Had Mark Twain been an astute investor instead of a foolish one, he might have quipped: “Reports of Value’s Death May Be Greatly Exaggerated.” As it happens, it was Rob Arnott, chairman of Research Affiliates, who tweaked Twain’s famed “death” quote in naming a white paper he released last month.
“…the stage is set for potentially historic outperformance of value relative to growth over the coming decade,” he argues.
In an interview with ThinkAdvisor, the “Godfather of Smart Beta” expands on his forecast for value’s big comeback “for the patient investor,” as well as providing his outlook for the U.S. economy and stock market. Further, he opines on President Donald Trump’s decision that has extended the long bull market.
Founder of Research Affiliates, Arnott has made a career of testing the conventional wisdom. In the interview, he maintains that profit opportunities are created when conventional wisdom is wrong.
Right now, he is predicting both a recession and a bear market in the next two to three years, and his forecast for growth investing is plenty gloomy, especially for FAANG stocks, the majority of which, in the long term, will likely be a “whole bunch of losers,” he contends.
Arnott founded Research Affiliates in 2002 to focus on innovative approaches to quantitative investing strategies. Today more than $190 billion in assets are managed using the firm’s strategies, licensed to companies including BlackRock, Pimco and Schwab.
In 2018, Arnott stepped down as CEO to devote more time to research and portfolio management. He manages the Pimco All Asset and All Asset All Authority funds and the Pimco RAE suite of funds.
ThinkAdvisor recently interviewed Arnott, speaking by phone from company headquarters in Newport Beach, California. He talked about the evidence of market bubbles and revealed that more than half his personal portfolio is invested in emerging markets.
“Value-oriented smart beta strategies [rebalancing based on elements other than market capitalization] in both the developed and emerging markets offer investors promising opportunities outside the many bubbles in today’s global markets,” he writes in “Bubble, Bubble, Toil and Trouble,” a July 2019 paper.
Here are highlights of our interview:
THINKADVISOR: What’s your forecast for value investing?
ROB ARNOTT: Value is so cheap that it will turn at some point — today, in three months, two years from now. But my confidence in its winning near-term isn’t high — I’m cautiously optimistic — because so many things could go wrong. The longer the horizon, the greater my confidence. Over a one-year horizon, I give it 60%/40% odds; for a three-year horizon, 70%/30% and over five and 10 years, 80%/20% and 90%/10%.
Why are your long-term expectations so high?
Historically, when value has been as cheap as it is today, 100% of the time it’s beaten growth and outperformed in every geography of the world over the next five years. So that gives me pretty darn high confidence that for the patient investor, value should win over a five-year horizon.
Are investors distracted by the giant tech stocks? Is that part of the reason for value stocks’ lagging?
Not just distracted; it’s more than that. They believe that the tech revolution is going to crush value stocks. They viscerally believe that the revolution will be massively beneficial to tech stocks and massively disadvantageous to other segments of the market, especially the value segments.
Your thoughts on that?
The fallacy in that view is very simple: The market already reflects those expectations in current prices. Value is cheap because people are expecting value stocks to have horrible growth in the years ahead because the encroachment of technological innovation will crush their businesses. Yes, that will happen to some companies, but not to whole swaths of the economy.
This fear is the conventional wisdom. Broadly, how does conventional wisdom affect investing?
The markets already price it into every asset. At best, conventional wisdom is useless. At worst, it can lead us astray by giving an explanation of what’s already happened masquerading as a forecast. The market is moved on surprises, not on conventional wisdom. I’ve found that yes, conventional wisdom is often right and yes, it’s often wrong. When it’s wrong, you have profit opportunity. So finding the gap between conventional wisdom and reality is a wonderful source of alpha.
What or who should be given credit for the long bull market?
It’s a series of things. The question is: How many of them are likely to deliver continued gains? Most look like they’re pretty well played out.
Earnings this past decade have grown considerably faster than historic norms. But that surge doesn’t presage a continuing surge. That, actually, would be a little dangerous — not just to investors but to capitalism because the prosperity is inadequately shared.
What would the repercussions be?
You run the risk of fanning populist flames. That can be ether conservative populism, which, in an extreme scenario, can bring in fascists or liberal populism, which can bring in folks like Mao Zedong.
President Trump often takes credit for the extended bull market. To what degree is he responsible for it?
He’s played a very positive role for the U.S. economy. He’s been a distinct plus, although his style leaves a lot to be desired. I don’t think there’s anything terribly wrong about his taking some credit for a booming economy and booming stock market. But let’s not overdo it!
What has he done that’s been beneficial to the market?
He stepped out of the way and let the capitalist economy make its own decisions. Standing aside and letting companies flourish is a proactive decision that he deserves some credit for.
What’s your outlook for the economy near-term?
Relatively benign for the time being. [But] we’re going to have a recession, probably during the next presidential administration no matter who’s in office.
What do you forecast for the market near-term and midterm?
I would give pretty high odds of seeing a bear market in the next two to three years, with a small risk that it could happen sooner. It could be a fairly serious bear market.
What do you predict for the market long-term?
U.S. stocks will be very hard-pressed to beat T-bills by much over the next 10 years because valuations are currently very high. Any mean reversion will pressure returns.
What do you see for growth investing?
It’s really tough to see how growth stocks could produce decent returns and hard to see how FAANG stocks [Facebook, Amazon, Apple, Netflix and Google] will produce positive returns at all, except maybe one or two of them. The collection of beloved, frothy tech stocks is likely to have only one or two winners and a whole bunch of losers [long-term].
When we spoke a year ago, you were seeing bubbles. Then, in July 2019 you published a paper, “Bubble, Bubble, Toil and Trouble,” a follow-up to your April 2018 “Yes. It’s a Bubble. So what?” See any bubbles now?
I sure do. Tesla is rocketing to a valuation higher than all other U.S. automakers combined, plus Volkswagen [Group], which is the largest auto producer in the world. That’s one of many bubbles. But we’re starting to hear language that’s very much like what we heard during the tech bubble — a lot of people saying, “It’s different this time.” No, I kind of doubt that.
Why isn’t it different?
Look back over the last 40 years: Eight of the 10 largest market cap companies in the world at the start of each decade didn’t survive on that list over the next 10 years. So I look at the current Top 10 and think: I don’t know which of you is going to [last] on that list, and even harder, which rises and delivers above-market returns. But I do have high confidence that seven or eight of the top 10 are going to underperform.
At the start of 2019, you liked emerging economies. What about now?
Emerging markets stocks are a little on the cheap side and can be just fine. They’re much more sensibly priced than U.S. stocks, but people are scared of them because they’ve underperformed U.S. stocks. Well, that’s how they got to be cheap relative to the U.S.!
To what extent do you invest in emerging markets?
I have a bit over half my personal investment portfolio in emerging markets’ deep-value stocks. But like the U.S., emerging markets have bubbles too — the BAT stocks: Baidu, Alibaba and Tencent. Two of those [Alibaba and Tencent] are among the 10 largest market-cap companies on the planet. Yet [they don’t have] a particularly large earnings base. So I would worry a bit about them.
What impact will the U.S. presidential election have on the markets and economy?
Probably less than most people think. I would worry if Bernie Sanders, an avowed socialist, is elected. But I wouldn’t overthink that worry. Socialism is very bad for the economy but not necessarily bad for stocks.
What would the impact be if one of the other Democratic hopefuls is elected president?
We will either elect a Republican — Trump — who wants to boost spending in a huge way or a Democrat who wants to boost spending in a huge way.
What are the implications of those scenarios?
With either one, we’re headed toward some sort of cliff. You don’t know if that’s three years or 20 years away, but you know that [the high deficit] isn’t sustainable. From the vantage point of fiscal discipline, I’m not happy with the current crop of candidates on either side. Fiscal discipline is very important for the macro economy, and neither party has it.