April 3, 2020

Excerpted from a letter to clients sent on April 3, 2020. Anyone can sign up for our quarterly updates here.

In our last letter, we explained why we think the pandemic seems unlikely to significantly alter the stock market’s fair value.

To very briefly recap:

  • Stocks represent ownership of a long-term stream of future earnings. The “fair value” of the stock market is the total value of the market’s expected earnings many years into the future, not just the period immediately ahead.
  • An examination of two past crises, the Global Financial Crisis and the Spanish Flu Pandemic, shows that neither had much impact on stock market fair value.
  • Given the vast, unprecedented government and central bank efforts to shore up the economy, as well as the inherently time-limited nature of a pandemic, it seems unlikely that the current crisis will have a greater effect on value than the Global Financial Crisis or Spanish Flu.
  • So, as dire as the current economic situation may be, the pandemic has probably not changed the global stock market’s underlying fair value in any significant way.

Now, let’s talk about price.

In crisis periods, stock prices can fall a lot, even if their underlying fair value hasn’t changed all that much. These steep declines are typically the result of decreased liquidity (everyone needing their money back at the same time) and investor fear, both of which tend to reinforce themselves and each other.

But to the extent that these crashes result in prices falling below fair value, prices are likely to recover once the crisis has passed. At least this is how it’s always happened in the past, and we can find no reason to believe it has changed.

We don’t think anyone can reliably know what the mood swings and liquidity cycles of the market will do to prices in the short term. (And we think trying to time getting in and out of the market is more likely to hurt than help, a topic we’ll cover more in our next letter).

But we can feel fairly confident in two things: the value of what we own, and the likelihood that prices will eventually make their way towards that value.

In the meantime, we can use the crisis as an opportunity to buy investments that we believe have become unreasonably, and temporarily, underpriced.

Stock Market Valuations
Before we get into specific stock market forecasts, let’s look at the general state of stock valuations (“valuation” meaning how expensive an investment is compared to its apparent underlying fair value).

This chart shows a common measure of valuations for stock markets around the world:



The most striking thing about the chart is that international developed and emerging market stocks are the most undervalued they’ve ever been during the 37 year period shown, including at the depths of the Global Financial Crisis (GFC). Unless one believes the world has changed in a way that justifies permanently rock-bottom valuations – and we don’t – this seems like an exceptional opportunity.

The US stock market is a different story. Unlike the international markets, it entered this crisis pretty overvalued to begin with. The ensuing price decline has brought valuations down a lot, but they remain on the high side compared to history.

One other note on this chart: compare the starting valuations for the recent stock crash vs. those preceding the GFC. The US actually began this year at a higher valuation than its housing bubble peak. But international valuations began the year dramatically lower than they were before the GFC hit.

This is an important distinction for investors in international stocks. People looking for a GFC-like outcome for stocks are probably not considering the fact that international stocks entered the current crisis at less than half the valuation of the prior one. This doesn’t mean that they can’t fall more in the short term – but it does mean that if they do, they will be even more undervalued, and that much more likely to snap back once there is a light at the end of the tunnel. (Investors in the broad US stock market cannot take similar comfort, unfortunately).

Return Forecasts
The chart below shows some stock return forecasts from an investment management firm called GMO. To be clear, these are not just numbers pulled from the air. GMO has been forecasting asset class returns for decades, using a sound, consistent, valuation-based methodology that has been very successful at predicting which asset classes would do well and which would do poorly.(2) We’ve updated the forecasts to account for price changes through April 1.(3)



Returns for US large cap stocks – what most Americans think of as “the stock market” – are looking pretty meager as a result of having started out so overpriced. Outside of that group, however, return forecasts start to get good, and in some cases, exceedingly good. This chart also omits several groups of stocks that GMO doesn’t publicly share forecasts for, but that have higher-than-normal return prospects. (These include US small cap value, developed international large cap value, and developed international small cap value).

The above graph shows forecasted annual returns. To help everyone think past the period we’re in now, here’s a look at what these annual returns would translate to over a longer timeframe of 7 years:


These forecasts – which are sensible and have been historically predictive – suggest that the crisis has created some rare opportunities for patient investors who understand the value of what they own.

The Rewards, and the Pain, of Being Unconventional

It appears that the best opportunities lie outside the US large cap stocks which happen to be considered the “norm” for US investors. And the difference is not a minor one: to take the most dramatic disparity, GMO’s forecast calls for emerging market value stocks to outperform US large caps at least seven-fold the next 7 years.

It’s clear to us, and it might seem obvious, that we can improve the chances of maximizing returns by leaning heavily on those areas of the global stock market with higher return prospects. But we also know that it’s emotionally difficult to invest this way because it requires allocating quite differently than most US investors do. We know very well that it can be hard to watch “everyone else” get better returns during those times (sometimes sustained periods) when things aren’t going the way it seems like they should. It can sometimes take a very long time for value to end up mattering and we must admit that there is no guarantee that it ever will.

All we can do is try to put the odds in our favor, and we believe that focusing on the best values (and avoiding the worst values) is the most effective way to do that. Since it can sometimes be hard to keep the faith, it does no good to be too different if one can’t stick with it through the tough times. So it’s a balancing act where one shouldn’t be any more different than can be tolerated.

We already have our clients about as outside-the-mainstream as we think they can stand. But given the huge potential reward at this point, we’re developing a set of portfolios that tilt even further towards the undervalued, atypical areas of the markets. (To clarify, they are not more “aggressive” in the risk-taking sense: they will have the same volatility/risk level as existing portfolios, but they’ll be even more concentrated in the areas with the best valuations).

These heavily value-tilted portfolios aren’t for everyone, but they may be a fit for some. If you think you might be able to endure being more unconventional in exchange for a potential boost in long-term returns, please get in touch so we can talk about it further. Or, if you’d like to read more about this tradeoff, here is an article we wrote on the topic in 2018, and a more recent one from GMO.

We’ve got another letter in the pipeline, this one concerning the futility of trying to time the ups and downs of markets. Look for that soon, and if we can be of help in the meantime, please let us know.

1 – The measure is the Cyclically-Adjusted P/E ratio, which compares prices to 10-year average earnings. Averaging earnings this way smooths out cyclical ups and downs, giving a better idea of the sustainable level of future earnings.
2 – Background on GMO’s methodology can be found here (in the section entitled “GMO’s S&P 500 forecast”). An Economist magazine article on GMO’s forecasting track record, “The View from GMO,” can be found here.
3 – GMO’s forecast is through 2/29/2020 (original here). We adjusted it to account for price changes from 2/29/2020 through 4/1/2020 using the following tickers on stockcharts.com: SPY for US large cap, IWM for US small cap, EFA for developed international large cap, SCHC for developed international small cap, VWO for emerging markets core, FNDE for emerging markets value. GMO’s forecast is in real (inflation-adjusted) terms; we added inflation into the forecast at an assumed rate of 2%/year. GMO publishes two forecasts: one assuming that real interest rates return to normal; the other assuming they do not. These are respectively called the "full mean-reversion" and "partial mean-reversion" scenarios; they are both shown on the graph, with the additional return in the partial mean-reversion scenario shaded.