2020's Perspective: The Death of... Investment Diversification?
Founder & Chairman
Rob Arnott is the founder and chairman of the board of Research Affiliates, a global asset manager dedicated to profoundly impacting the global investment community through its insights and products. The firm creates investment strategies and tools based upon award-winning research, and delivers these solutions in partnership with some of the world’s premier financial institutions. Rob plays an active role in the firm’s research, portfolio management, product innovation, business strategy and client facing activities. With Chris Brightman, he is co-portfolio manager on the PIMCO All Asset and All Asset All Authority funds and the PIMCO RAE™ funds.
Over his career, Rob has endeavored to bridge the worlds of academic theorists and financial markets, challenging conventional wisdom and searching for solutions that add value for investors. He has pioneered several unconventional portfolio strategies that are now widely applied, including tactical asset allocation, global tactical asset allocation, tax-advantaged equity management, and the Fundamental Index™approach to investing. His success in doing so has resulted in a reputation as one of the world’s most provocative practitioners and respected financial analysts.
In 2002, Rob founded Research Affiliates as a research-intensive asset management firm intent on delivering innovative and impactful products and insights. Using a unique business model, Research Affiliates delivers investment solutions globally in partnership with leading financial institutions. Rob served as chairman and CEO from 2002 to 2018.
Prior to establishing Research Affiliates, Rob managed two asset management firms. As chairman of First Quadrant, LP, he built up the former internal money manager for Crum & Forster into a highly regarded quantitative asset management firm. He also was global equity strategist at Salomon Brothers (now part of Citigroup), the founding president and CEO of TSA Capital Management (now part of Analytic Investors, LLC), and a vice president at The Boston Company.
Rob has published more than 130 articles in such journals as the Journal of Portfolio Management, Harvard Business Review, and Financial Analysts Journal, where he also served as editor in chief from 2002 through 2006. In recognition of his achievements as a financial writer, Rob has received seven Graham and Dodd Scrolls, awarded annually by CFA Institute to the top Financial Analysts Journalarticles of the year. He also has received four Bernstein Fabozzi/Jacobs Levy awards from the Journal of Portfolio Management. He is co-author of The Fundamental Index: A Better Way to Invest(Wiley 2008).
Rob Arnott received a BS summa cum laude in economics, applied mathematics, and computer science from the University of California, Santa Barbara.
Recap, Highlights, and Thoughts
The last decade came to a close with us in the midst of a bull market in for the ages, while that was great, what's next? Will the good times continue to roll? Or, will the 2020’s be a lost decade for returns? Or something in between? To help chew on this, I was happy to welcome back Rob Arnott, Chairman of Research Affiliates to the podcast. If you are not familiar with Rob, despite his fancy titles, he plays an active role in the firm’s research, portfolio management, product innovation, business strategy, and client-facing activities. He has pioneered several unconventional portfolio strategies that are now widely applied, such as tactical asset allocation, global tactical asset allocation, tax-advantaged equity management, and the Fundamental Index™ approach to investing. His success in doing so has resulted in a reputation as one of the world’s most provocative practitioners and respected financial analysts. During our conversation about what the next decade could hold for the financial markets, he shares the difference between a nowcast and a forecast, some amusing “death of” statements, inflation, and a few truisms. He also provides the best explanation I have heard of yet about negative interest rates and their impact on individuals, economies, and the markets.
Before we get started, if you a new to the podcast, don’t forget to check out our nearly 200 prior episodes with expert guests like Rob. You can easily scroll through them and listen on-demand on your favorite podcast app, if you are looking for something specific and can’t find, shoot me an email to firstname.lastname@example.org and we will see what we can do to tackle it in a future episode.
Thanks for listening!
Sincerely Your Host,
NEW: Episode Transcript
Rick Unser: 00:00 Well, Rob, welcome back to the podcasts. Always fun to hear from you and as we launch a new year in launch a new decade, can't wait to hear what you have to say.
Rob Arnott: 00:09 Thank you very much. It's a pleasure to be back.
Rick Unser: 00:11 Well, I I guess as we launched into this new decade, I hate to say this, but I'm starting to see some people maybe lose faith or even you know, ditch their quote unquote diversifying asset strategies. Whether that's, you know, individuals may be doing that on their own, but also at a plan level. I'm starting to see some fiduciary is kind of say, you know, what do we need this thing for? I'm guessing you might have some thoughts there about how that might not be the best idea.
Rob Arnott: 00:38 Sure, absolutely. One of the things to think about is to roll the clock forward five or 10 years and pose the question, well, I as a fiduciary faced some backlash for decisions I make today and decisions I make today. If they are trend following, if they are adding new options that have performed brilliantly in the past five years, that's going to be second guessed only to the extent that the performance of the past five years doesn't repeat. But one thing that's fascinating, we did a study going back a quarter century in which we asked what are the best ways to choose mutual funds and one of the strongest is also one of the simplest and that is if you buy funds that are in the top desk file in a trailing three year basis, on average you underperform the average fund by a hundred basis points a year over the next three years.
Rob Arnott: 01:40 If you buy funds that are in the bottom death style, the worst performing over the last three years, you outperform by 150 basis points. That's a 250 basis point spread. So the temptation is always there to abandon or trim back on recent disappointments. It's human nature. Anything that's newly cheap is likely to have gotten there by inflicting pain and losses. And none of us likes paying our losses and reciprocally anything that's newly expensive probably got there by producing joy and profit. And we all want more of that. But wanting more of that doesn't make it happen. When that joy and profit is in the past, that's already happened and we know that it's a poor predictor for the future. So as a fiduciary, you got to worry a little bit about abandoning diversification when diversification has been disappointing and it has been diversification's a terrible bull market strategy.
Rob Arnott: 02:40 Your diversifiers hurt you, but they are massively important both in reducing portfolio risk, which they'll do on the upside. Nobody likes to reduce portfolio risk when it's upside risk, but they also do it on the downside. And over the course of a market cycle, if you're benefiting by softening downside impact and giving up a little by seeding some of the upside, you can wind up at a similar place or a better place with less risk. Now that's the beauty of it. So diversifiers I like to think of them as insurance that pays you to buy the insurance cause you're getting a return, you're getting a respectable return. It just isn't keeping pace with the bull market. So yeah, we see outflows from diversifying strategies. We see outflows from value. Value investing is on the outs with Tesla soaring above $500 a share who needs value. And so there in lies, one of the key challenges were the human nature guides us to chase what's performed well in the past.
Rick Unser: 03:48 Yeah. And I think one other challenge for workplace retirement plan sponsors is they love all their little green indicators. They love all the stars, they love big high numbers talking about how great their investments are. And, and I don't fault them, but I, I think to your point that is one thing that people kind of wrap themselves in that really good feeling that Hey, all of our funds are green or all of our funds have a, you know, a certain number rating that makes us feel really good. And as you said, I think that may or may not be the best outcome for everyone involved.
Rob Arnott: 04:22 Exactly the issue with value as much the same people are fleeing value because value is underperformed now for 12 years. Is there any precedent for that?
Rick Unser: 04:33 I heard value was dead.
Rob Arnott: 04:35 Yeah. Yeah it is. But in the market, nothing is dead forever. I wrote a paper back in 2000 entitled death of the risk premium and it really stirred some anger in some quarters. But in that paper I made the very simple case that it will be very hard for stocks to beat bonds in the years ahead from current levels. Stocks were priced at a Shiller PE ratio of 44 44 times the 10 year average earnings. Just remarkable and tips were yielding 4% you could get a government guaranteed real return of 4% well we did the math. Historically, earnings and dividends grow one or one and a half percent above inflation. That's all. And you add that to a 1.1% yield and you've got a two to two and a half percent real return for stocks. Unless valuation levels soared from those already extraordinary and unprecedented levels. And so I said the risk premium is dead, but I closed that paper by saying like the Phoenix in markets, nothing is forever and in markets the risk premium can come back. And of course it did. So what it required was a revaluation upward for bonds, downward on yields, and a reevaluation downward on stocks. And we got that in spades over the next decade. To this day, long bonds have outperformed the stock market since the year 2000 a lot of people don't, don't realize that, but it's true.
Rick Unser: 06:18 Yeah, I would not have guessed that. That's for sure.
Rob Arnott: 06:20 Yeah. So the notion of death of anything last I checked, 10 out of 10 people eventually die. But the notion of anything in the market's dying and not coming back is a bit naive. Things constantly change. So death value value's dead retroactively over the last 12 years. It's underperformed. Any precedent for that. Yeah, 1988 to 2000 value underperformed and underperformed even worse than it has in this cycle. The end point after that 12 year span was peak of the tech bubble and value outperformed heroically over the next few years in just seven years value stocks roughly doubled relative to growth stocks. Just a tremendous relative performance. And when we look at value today, it's very nearly as cheap relative to growth as it was at the peak of the tech bubble in 2000 in the U S it's almost as cheap globally. It's even cheaper.
Rick Unser: 07:23 And I guess since we're talking about peaks, I mean the Dow kind of hovered around 29,000 I mean I know that's obviously we're talking about 30 stocks, but it's just, you know, a popular sentiment indicator I feel like as we enter this new decade. And as you look forward, does that make you nervous? Does that give you comfort? What, what's your, what's your thoughts on, on where we sit in some of the, whether it be the Dow or the S and P, you know, just some of the popular equity indexes.
Rob Arnott: 07:52 Sure. Well, when it comes to Dow, hovering around twenty nine thousand twenty nine thousand is just a number. It doesn't mean anything. What does mean something is valuation levels. When you looking at the PE ratio or the dividend yield, if you buy the broad us stock market, you have a dividend yield of 1.8% that means that unless there's price appreciation, it takes you roughly 55 years with the dividend to recapture your investment and that's a long time. What's interesting is that main street businesses don't sell for anywhere near that kind of multiple. If you're looking at buying the corner convenience store and it's producing profits of let's say a quarter million a year, are you going to pay five million ten million dollars to get that quarter million of income? I don't think so and yet in the stock market we do. The Shiller PE ratio, which is priced relative to 10 year smoothed earnings is now back above 30 it's back to levels seen historically only at the peak of the tech bubble and in 1929 and that's not very comfortable company to be keeping.
Rob Arnott: 09:08 There's a lot of reasons that can justify high multiples, but the problem is none of them is likely to be a permanent reason. Economic stability. When you have low volatility in GDP, when you have low volatility in CPI inflation, the normal valuation for stocks tends to be much higher. We've written about that and I think it's some pretty important work that shows this linkage, but that works until economic volatility returns until we get increased economic uncertainty and then the normal valuation tumbles. Low yields are cited as a great reason for valuations to be high. Well, if the Shiller PE is okay at 30 plus with us yields being in the two range, then what about Europe? Where are in the zero range? Shouldn't evaluations be higher? What about Japan? What about us? In the 1950s Europe and Japan are trading at 15 to 20 times the 10 year smoothed earnings.
Rob Arnott: 10:11 The U S in the 1950s with yields lower than today was trading in the eight to 12 times ratio, and so the argument that low yields somehow guarantee high valuations is naive. Low yields can simply mean that the bond market doesn't expect much economic growth. So the numerator and the denominator of the classic Gordan equation, low yields mean high multiple. Low growth means low multiple. They can cancel as they do in Europe as they do in Japan and as they did in the U S in the 1950s so all of the reasons for such high multiples are inherently temporary. And that's one of the really fascinating things. When we look at markets today, I asked the question not is the market going up, down or sideways this year? Nobody knows that I asked the question, what's the likely real return for us stocks looking ahead 10 years. And that turns out to be something you can predict with reasonable accuracy. Simply looking at Eli plus historical, normal real growth, it gives you an answer that historically tends to be within plus or minus about 2% and what does it saying today? Yield plus growth today gives you an expected real return of less than 3% over and above inflation. That's all. And if there's any mean reversion on valuation, just the coming decade doesn't finish with a Shiller PE above 30 then you get a much smaller number and it can easily go negative as it did in the two thousands
Rick Unser: 11:51 And just for people along at home. If inflation is one and a half to 2% and maybe we'll come back to that here in just a second, that means that your expected return on stocks, it if the decade finishes with high valuations would be four and a half to 5:00 AM I doing that math right?
Rob Arnott: 12:09 Something in that ballpark. That's exactly right and that requires current valuations well in the top desk file of all of history to still be in the top desk file of all of history. If it goes back to historic norms, back to the median, the historical median that's going to cost you 6% a year, you're going to be minus one or minus two per year net of inflation minus three minus four that's not a pretty picture. So in our work, we simply make the grossly simplifying assumption that valuations go halfway back to historic norms. Over the next decade and out of that work comes an expected real return of about 20 basis points, two tenths of a percent over and above inflation or a total return of two to two and a half.
Rick Unser: 12:58 Well, Rob, I'm starting to see some people saying, well, Hey, you know, this economy's recession-proof and Hey, this is the new economy and this is the way things work. Now, I mean, I hate to say it. Do
Rob Arnott: 13:09 You recall the labeled new paradigm in 1999 people are starting to talk in ways that reflect an expectation that the world has drastically and materially and permanently changed. We've heard people talk about the end of recessions, a recession proof economy in the 1960s we had people talking about, we now understand the economy. There won't be anymore recessions. There are subsequent recessions. Of course there are. You get animal spirits getting ahead of themselves in the economy. People spending too much and having too little in reserve and then tightening the purse strings in reaction to that and pushing you into recession. You'd have central bank interventions where the central bank gets skittish about something, pushes interest rates up to a level that leads to a yield curve inversion, and that pushes us into recession. Kim Harvey was the one who first identified yield curve inversion as a superb predictor of recessions.
Rob Arnott: 14:17 And what's interesting I think is that you'll curve in version isn't the predictor of recession. It's a creator of recession. It causes recession. How does it cause recession? If you have higher short term rates, the longterm rates, the longterm rates set by the macro economy reflect an expectation of anemic future growth. The high short term rates mean that people are not rewarded for taking longterm risks. They're rewarded for hunkering down and going risk off, and that in turn can create the very slowdown that you're afraid of. So I look on the recent yield curve inversion and today's very almost flat yield curve as a warning sign that we may be creating the basis for a recession.
Rick Unser: 15:10 That I tell you that one I haven't heard. Let me ask you just while we're here, I guess I'll give you a two part question and let you run with it. Number one, certainly, you know, I think you and I've talked about, and I've talked with others about the yield curve inversion and it's sort of predictive powers are now, I think what you're also saying is its creative powers in a future recession. Where are we on that clock? Because I think a lot of people have said, well, Hey, within a yield curve conversion, what does it six out of six times, we've had a recession within 12 to 18 months, and then I guess the second part of that is, okay, well if we're seeing this thing coming at us at some point in time in the future, does the fed have any power to control things anymore?
Rob Arnott: 15:57 Sure, sure. Well, you'll curve inversion. Firstly, negative real yields are a function of central bank prophecy and pushing real rates artificially too low negative yields outright where the nominal yield is negative in a 500 year history of bond yields. It's never happened before. So we've been pushing ourselves, especially in Europe and Japan, into a truly unprecedented territory. The notion of paying someone for the privilege of lending them money is an astonishing concept. And briefly this last summer, you actually had a dozen or more issues in Europe where negative yields were attached to junk bonds. So you'd take a borrower where repayment of your principal is in doubt, and you say to them, here, I want to lend you 100 million and I want you to pay me back 98 million with no yield in the interim. And yeah, I know you might not be able to pay me back, but here's the a hundred million and that gracious, that's crazy.
Rob Arnott: 17:10 So negative yields are a function of central bank intervention. Now, does the fed have any power or to control the economy? Not really. They can control the cost of money on a short term basis, but who sets the cost of money better? 12 Weizmann on the fed or the broad macro economy driven by the decisions of millions of people. In short, the fed does have the power to influence the economy, but it's a very weak power to do good and it's a very strong power to do harm. So if they had a Hippocratic oath for fed governors first do no harm, that would be interesting. And I think the fed has repeatedly done harm by inverting the yield curve when they weren't paying attention to what the long end was saying about longterm future growth by pushing money into an economy that didn't want it on undo profligacy.
Rob Arnott: 18:14 I don't doubt that the fed probably helped a little in the depths of the financial crisis by being not just a lender of last resort, but a shoveler of vast quantities of money of last resort. But I asked one fed governor about two years after the financial crisis did, after the crisis passed, after the risk of Armageddon was off the table, did you and the rest of the fed give any thought to allowing the invisible hand of the marketplace to start setting interest rates again? And he looked at me with absolute disbelief and said, not for a nanosecond. Ouch. That's a very, very strange attitude that not for a nanosecond would you consider letting the invisible hand of the market set prices as it does so brilliantly in other parts of the economy. So I look at the negative interest rates as a failed experiment to create stimulus.
Rob Arnott: 19:20 Ben Bernanke, he has been on the record saying the difference between a 1% yield and a half percent yield is only half a percent. The difference between zero and minus a half is only half a percent. It's much the same. No, it's not much the same. There's a difference between getting a skinny pay out for lending money and paying for the privilege of lending money. The ladder can be construed by the marketplace as evidence that the fed is in an absolute panic and that maybe they should be too so that they hunkered down on spending, they hunkered down on investing, they borrow money cheap because they can and use it to buy back stock instead of investing in long horizon new business initiatives and we've seen that happening playing out all over the world on a very large scale. Buy backs are a phenomenon for market tops, not bottoms. You don't see buybacks at market bottoms.
Rick Unser: 20:19 Yeah. And people don't like to buy stocks when everyone's in a panic to sell them,
Rob Arnott: 20:23 Including the management of their own businesses.
Rick Unser: 20:25 Sure. I want to hit on the negative rates thing for a second cause I have to be honest, I completely failed in explaining that in a way that somebody could understand last night and I just want to either repeat or just make sure I'm following what you said a minute ago. Coming back to that junk bond issuer or junk bond borrower that said, all right, you know, I, I, I get $100 million but I only have to pay you back. 98 million is, you know, as a borrower might not do that. Yeah. Because my business might fail or you know, we might go bankrupt or whatever. Right. I mean I'm assuming that's the, that's what you're, yeah.
Rob Arnott: 21:04 The test, that message. If we, if we succeed, you got 98 million of your 100 million back. If we fail, you got whatever's recovered in bankruptcy, which might be 20 million, it might be zero, it might be 40 million. Anyway, you wind up with somewhere between a small loss if you're, if we're more successful than the market fears and you lose most of your money if the market's fears about our credit worthiness are correct. Why would anyone buy that kind of a bond?
Rick Unser: 21:34 There you go. And what is that reason?
Rob Arnott: 21:36 I was talking with the head of one of the largest pensions in Europe and he told me a story and because this is hearsay take it with a grain of salt, but he said that they had a board meeting where they discussed the possibility of selling the negative yield bonds that were in their pension portfolio and they got a call from a regulator the day after the board meeting saying we're going to come in and do an audit of your operations. This may turn out to be an in depth audit in which we are going to be scrutinizing for any actions which could be deemed to have been illegal pass it threat was you proceed with liquidating your negative yield bonds and we're going to find you did something illegal. I mean if you do a thorough enough audit you can probably find something that could be deemed to have been illegal and we're going to try to put you in jail. Well, needless to say, that motion to consider liquidating the negative yield bonds disappeared in a heartbeat. That's interesting and that says to me that the, the, the reason people buy negative yield bonds is because they're not given a choice.
Rick Unser: 23:00 Well, as you were talking about the negative yields, that was one other question I had is, and maybe just clarify or sorry if this is redundant, but are people really issuing negative yield bonds in mass or is it just based on market forces? Bonds are dipping into a negative yield after issuance.
Rob Arnott: 23:22 You see a little bit of both. Some bonds have a positive yield and then B come a negative yield because the price rises so that all future coupon payments on the bond are smaller than the current premium price. Well that's by definition going to give you a negative yield. You also see original issue, negative yield bonds, mostly in the sovereign data arena where a government issues a 10 year bond at a minus 20 basis point yields. So basically they say we're going to issue bonds that will pay back 98 cents on the dollar after 10 years and we'll have zero coupon. All right, well that's a negative yield original issue bond. And of course the, the issue there is why would people buy
Rick Unser: 24:13 Last question on negative yields cause I think we've kind of beaten this one a little bit, but I think it is important just based on how prevalent these are around the world. If I'm the average saver, you know I've got a banking relationship and you know, I'm trying to squirrel away money in a savings account or I'm trying to put money away for a rainy day is an emergency fund. I mean here in the U S yeah, I don't get much yield, but at least I get a little something on my savings account. And if I'm thinking about this in a negative yield environment as a saver or as somebody, again, just a consumer trying to put money away for the, you know, for a rainy day, if I've got $100 in my savings account at the end of the year, do I have $99 or, or how does the, I guess, how does that work?
Rob Arnott: 24:59 That's the basic idea. That's the basic idea. And what's interesting here is if you have currency, you could simply take the currency stuff in your mattress and still have the same hundred as long as nobody burgles your house. So this is one reason behind the fairly aggressive moves to get rid of currency in Sweden and China, 98 99% of all transactions are done electronically with no currency. People in China don't even bother carrying currency because it's too much of a hassle. You can't use it in most places. So therein lies an interesting observation. If you're a government and you want to impose negative yields, what's the biggest impediment to imposing the negative yields? It's the availability of currency that allows people to accept a zero yield and you don't want them to accept a zero yield. So unless you have institutional pressures to enforce the negative yields, it's hard to impose them.
Rob Arnott: 25:59 The availability of currency as one, the availability of other assets and other countries is another. We look around the world and we see emerging markets debt yielding more than us junk bonds. Well that's odd because a lot of emerging markets, debt is investment grade, so why would it have a higher yield? To me that seems to be one of the most peculiar anomalies in the bond market today and represents a wonderful opportunity for those willing to see emerging market economies as a broadly diversified portfolio of economies, some of which will struggle, some of which won't and in large measure, many of which are investment grade. Okay. If I can get a 6% yield on that or a 5% yield on junk bonds, I'll take the six there. So there are opportunities out there for those with a wider perspective. You don't have to settle for the negative yields.
Rob Arnott: 27:02 Now Cura saver and the yields are negative. The natural implication is you're going to want to do something else with the money and the goal of the government is to see you spend money to stimulate the economy. But what if you're fearful that the negative yields are a signal of problems to come? And so you're reluctant to spend the money? Well, maybe you use it to pay down credit card debt. Credit card debt has an 18% yield attached to it. That's like earning 18% on your money. That's a wonderful yield. So pay down your existing debts. That's an option. Consumer debt has been falling in many areas, although not in student debt and not in automotive debt. So subprime that keeps soaring and prime debt at the retail level keeps tumbling so interesting. Tradeoffs. Negative yields do not stimulate. In fact, in general, monetary stimulus does not stimulate on a longterm basis. So the stimulus that people are trying to achieve is in and of itself a sham.
Rick Unser: 28:15 And I'm going to, I think maybe tie this all back together. Maybe not though you be the judge. So I'm assuming that in an environment where you have negative yields because there's concern around growth, that means lack of inflation or inflation, that's not hitting targets. Am I going down the right path so far?
Rob Arnott: 28:34 I think that's a legitimate path. I think negative yields actually impede inflation. Central bankers say they want low rates to prod inflation upward. Well, the link between yields and in the [inaudible] is a positive one. Now that's, that's not just because when you have inflation, you need a higher yield to give you a positive real return on your money. It's also a causal link. If you do correlations of yields with subsequent, with subsequent rates of inflation, you find that it's a positive link there too. And so what we find is that the effort to stimulate the economy and to stimulate inflation as a failed effort has European growth exceeded U S growth because their interest rates are so much lower. Obviously not have, has European inflation exceeded U S inflation because of their monetary stimulus? Obviously not as it worked in Japan, obviously not. And so there's this just remarkable in the economics community at central banks about the notion that gee, maybe their theories don't quite work. Instead of viewing a theory as a crude approximation of the way that the world works, there's this mindset that the, the models are the reality and that the reality observed around them will eventually conform to the models. No, it doesn't work that way. Reassess the models.
Rick Unser: 30:09 Yeah. And I would say the model on inflation, again from one man's, you know, vantage point seems to be a little broken. And I think that's one thing kind of coming back to the diversifying asset strategies that some people are struggling with. And I would really be interested to see, you know, how you are kind of thinking about or helping people position that, which is, you know, I know we talked about where we are in kind of the market cycle and some valuations and that's kind of one thought process for why you might want to, you know, diversifying asset strategy. But the other one that I think is pretty popular is as an inflation hedge and without a lot of inflation today or maybe forecasted in the near term, how do, how do you process or how do you position having sort of that diversifying asset strategy within your portfolio, within your retirement plan, et cetera.
Rob Arnott: 31:02 Let's talk about diversification from two perspectives. One, the inflationary perspective and to the returns perspective. The inflation perspective is a pretty straight forward. When I'm giving a talk in a conference, I'll often ask the audience, how many people here think that inflation is likely to be a serious risk in the coming one to two years and usually out of for every hundred people in the audience, you get two or three hands going up. That's about it. Hardly anyone's worried about inflation near term and then turn it around and ask the question. With the profligate spending deficit spending growing debts, doubts about servicing those debts unless the real value of the depth declines. How many of you think that inflation won't rear its ugly head some time in the next 10 to 20 years? And once again, for every hundred people, two or three hands go up.
Rob Arnott: 31:59 Most people think that inflation is in a coma but is not dead. And then I pose the question, well, if inflation is highly likely on a 10 to 20 year basis, how many of you think that it will warn us in advance so that we can put our inflation hedges in place on the cheap just before it strikes? And of course no one raises their hand on that one. So inflation is resting. It's it's there is a risk. Anytime you have a Fiat currency, it's a risk. And we all yak currencies, now they're, they're all mere scraps of paper or bits and bytes on a computer somewhere. None of it is tied to anything tangible, any longer. And as a consequence, inflation is the go to answer for governments that want to reduce the real value of their debt. This is why central banks want to create a reliable 2% inflation rate.
Rob Arnott: 33:05 It halves the purchasing power of the currency over the 35 year span and therefore it has the real value of debt over a 35 year span, unless new debt is being accumulated. So bottom line is inflation does represent a very real risk. Do our bonds help us? No. You get renewed inflation and the yields get pushed higher. So you have capital losses and negative real returns. Do stocks hedge against inflation? Yes, but not against inflation shocks. The change in the rate of inflation is a negative for valuation levels on stocks. Now, diversification, if you're looking at in inflation hedges, you've got a broad toolkit, obvious inflation hedges like tips, commodities and rates, stealth inflation, fighters like emerging market stocks and bonds and high yield bonds. High yield bonds have a higher correlation with inflation shocks than tips do. Even though tips are contractually linked to inflation and high yield bonds aren't.
Rob Arnott: 34:13 Why? Because when you get a surge of inflation, the real value of the junk bonds is going down. The real value of their debt is going down. Their debt service capacity is improving because the cost of their goods are going up, and so you get a tumbling of high yield spreads and that's what makes high yield bonds pretty powerful inflation hedge. Now, diversification can also serve a powerful role. Merging market stocks are priced at a Shiller PE ratio of 14 to 15 times the 10 year smoothed earnings and emerging markets of value is priced at a nine to 10 times earnings. If you can buy half the world's GDP for nine to 10 times earnings or the U S for 30 times earnings, what do you want to do? Ignore that opportunity just because it feels risky or view it as a in modest allocations, a risk reducer.
Rob Arnott: 35:14 Because of the low correlation, the latter is a much more sensible way to look at it. So diversification serves the need of protecting against unexpected inflation, both of which both stocks and bonds get savaged by unexpected inflation. They're inflation hedges that have pretty good yields, so use those and look to diversification for higher returns in a world of negative yields and lofty equity valuations. So I see diversification as serving two very important purposes. What are people running away from diversification because it's hurt them lately and what people forget is that anything that has is becoming cheaper and therefore more attractive to own inflicts pain while getting cheaper. So we do see the capital markets are one of the only parts of the global macro economy where people hate a bargain, where bargains drive people away rather than attracting customers. And it's just a shift of mindset that allows investors to take advantage of those bargains.
Rick Unser: 36:26 And to quote you from a prior podcast, that sounds like a truism to me.
Rob Arnott: 36:31 Yes, there's a lot of truisms in the market. Markets don't reward comfort buying what's comfortable and popular may be profitable on a short term basis, but is not likely to be profitable on a longterm basis. With Tesla worth nearly as much as all other U S car makers combined and more than GM and Ford combined. Would I rather own GM and Ford or Tesla? To me, that's a pretty obvious comparison. And one where the choice is very easy to people who are fearful about buying what is comparatively cheap because it has performed worse lately. The, it's a very difficult choice to make, but it shouldn't be. There's a lot of truisms and there's a lot of stated truisms. Death of a value, a death of diversification. These are what we would call now tasks we wrote the paper just released it. Looking at now casts versus forecasts, how do we define now?
Rob Arnott: 37:37 Casts now casts. Anytime you deliver a cogent and thoughtful explanation of what's already happened and presented as if it's a forecast that's an outcast, that's merely an explanation of the past, not an explanation of the future. Forecasts are harder. They require you to think about what could happen in the future that hasn't already happened. And it's also more risky if you issue a now cast, it sounds intelligent, it sounds thoughtful and wise. And if it doesn't turn out to be dead wrong super fast, people forget that it was a now cast at the time, which was only temporarily, right? So some people amnesia kicks in and now casts that are wrong. Turn out to be forgotten if aren't wrong. Immediately when Goldman Sachs said oil was headed for 200 a barrel back in 2008, that was a now cast. It was extrapolating recent trends and using the what drove those recent trends as your justification for the future.
Rob Arnott: 38:52 And it was dead wrong almost immediately. So people remember it. But if you issue a forecast and it's wrong, people remember that. And so forecasting is, is both harder and more dangerous. But forecasting involves asking what's likely to happen in the years ahead that has not already happened and renewed inflation at some stage. We all know it's going to happen at some stage talking about it as something that could strike in the coming five years or so is a dangerous statement cause it's good. Turn out to be wrong and will be remembered. The notion that the tech bubble of 2019 could reverse and become a surge in value performance, at least on a relative basis that could turn out to be wrong and therefore is dangerous. This is why people don't make contrarion forecasts. Most people, but the contrarian forecasts I think are by far the more interesting and by far the more likely to be profitable.
Rick Unser: 39:57 Yeah, and I guess as we look out into the 2020s you know, so you've mentioned inflation. You've mentioned kind of the tech bubble, again, not going to commit you to a forecast, but are there other things that you're, you're looking at that give you some pause or that would say, you know, this is something that might cause you to think a little differently about things today or what you're looking at or how you're helping your employees or your plan sort of position the investment choices you have available.
Rob Arnott: 40:27 Well, I'm totally fine with people investing in a well-diversified, conventional, balanced portfolio, domestic stocks and bonds. If they do so with a recognition that these are expensive and the yields are abnormally low and those fields could go up, meaning prices could go down, I think it would be extremely dangerous for people not to have diversification to protect them. If inflation surges or if this bubble and I will use the word bubble reverses in the near term thing about bubbles is that they continue until they don't, meaning that selling out of a bubble, you're going to be early, you're going to be selling out early and you have to be willing to do that else. You ride it through to its natural conclusion. When people say, I don't want to sell yet, my question is what is the, what is the signal you're going to be looking for?
Rob Arnott: 41:26 What is, what is your sell discipline and if there's not a sell discipline, then it's all you're doing is riding with the trend and trends reverse eventually. So I look on today's markets and I think a forecast that I'm very comfortable making is that value, which has been awful for the last 12 years is going to be brilliant in the coming 10 years. But I don't know if it's going to be brilliant this year. I don't know when the turn is likely to happen, but I do know the relative valuations are abnormally stretched all over the world, especially in the U S and emerging markets. The home of the Fang stocks and the home of the bat stocks. These are markets where growth is frothy and value is cheap. I have considerable confidence in saying emerging market stocks will beat us stocks over the coming decade. Why? Because they're priced at half the valuation of us stocks and their growth is faster, so if they have faster growth and lower valuations, that's an easy forecast to make. It's not an outcast because it's not explaining what's already happened. It's taking advantage of what's already happened and saying these stocks are now cheaper relative to us stocks than they've been in a while and that represents an opportunity.
Rick Unser: 42:52 I like it. Before I let you go, anything else that you are working on? Anything else that your team at a research affiliates is, has been thinking about? Sorry, let me try that one more time. Anything else that your team at research affiliates has been putting out into the world that would be good to draw people's attention to.
Rob Arnott: 43:13 Last couple of years we wrote some very interesting papers on bubbles and came up with what I think is perhaps the first robust definition of the term bubble that can actually be used in real time to diagnose a bubble while it's happening rather than after the fact with the blessings of 2020 hindsight. And that definition is very simple. It says that to justify the current price of a stock of a sector of a market using a conventional model like a discounted cashflow model, you would have to use implausible assumptions to justify today's price. Well, that would tell you negative yields. Negative yielding bonds are by definition a bubble that would tell you that thang type stocks are a bubble. Now the second part of the definition is just as important and that is that the marginal buyer has no interest in these valuation models. You don't hear somebody laying out a discounted cash flow model for tests low or Netflix or Zillow to explain why they have their valuations.
Rob Arnott: 44:27 And so if the marginal buyer doesn't care about or evaluation models doesn't have any opinion on what the fair value should be, and if you'd have to use aggressive assumptions, implausible assumptions to justify the current price, you have a bubble. We have a bubble in the high end of the tech market, Apple and Microsoft, not so much. There are people who use discounted cashflow models for those. There are valuation justifications for their current price. You'd have to say that the assumptions that would justify today's price for those stocks are aggressive but not implausible for the thing and bath type stocks. They're implausible and so you wind up with a market that you can diagnose today as a bubble. Now, the other issue that's interesting about bubbles is, as I said earlier, they continue until they don't. So when you sell out of a bubble or fear speculative enough to short sell a bubble, which is very dangerous, you have to recognize that bubbles can go way further, way further than you ever thought possible.
Rob Arnott: 45:38 Who to thought a year ago that Tesla was going to be tripling and a year ago people were making the case that the fair value for Tesla is zero. I never thought that was the case, but I did think it was lower than the then current price and I still think it's lower than the then current price, let alone today's price, but short selling it, you would've lost twice your money and so bubbles you have to treat with great care. You can choose not to invest in them. That's easy, but to bet against them gets to be dangerous because you could have a bubble go up twofold, threefold, 10 fold, 50 fold, you just don't know and if it goes up 50 fold, you lost 50 times your money, you might turn out to be right. It might go up 50 and then crash to zero. That's what the Zimbabwe stock market did during their hyperinflation.
Rob Arnott: 46:35 In us dollar terms, they went up 50 fold and then to zero. So if you had a 2% short position, you got wiped out before you were proven. Correct. So back to the basic point, I do think we're seeing bubbles all over the world in negative yielding bonds and in frothy tech stocks. I do think these bubbles will burst. I don't know when I prefer to sit on the, not on the sidelines in cash, but on the sidelines in markets that are cheap, that are priced off are wonderful forward-looking yields, let alone forward-looking total returns and stick with those patiently waiting for the market to reassess some of those frothy valuations.
Rick Unser: 47:23 Perfect. And maybe just to bring this all home one last time here. So for that investment, for that retirement committee that's looking at their investment lineup and saying, you know, Hey we, we love our large cap stocks, we love our us, we love our, you know, bond exposures in there. They're still struggling with their ideas of getting their arms around this diversifying asset strategy. What's your closing comment that says, Hey, this decade is the, this is the time. If you haven't done it already or if you're considering getting rid of it, this is the time to stick with it or this is the time to add it. I guess. What's your closing pitch and then I'll let you go?
Rob Arnott: 47:59 Sure. Back in the year 2000 I was invited to speak to a group called CIBA that's focused on large corporate pension portfolios, mostly at the time defined benefit and my observation was forward looking returns are going to be at much lower than most people expect that you're publishing documents that encourage your employees to extrapolate 8% returns and see how well off there'll be in retirement and if they don't make anywhere near 8% you're going to face litigation. Even on the defined contribution side where you think you have no such risk and the reaction was nobody sues about defined contribution plans. Well now they do. So I think depriving your employees of diversifying choices is actually a very dangerous decision. Employees will invest approximately in proportion to what's on offer on the 401k platform. If 80% of the options available are stock strategies, stock mutual funds and index funds, then 80% of your employees money is going into stocks.
Rob Arnott: 49:17 Is that wise from today's valuation levels? I don't think so. But to deprive them of the anti diversifying strategies that can protect them in down markets creates a an element of fiduciary risk that I think is downright dangerous. Ethically. I think you owe it to your employees to offer them choices that are out of mainstream that might be unpopular today and might turn out to be the best place to invest in the coming decade. And from a fiduciary perspective, you owe it to yourself to make sure these options are available so that people can't point after the fact to the lack of such availability and say, look, you only gave us options that provided horrible returns. How dare you have done that? Let's not take that chance.
Rick Unser: 50:12 Well said, Rob, as always a pleasure, love all your thoughts, love all the expertise and insight that you bring to the conversation. That's why I love having you back, and certainly as we have this conversation again down the road, we'd love to, we'd love to catch up in the next year.
Rob Arnott: 50:30 All right. Thank you so much. It's been a real pleasure.