How to Build Robust Portfolios in Slow Burn Minsky Moments? GMO Gave the Suggestions.

With more and more economists warning about the potential for a Minsky moment, investors may wonder how to manage this risk and adjust their investment strategies. In a recent study,James Montier, a partner of GMO, gave his suggestions, discussing the merits and drawbacks of simple long volatility strategies and presenting three alternatives.

Long volatility plays are commonly believed to negatively correlate with tail risk events such as illiquidity or equity market drawdown events. Buying volatility contracts is the simplest example of such a strategy.

While simple long volatility can be effective hedges against tail risk events and provide some protection, their long-term performance is often poor due to the negative roll return over time. For instance, $100 invested in this strategy in 2005 would only be worth $0.004 today.

Holding cash is one of the oldest and easiest tail risk protection. In James Montie's opinion, cash and bonds are largely equivalent unless a different view on the path of rates from the one implied. According to Truist Advisory Services, the equity risk premium, measuring the S&P 500's earnings yield against the 10-year Treasury note yield, is approaching its lowest level in over a decade. That is to say, the stocks are at around their least attractive levels. If rates stay elevated, the attractiveness of bonds may improve further.

While showing very similar insurance properties to a long volatility position, a simple long quality/short junk portfolio is a much better chance of protecting investors and delivering positive returns in the long term.

The current valuation is the main issue with the long quality/short junk strategy. While the case for quality over junk has historically been strong, with quality performing well during market downturns, the current price of simple quality is now the most expensive relative to junk since the early 1980s. As a result, there are concerns about whether quality can continue to serve as an effective long-term store of value.

While value relative to growth may not provide the same level of drawdown protection as quality relative to junk, it has demonstrated strong performance and outperformed cash during market downturns.

The current valuation gap between Value and Growth presents a compelling argument for using it as a hedge against slow-burn Minsky moments. In particular, deep value stocks in the U.S. offer a significant margin of safety and could potentially weather market downturns while still providing solid returns.

According to James Montier's research, a reasonable allocation of 30% towards long volatility tail risk protection can help avoid drawdowns similar to those experienced during the 2007-2009 financial crisis.