I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Sunday Planning, I plan for the week ahead.
My monthly portfolio update day is tomorrow. The day before that each month, I review charts for all my positions and for any positions I’m thinking of entering. Then I decide what to buy, hold, or sell.
I currently am worried that U.S. large and small caps are in a bubble, and so I’m tilting away from that.
In the terminology of Ben Inker writing in GMO’s quarterly letter It’s Probably a Bubble, But There is Plenty Else to Invest In, I may be an “agnostic investor”:
I think most people can admit that there may well be a bubble in AI and related stocks today…. It certainly looks like a bubble to us, although I don’t believe I’ll convince any true believers in the AI version of “this time it really is different” of that fact. This letter is not written for the true believer, however. It is written instead for the “agnostic investor.” Such an investor is one who recognizes that there is plenty of evidence indicating we are in a bubble, but also harbors a belief that, despite evidence, a decent starting assumption is that all assets are priced to deliver a normal return at all times.
That means even though I believe we are in a bubble, I also believe that there are good reasons for the prices of current assets — that they represent the potential for a “normal return” going forward not necessarily some immediate burst and loss of capital.
Fortunately for me and other agnostic investors, there are plenty of places to invest other than in the alleged bubble:
Bubbles are usually a problem for the agnostic investor, but some bubbles are more of a problem than others. The good news about today’s bubble is that it’s one that allows an agnostic investor to build a portfolio that can strongly outperform if there is a bubble that ultimately bursts, and can also do just fine if all assets deliver normal returns.
What he’s saying is that even though U.S. equities show potentially poor forward returns based on their high valuations, there are plenty of options with lower valuations but similar risk profiles that likely will provide good returns over reasonably lengthy time frames (five and ten years).
Inker shares a chart that shows expected returns based on valuations at the height of the Internet bubble in June of 2000, a time, he suggests, that showed opportunities like today to reduce risk to a portfolio of a bubble bursting without reducing the probability of good forward returns:
Note how the forward expected return for U.S. Large Caps at the time was negative, whereas many asset classes had a much more promising outlook. This structure of market valuations provided a good way for agnostic investors to achieve good returns without depending upon the bubble’s continuation.
By moving away from U.S. large caps and diversifying into a portfolio made up of the asset classes with lower valuations and better expected returns, an agnostic investor could protect themselves from losses if the bubble burst. This is what GMO did, to good effect:
At GMO, we had no doubts in our minds that the 2000 bubble was indeed a bubble. We moved our asset allocation portfolios aggressively away from U.S. large caps and toward the cheaper assets accordingly, within the bounds our clients allowed…. Our Global Asset Allocation Strategy was therefore able to outperform the 65% Global Equities/35% U.S. Aggregate Bond benchmark by over 10% per year from 2000 to 2003, making money in real terms during the S&P 500’s bear market, while the 65/35 benchmark fell by over 27% after inflation. By the time the traditional 65/35 portfolio regained its 2000 peak in real terms at the end of 2005, our strategy was up more than 50%, an annualized net return of 7.3% real.
The current risk/reward tradoff chart looks similar to that of 2000. Inker suggests that an equal-weighted portfolio of risk assets offers a much higher expected return that MSCI World, which is market cap weighted, and therefore includes very large allocations to U.S. equities.
Inker continues:
Value stocks everywhere are very cheap, and in the U.S. and EAFE markets, deep value stocks are trading at some of the widest discounts on record. Non-U.S. small value stocks are also attractive, particularly in Japan, where they benefit from both a very undervalued yen and the opening of the market for corporate control. Liquid alternatives benefit from decent yields on cash and wide valuation spreads across various asset classes, and government bonds are priced to provide capital gains in a recession and a decent yield if the global economy holds together.
This situation is different from the everything bubble before the Great Financial Crisis and the 2021 “duration bubble” Inker notes. During those time periods, there weren’t good alternatives to investing in bubble-icious parts of the market while maintaining a good forward return outlook.
What does this mean for my portfolio update? It suggests a tilt towards asset classes with lower valuations: moving away from the S&P 500, the NASDAQ composite, and possibly U.S. small caps which are looking more overvalued lately and instead leaning towards non-U.S. stocks especially value stocks, emerging market equities, and possibly bonds. I’m already doing that in my non-retirement portfolio but it might be time to do it even more aggressively, to lock in my gains in U.S. equities while positioning myself for less risk of capital loss should the bubble burst.
My portfolio is already leaned away from U.S. equities: I hold a variety of emerging market ETFs, a large position in gold, a bond position in TIPS, an international small cap value ETF, and a variety of other international ETFs. I think I may simplify this, and I’m glad to have Inker’s quarterly letter to help guide me.