This is where a fund manager says you should look for stock market trades

Last week’s stock movement showed investors’ concerns about high valuations. One fund manager said these concerns are reasons for restraint Investopediabut not the alarm.

“High valuations offer lower expected returns and higher risk than fair-value or cheap markets,” John Thorndike, a portfolio manager at GMO, said in an interview with the magazine. Investopedia. “Although valuation is not a great short-term indicator of market movements, it is not surprising that an expensive market can decline with the slightest whiff of investor anxiety.”

One way to deal with valuation anxiety, and the growing chorus of investment professionals warning of a potential market downturn, is to invest away from high-priced stocks. The GMO Dynamic Allocation ETF (GMOD), an actively managed strategy that turns to asset classes that offer relatively higher returns as suggested by its valuations, aims to facilitate this.

The fund, which launched in October, is the latest from GMO, co-founded by veteran value investor Jeremy Grantham, who predicted the dot-com bust and financial crisis of 2008. Grantham’s investment wisdom — that all asset classes eventually return to their historical means — underpins the strategy through the firm’s asset class outlook, which forecasts potential real returns over a seven-year horizon.

For example, US large-cap and small-cap stocks were expected to have negative returns as of the end of September.This explains the fund’s low weight in US stocks.

The fund has about 60% of its assets in stocks and 40% in bonds, says Thorndike, who runs the fund with Ben Enker. Currently, it is biased towards quality and value stocks, both in US and non-US stocks, overweight in Japan, emerging markets excluding China, and medium-term bonds.

Modified version of Investopedia Below is an interview with Thorndyke.

Q: What is GMO’s vision for the market now?

Thorndyke: This [market] It’s not like 2007 or 2008 when everything was so expensive and you needed to hide in safer assets. Today, you only need to avoid the most expensive part of the market, but otherwise it can be fully invested.

In the US, growth stocks, and certainly some AI-related stocks, come with very high valuations and expectations. This is the part of the market worth avoiding, or at least underweight depending on your risk tolerance, while value stocks in the US are trading at almost as deep a discount as we’ve seen before. We see opportunities in the US and abroad, with the highest expected returns outside the US.

Q: Is there anything that has happened this year that gives you conviction that relatively low-value stocks or high-quality stocks will outperform despite the current risk-fueled rally?

A: The Great Six [GMO says “Tesla doesn’t make the cut on Magnifence”] The company has continued to deliver impressive fundamental returns, and its ability to do so has already paid off for investors.

What has changed? These companies were often considered undercapitalized. They had significant free cash flow. They didn’t have to make a lot of investments in their business. Now they are all investing a lot of money in real world investments, building data centers, etc. Those capital expenditures would have to earn a significant return to justify their valuations, and that’s a change in what you need to believe about those stocks from here, compared to what they’ve delivered over the past few years.

Q: Have there been any kind of shifts in allocation recommendations around Fed rate cut expectations?

A: This has not been a big driver of portfolio changes this year. The job of fixed income is to earn some income and help protect you in the event of a bad economic event where you expect stocks to decline. The higher the yield, the greater the opportunity for fixed income to perform these functions.

Today, you have a real return over 10 years [Treasury] This is between 1.5% and 2%, which is perfectly acceptable. If the Fed lowers interest rates to the point where you no longer get that yield, fixed income becomes less attractive. Remember when the 10-year yield was trading at 60 basis points nominally? Well, it basically doesn’t give you any income, and has never had any chance of appreciation. In that environment, we did not have a fixed income term, whereas today we have the equivalent of a few years.

Q: It appears GMOD is split into 60% stocks and 40% bonds. This is considered neutral in terms of equity exposure since the ETF can own up to 40% or up to 80% of the stock.

A: Because our equity book looks markedly different from the value-weighted index, we feel comfortable having a normal weight in stocks. The stocks we own offer an attractive risk premium relative to bonds, unlike the expensive parts of the US stock market.

Q: Which corners of global stock markets look most attractive at the moment?

A: Japan is a particularly cheap country, and we have a significant amount of our investment portfolio there. It’s a market that many investors ignore, or at least shy away from, because it has delivered very poor returns on capital for too long. They have seen improved returns on capital and shareholder friendliness from management teams and policymakers. Of course, as a US investor, you can buy into the Japanese market at a very attractive exchange rate.

Question: So a lower dollar makes non-US stocks more attractive?

A: It’s not so much about the dollar falling as it is about the dollar’s valuation. A more expensive dollar tends to make non-US stocks look more attractive to US investors for two reasons – either the value of the currency rises [against the dollar] So you get those windfalls, or companies take advantage of the competitive currency and see faster earnings growth.

The fact that the US dollar is so expensive compared to almost any other currency should be so [a] Headwinds for non-US stocks, and the fact that the dollar has weakened over the course of this year, have helped non-US stock returns, but valuation is what determines the outlook.

Q: What would happen if US stock markets fell significantly – I’m not asking for a forecast, but if the 7-year forecast completely changes its recommendation, does the fund have the ability to change its entire portfolio?

A: Not only is this a prediction, but if stock markets decline significantly, we would also expect fixed income yields, especially Treasuries, to decline. This would lead to lower expected returns. Meanwhile, the intrinsic value of your stocks – as long as we’re talking about something resembling a recession and not a depression – would not have fallen by much, and their prices would have fallen by a lot. Stocks may seem much cheaper, and fixed income less attractive.

GMOD has the potential to have up to 80% equity stake, okay? I can’t tell you exactly what we’re going to do, because we don’t know how [a downturn] It will appear. We like to buy things that look cheap and sell things that seem expensive.