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Research Affiliates’ Arnott Sees ‘Bubbles Galore’ in Stock Market

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What You Need to Know

  • A stock is in bubble territory when its price is based on implausibly optimistic assumptions.
  • Another bubble indicator, according to Arnott: when the marginal buyer of a stock doesn't care about valuation models.
  • He forecasts a 1.9% average annual nominal return over the next 10 years.

“There are bubbles galore” in the current stock market, says Rob Arnott, founder of Research Affiliates Research Affiliates, a Newport Beach, California, firm that specializes in smart beta and asset allocation investment strategies.

In a recent wide-ranging webinar, Arnott expounded on this opinion, noting first that a stock is in bubble territory when its price is based on “implausibly optimistic assumptions,” using a discounted cash flow valuation model, and when its marginal buyer doesn’t care about valuation models.

Netflix, Facebook, Tesla and GameStop shares are bubbles because the average marginal buyer doesn’t pay any attention to valuation models, Arnott said.

“The relative assumptions you’d have to make to justify Tesla valuation are pretty extravagant,” Arnott said. Applying the highest profit margin among the eight largest automakers over the next 10 years to Tesla would yield a value of $430, according to Arnott. That’s 27% lower than Tesla’s closing price of almost $590 on Friday. Tesla’s share price has already fallen 33% from a late January high of over $883, but according to Arnott, it is still overpriced.

“Tesla will survive and be big,” Arnott said, “but is it worth more than the next nine automakers? No.”

Tesla was among the 10 largest publicly traded companies by market capitalization at the beginning of the year, but it likely won’t be in 10 years, according to Arnott. He showed a chart of the top 10 stocks by market cap for every 10-year period between 1980 and 2010.

Usually only one or two of the “top dogs,” as he calls them, remain a top dog in the next decade, although they can stay on top for a long period of time. But when they fall, “they lose big,” Arnott said. “There’s a lot of rotation at the top.”

The top 10 stocks are constantly changing (Chart: Research Affiliates)

In addition to Tesla, today’s top dogs include five of the six FANMAG stocks: Facebook, Apple, Microsoft, Amazon and Google (Alphabet); Netflix is excluded. The FANMAG stocks account for close to 25% of the S&P 500, which is a “remarkable concentration,” Arnott said.

Arnott is not calling for these bubbles to burst imminently. “Bubbles can last longer and go farther than anyone can possibly imagine.”

Overall, he favors value stocks, which he says are now one-eleventh as expensive as growth stocks and can expect to beat growth stocks by 4.5% or more. “There’s lots of juice left in their orange,” he says.

As for the S&P 500, Arnott is forecasting a 1.9% average annual nominal return over the next 10 years.

The forecast is based on current dividend yield (1.5%), real fundamental growth (1.2%), inflation (2.4% using the Consumer Price Index) and change in valuation (-3.2%), the latter reflecting a Shiller Cyclically Adjusted Price to Earnings Ratio (CAPE), which Arnott pegged near 34 using data from the end of March, falling to around 26, as a halfway reversion to the mean. The current CAPE ratio is now near 37.