twitter, Mulvaney and DUNN, I think in February and March, put up something like back-to-back 40% months up each. 40% each in February and March. I love to see it. They’re not low vol, and it’s like the hedge fund cowboys of yore to see some of these old school trend followers. But I imagine not a trivial amount of that was cocoa. So you can help blame them for the dandelion being 60 bucks or whatever it is.

Catherine, it’s been a lot of fun. Where do people find your writings coming up, your prognostications, what you’re up to? Where’s the best place to go?

Catherine:

Everything’s on gmo.com.

Meb:

Piece of cake. Catherine, thanks so much for joining us today.

Catherine:

Thanks for inviting me.

 

 

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