GMO's Inker: How to Escape the Growing Stock Bubble

Q&A January 20, 2021 at 03:25 PM

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There's a great big speculative bubble in secular growth stocks right now, and "the crazies" are a major sign of it: They are "widespread situations where the market is clearly operating off something other than rational security analysis," argues Ben Inker, head of GMO's asset allocation team.

While he calls bubbles "natural Ponzi schemes," saying "they need to grow, or they collapse," Inker, portfolio manager and a member of GMO's board of directors, sees no indication that the current bubble is beginning to burst, an event that would send many stocks plummeting and could set the stage for a bear market.

What he does see now — in the late stages of this growth bubble — is "exceedingly bright" opportunities for value investing. Indeed, since the last quarter of 2020, there have been signs of value's reawakening.

What could stymie the mean reversion from growth to value? America's failure to reach COVID-19 herd immunity via vaccination in "a reasonable amount of time," Inker says.

Why? Because value companies' activity is largely in the "physical world" of person-to-person interaction. In contrast, that of growth companies is in the "virtual world."

In the interview, Inker, who joined GMO in 1992 right after graduating from Yale University, discusses in detail GMO's Equity Dislocation Strategy fund; launched in October, the long-short portfolio is designed to benefit from a rotation to value and focuses on value equities in emerging markets.

He also offers his assessment of Donald Trump's presidency — the good, the bad and the as-yet unknown.

ThinkAdvisor recently interviewed Inker by phone. Speaking from the Boston area, he talked about bubbles, value and bright, shiny prospects.

Here are excerpts from our conversation:

THINKADVISOR: In your Q3 2020 quarterly report, you write that "growth stocks are indeed in a bubble." GMO co-founder Jeremy Grantham writes in a Jan. 5 paper: This "epic bubble … will be recorded as one of the great bubbles of financial history." So, is the long bull market favoring growth stocks rotating to value?

BEN INKER: Value stocks did badly in 2020; they're very cheap now. [But] we certainly haven't seen any kind of repudiation of the high-flying speculative growth names. Although value has been doing better, I don't see any evidence of the beginning of the bursting of the bubble. Bubbles are this natural Ponzi scheme where they need to grow or they collapse.

What was clear evidence signaling a potentially imminent rotation to value investing?

Once we saw the behavior that we thought was very indicative of a bubble, that's what gave us the confidence that things have to turn fairly soon. But it doesn't mean we couldn't get another strong upward jag in growth for a few months. It would be hard for that [period] to be a few years, though.

Do you consider investors' current manic behavior one criterion for a bubble?

Absolutely. We've got extreme valuations, but we've also got "the crazies" — widespread situations where the stock market is clearly operating off something other than rational security analysis. We saw that in 2020; and you're already seeing examples of it in 2021.

Such as?

The other day, when Elon Musk tweeted that he uses Signal and that investors should buy Signal, the stock of Signal Advance Inc. went up several hundred percent.

Why was that crazy?

Because the Signal that Musk was talking about is a [private] chatting app and not publicly traded. It has nothing to do with the other Signal, which zoomed higher on the back of that mention. It's an example of people just blindly buying things on the back of incredibly thin narrative and not bothering to do the work.

Why is that occurring?

In the retail [investing] community, it's not just that there are a lot of new investors who don't know how to do security analysis. There's a real disdain for the old-fashioned way of trying to value companies. We saw that with the internet bubble. We saw it in the run-up to the financial crisis.

Why does this relate to a bubble?

It's a feature of a bubble — a belief among a reasonably wide group of investors that the ordinary rules don't apply and that failing to do the work that investors used to think needed to be done is a badge of honor.

What's the dynamic between the COVID-19 vaccine effort and the impact on value stocks?

If we can't get a majority of people vaccinated in a reasonable amount of time, there's a very bad surprise with regard to the vaccine.

That will be bad for value stocks vs. growth stocks because value tends very much to be companies in the physical world rather than the virtual, or computer, world. The longer there's less activity going on in the physical world, the worse that is for value stocks.

How long is "longer"?

I don't think it's a big deal if it takes three or six months longer — till early 2022 — than the optimistic view of the vaccines getting us to herd immunity in late summer 2021.

Yes, you can paint nightmare scenarios about the vaccines for humankind, the economy and the financial markets, such as, if you've had COVID-19 before, the vaccines give you no protection. But I don't think there's a high likelihood of those [happening].

Are we headed for a bear market?

The animating force behind the market in recent months has been a very speculative bubbly one, and those usually end with significant pain. I'm not entirely sure if we'll get a bear market, but the nature and feel of what's been driving the market makes it more likely.

The market is very expensive, and that creates a situation where a bear market can definitely happen. I do think we'll get one sooner or later, later being months, not years. A bursting of this speculative bubble in secular growth names will probably drive the stock market down materially.

What are your thoughts about investing in value right now?

To be excited about value stocks, you don't have to care whether the market goes down or not. If the market is fair valued — with the S&P around 3,700 — value stocks around the world, desperately cheap, deserve to rally pretty strongly.

When do you estimate the bubble's bursting — that is, what will cause mean reversion to value?

I'd certainly be surprised if it lasted the year. I don't know what the trigger will be. We still don't know what the trigger was for the Japan bubble bursting, and others.

Why did you introduce the GMO Equity Dislocation Strategy fund?

When we see a bubble, we put together a portfolio that we think can make money from the breaking of that bubble. We did it in 2000 with the Internet bubble and in the run-up to the global financial crisis. This is the fourth such [portfolio] in 30 years.

When we see really large [pricing] dislocations in the stock market, to benefit from the mean reversion, we try to put together a long-short portfolio — buying stocks we like but at the same time selling short a group of stocks we think are very overvalued.

Why didn't you launch this fund earlier?

One big reason was that, while value stocks were very cheap, at the end of last year we hadn't seen the strongly speculative behavior in evidence.

What's the fund's potential return?

Right now, value stocks are trading at a much bigger than normal discount to the market. If that discount were to go back to normal, value deserves to beat growth by, maybe, 70 or 75 percentage points.

That would be a very big deal. There's no guarantee it's going to go back all the way to normal exactly, but it really does look like a very large opportunity.

Jeremy Grantham recommends in his Jan. 5 paper: "It is the overlap of value and emerging that your relative bets should go, along with the greatest avoidance of U.S. growth stocks that your career and business risk will allow." Please elaborate.

That's exactly what we're doing. We think the U.S. stock market is the most overvalued market and that the emerging markets are a whole lot cheaper, particularly the value stocks within them.

We own a little bit of U.S stocks that look relatively cheap; our largest exposure within equities is to emerging markets value. After that, we like small-cap non-U.S. stocks both in Europe and Japan, particularly Japan.

What's the fund's ratio of U.S. stocks to emerging markets?

About 40% on either the long or short side is in the U.S., and 60% is in other countries.

You write that for this fund, you used a "diversified set of bets that are driving dislocation in today's equity market, without excessive risk on any one of them." Is that your rationale, broadly speaking?

Yes. For example, a group of stocks that really underperformed in 2020 was financial companies, one reason being that if interest rates are at zero and are going to stay there, it's harder for banks to make money.

As we see it, banks will probably find a way to make decent money. Banks are cheap and we want to own some.

Please further explain your strategy.

We don't want our bet to be all that big. We're saying that we know which side we want to be on, but we don't want this to be simply a bet against [say], information technology, which has done really well during the pandemic.

We want it just to be a bet in favor of banks. So we've built a position that's willing to take bets on banks and take bets against information technology but not make them huge in size.

So you want to balance the risks?

Yes. We're trying to not get rid of every bet to make this seem like a very low-risk portfolio. It's to try to have a balance of the risks that come along with the value idea and to try to make sure that none of them are gigantic.

We don't allow this portfolio to have huge positions because no matter how overvalued a company looks, it's not impossible for it to grow into its valuation. We wouldn't want to make a mistake on an individual company and blow a hole in the return for the overall strategy.

When I interviewed you three months before the 2016 presidential election, you argued that "a sufficiently ill-advised set of [economic] policies in the U.S. could do profound damage" and that "some or the things [Donald Trump] has said would be really scary." Now that he's leaving office, how would you sum up his performance as president?

At the end of the day, other than mismanagement of the pandemic, it was a reminder that politicians don't have that much impact on the economy. He did some stuff that I think was a net negative for the U.S. economy, but the economy did fine under Trump.

The economy would be in better shape had Trump managed the pandemic better — he was a part of that, [but] there are plenty of other people who made mistakes along the line.

What did Donald Trump do that's been good for the economy?

In the shorter term, the tax cuts proved to be a fiscal boost, though we probably would have done even better if the money had been spent on infrastructure or something the economy needed. The trade war stuff was almost certainly a net negative, but it turned out not to be disastrous.

His roll-back of regulation in the near-term may well have been good for the economy. But I think a number of [his rollbacks] were shortsighted and certainly, on the environmental side, bad for the collective well-being of the people who live in the U.S.

Anything else?

There's other damage he seems to have done to the country, and we will see how lasting that is.

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