The years leading up to the 2000 stock market bubble were extraordinary and unprecedented. They caused unique pain to the portfolios of valuation-driven investors. The valuation extremes, though, created the greatest opportunity set for valuation-driven investors since the Great Depression. While the events of the last decade have not been as striking as those of the late 1990s, the recent cycle has gone on for significantly longer and the pain caused to our portfolios has begun to approach 1990’s levels. As the current cycle has ground on slowly but surely, the valuation extremes have moved wider, creating an opportunity set for valuation-driven investors that looks as extraordinary as what we saw 20 years ago.
Most of us have times in our professional lives we prefer not to think too much about. In my case, the period from 1997 to early 2000 was that time. It seemed as if every single thing that could go wrong for us from an investment standpoint did. Sure, value stocks were drastically underperforming, but emerging equity and debt didn’t have to go through a crisis simultaneously. Long-Term Capital didn’t have to blow up taking with it a whole series of assets that had little or nothing in common with each other besides the fact that anyone with an eye to history would have judged them relatively cheap. In my own personal contribution to ensuring nothing would go right, I convinced our U.S. quantitative equity team to make a tiny change to our stock momentum model. It disqualified any stock from being purchased on momentum grounds if it was trading at over 25 times fair value on our intrinsic value model. It removed a grand total of one stock from our equity portfolios.1 Unfortunately, that stock was America Online; in the course of 1999, that omission lowered the return of our U.S. Core strategy by something over 1 percentage point.
The relative performance of our global equity and multi-asset strategies over the last half of the 1990s was, frankly, unimaginably bad. Exhibit 1 shows the performance of each strategy relative to its respective benchmark from 1994 to 1999.
EXHIBIT 1: GMO GLOBAL EQUITY ALLOCATION AND MULTI-ASSET PERFORMANCE VS. BENCHMARKS (1994-99)
As of 12/31/99 | Source: GMO
All performance is net of fees.
For strategies with tracking error in the 3% to 4% range, these numbers were the kind of events that should have happened about every 900 years.2 Those of our clients that stayed with us were unsurprisingly rather annoyed and quite tired of listening to our argument that the prospective returns for our strategies were actually very good. We were often told, “You just don’t get it,” and asked, “How can you make up for the lost ground?”
Happily, for those clients that believed enough of what we were saying to stick around, on or about the turn of the millennium things changed. The next decade saw the strategies win by amounts that well rewarded their patience.
EXHIBIT 2: GMO GLOBAL EQUITY ALLOCATION AND MULTI-ASSET PERFORMANCE VS. BENCHMARKS (1994-2009)
As of 2/28/09 | Source: GMO
All performance is net of fees.
Ever since 2000, we have always assumed that neither the pain from the 1990s, nor the opportunity set that the pain created, would come our way again. And on a day-to-day and month-to-month basis, nothing quite like it has occurred. But there is more than one way for things to get to extremes. The performance of some of our strategies is once again approaching the 1990s-style cumulative pain level, as we can see in Exhibit 3.