Underweight U.S. equities. The U.S. equity market remains overvalued by virtually every measure, says Grantham. GMO's most recent seven-year real return asset class forecast calls for large-cap U.S. stocks to lose an average of 2% annually after inflation, compared with an average annual gain of 3.4% for large-cap international equities. U.S. small-cap stocks as a group will suffer annual losses averaging 1.3% compared with gains of 4.6% for international small-cap equities. The chances that small-cap or value stocks will materially buck any downward trend in 2005 or 2006 appear minimal, since both are fully valued against the market. However, a value bias should help cushion the impact of a major meltdown.
Overweight international equities relative to domestic equities, and in international equities overweight smaller value stocks. While foreign developed markets are vulnerable to a sympathetic decline if the U.S. market falls, the declines should be substantially less because of the relative cheapness of foreign markets. According to Grantham, the MSCI EAFE (excluding Japan) would need to go up 35% to close the valuation gap with the U.S.
A falling dollar should also help foreign stocks. Favorable currency translation for investors, says Grantham, more than offsets the negative impact of a weaker dollar on European exporters. International small stocks still look cheap enough relative to their markets to warrant and overweight as well, although their recent strong performance has reduced their attractiveness somewhat.
Japan remains a questions mark. "Japan is the hardest call of any equity market because it involves more political ramifications than value situations. Companies with lots of debt are being kept afloat on political grounds." Despite the uncertainty, he maintains a neutral to slightly overweight stance in that country.
Adopt a bias toward quality stocks. A year from now, investors will covet the perceived safety of classic blue-chip names as they seek shelter from the bear market storm.
Go overweight in emerging markets in 2004, but exercise caution next year. Emerging markets are still cheap in absolute terms, but are not the bargain they once were because of last year's huge move. "If the U.S. market holds up, I expect that emerging markets could rise another 30% to 40 % in 2004," says Grantham. After this year, however, he plans to pare back his emerging market position to a neutral weighting.
Stay flexible on the fixed-income side. Maintain a strategic investment in inflation-indexed bonds. Although the yields on these bonds are not as attractive as they once were, they offer some flexibility and protection in a rising rate environment.
Employ an asset allocation strategy that includes non-equity market exposures, such as commodities. Alternative asset classes provide diversification for a portfolio, since they tend to be uncorrelated with equity markets. Increasing demand for commodities from China and India should also help prices. And if the dollar goes into a spiral, real assets will probably hold their value.
Grantham is particularly bullish about timber, which he believes will see increased demand as China continues its expansion. His firm, which predicts a 7% annualized real return for the asset class over the next seven years, runs some $750 million in forestry limited partnerships that invest in over one million acres of timberland.
Financial advisors who do not wish to pony up the $5 million investment minimum Grantham's firm requires can still access GMO's investment and asset allocation strategies through the Evergreen Asset Allocation Fund, which invests in 15 core GMO portfolios. Currently, the fund has 33.8% of assets in international equities, 32.9% in U.S. equities, 27.5% in U.S. fixed income and 4.9% in international fixed income.