In late March, GMO founder Jeremy Grantham and his asset allocation team found "most risk assets" to be bouncing around fair value or even at cheap levels. At the time, the team was factoring a hit to fair value into its calculations that would account for "a severe recession."

But after seeing equities provide four to six years of normal returns compressed into a mere two months, GMO has reduced the net equity exposure in its benchmark-free asset allocation strategy from 55% to 25%. Furthermore, it is exploring long-short trades.

The gap between stock market expectations and economic reality may never have been wider. Grantham notes that equity valuations stand in the top 10% of historical highs, while the U.S. economy is in the bottom 10%, or "perhaps even the worst 1%."

Markets would appear to be pricing in "a widely available" vaccine for Covid-19 or a "strikingly effective treatment." That scenario is "certainly possible," but if it fails to materialize, investors could suffer "substantial losses," in Grantham's view.

As his colleague Ben Inker writes, uncertainty has never been higher—nor has the stock market, except perhaps in 1999 or 1929. In Inker's opinion, anything is possible, ranging from a V-shaped recovery to an extended global depression.

The speed with which employment and industrial production have fallen has no historical parallels. "Covid-19, unfortunately, is a true global menace," Inker writes.

When the scope of economic contraction became "clear to investors," global stocks fell 33% in just over four weeks. Junk bonds tumbled 33% and REITs declined 44%.

Since March 24, the rebound in U.S. equities has been striking, prompting many respected investors like Stanley Druckenmiller and David Tepper to argue the risks now severely outweigh the rewards. Many believe that gain of more than 30% is driven largely by liquidity provided by the Federal Reserve.

Another credible explanation offered by Wharton School of Finance professor Jeremy Siegel is that equities are a long duration asset. Consequently, 90% of their current value is attributable to what they earn starting 12 months from the current moment in time.

In its models, Inker says GMO marked down its estimate of fair value for global equities to a level that assumed a downturn twice as nasty as the Great Recession (or GFC x 2). Then GMO began stress-testing different "GFC x 2" scenarios.

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