GMO co-founder Jeremy Grantham.

Jeremy Grantham, the founder and chief investment strategist of asset manager Grantham Mayo Van Otterloo, is dissing the traditional diversified 65% stock/35% bond portfolio and championing “very large” investments in emerging markets.

In the latest GMO quarterly Lletter, the asset manager, writes that returns in the traditional balanced portfolio are likely to be dismal, about 1% to 3% annually over the next 10 years, while emerging market stocks — “the only cheap asset” — are poised for an estimated 5.5% annual return, especially if they’re tilted toward value.

“Be brave,” writes Grantham. “It is only at extreme times like this that asset allocation can earn its keep with nontraditional behavior. I believe a conventional diversified approach is nearly certain to fail.”

Grantham, a value manager, argues that valuations for emerging market stocks are historically low — 65% below their highs in 2007, using Gerard Minack’s cyclically adjusted price-to-earnings ratio—far more undervalued that U.S. or developed market stocks excluding the U.S.

Grantham admits that in a major downturn emerging market equities could decline more than U.S. equities, but he believes that’s “improbable” given that the recent outperformance of EM stocks is far less than outperformance periods in the past 50 years.

 “Since hitting a multiyear low in February 2016, at 11 times Shiller P/E, the MSCI emerging Index has beaten the U.S. market by 11% in total return, measured in dollars, with the outperformance driven mostly by currency. The relative P/E has moved less than 5%,” writes Grantham, noting that the current Shiller P/E is around 16.

That 11% performance spread is far less than the more than threefold outperformance versus U.S. stocks that prevailed from 1968 to 1980 and from 1987 to 1994, and the more than 200% from 1999 to 2011, according to Grantham. “Let’s summarize by agreeing that the +11% is in this context trivial.”

Grantham also prefers developed market equities excluding the U.S. — the EAFE index (which also excludes Canada — and early-stage venture capital best of all. (His foundation has 45% of its assets in early-stage VC.)

Throughout Grantham’s latest investment letter, he fantasizes about managing Stalin’s pension fund, where the failure to deliver a 4.5% real return annually over 10 years is punishable by death. Given those stakes, he would chose to keep two-thirds of his money in early-stage VC and the final third in emerging market equities.

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