4Q 2022 GMO Quarterly Letter

2022 was a painful year in financial markets with almost all traditional assets delivering significant losses. Just about the only strategies to deliver meaningful gains in the year were exactly those strategies that had been woefully out of favor not just in 2020 and 2021 but for most of the cycle prior to that. The losses in markets were not randomly distributed, and the extent of the pain lined up fairly well with how extreme valuations had become in the 2020-21 Covid “FOMO” bull market. The correlation of losses to previous silliness was not perfect – emerging equities and debt were hurt by the war in the Ukraine in a way that owed nothing to the previous bull market, and in the U.S. a strong year for value didn’t actually do as much for the cheapest value stocks as one would have expected. When bad things happen to relatively cheap assets it generally creates a good buying opportunity, and we believe emerging equity and debt and U.S. deep value stocks are well worth investing in today. But with bad things having happened to so many assets, the opportunity set has broadened out quite nicely and is far better than it was a year ago. Broad U.S. stocks and government bonds are still priced at high valuations relative to history and further difficulties in markets would not be at all surprising. But for the first time in several years, it is possible now to put together a well-diversified portfolio of assets and strategies that are either outright cheap or at least fair value, and even if more market trouble is on the horizon, it is far better being too early than too late when buying assets that are cheap in absolute terms. All of this makes for an excellent silver lining to a year most investors would like to forget.

I don’t mind admitting that the weird “everything” Covid bull market of 2020 and 2021 was the most disorienting market environment of my life. I’ve certainly lived through investment bubbles before, but as Jeremy Grantham had pointed out to me multiple times over the years, they almost always take place when investors assume a Goldilocks economy will continue indefinitely. In Covid, of course, things were fundamentally going anything but well, but you’d have never known it from the markets, which showed more signs of speculative frenzy than anything we have seen since the height of the 1999-2000 internet stock bubble. When the histories of this era are written, my guess is that the phenomena of meme stocks and crypto will wind up being the stars of the show and could well wind up replacing Dutch Tulips as history’s greatest examples of speculative insanity.

One thing meme stocks and crypto had in common was the fact that “fundamentals” simply weren’t a part of the discussion. Neither of them had fundamentals, at least in the form of meaningful cash flows one could plausibly expect to ever come out of them, and that seemed, remarkably, to have been viewed as somehow a feature rather than a bug. In a market driven by FOMO (Fear of Missing Out), the last thing you wanted to be doing was investing based on expected future cash flows. And then 2022 happened. In a year where pretty much every traditional asset fell pretty sharply it's hard to say it was precisely “fun” for me. I’ll admit to a certain amount of satisfaction watching some of the embodiments of the excesses of the bubble get their comeuppance, but our ability to shield our clients from some of the pain was very much driven by the extent to which we were able to move them out of traditional stocks and bonds and into the kind of liquid alternative strategies that had seemed woefully out of step over the last few years. In places where we had that freedom, results ranged from small losses to sizable gains, but where stocks or bonds were our only options, it was hard to avoid substantial losses, even if we could console ourselves that those losses were generally smaller than those in the clients’ benchmarks.