The Best Investment Writing Volume 3: Rob Arnott Yes. Its a Bubble. So What?
Welcome podcast listeners. We have a fantastic episode for you today. Last year. When we publish the best investment writing volume two two we offered authors the opportunity to record an audio version of their chapter to be releases a segment of the podcast and listeners loved it this year we're bringing you the entire volume of the best investment writing volume three in podcast podcast format you'll hear from some of the most respected money managers and investment researchers all over the world enough for me? Let's get to our guest and let them take over this special episode. Hi I'M ROB are not founding founding chairman of research affiliates were best known for our work and smart Beta and asset allocation with about one hundred eighty billion in assets managed worldwide using our investment strategies. We're a bit unusual were singularly focused on research searching product innovation and we work with distribution partners to make our ideas available to the marketplace so we deliver solutions in partnership with distribution powerhouses like Pimco Footsie S._S._G._I.. Ed Black Rock Legal and General INVESCO and the more to name just a few these firms bring our ideas to their end clients through mutual funds E._P._S. separately managed accounts and other vehicles so as one of the pioneers here's in smart Beta in two thousand five we introduced the research affiliates fundamental index also known as Rafi as an alternative to traditional market cap weighted indexes the fundamental index weights companies based on the size of the business business not based on the popularity of the company not based on how much the market value is not based on how extravagantly expensive the company is so we wait companies based on measures like value cashflow no dividends and sales thereby severing the link between the price and the weight of stock in the index. The Achilles heel of cap waiting is that it links the weight directly to the price so that the price doubles the weight in the portfolio also doubles. Cobbles and that means that you are inherently overweight all of the overvalued companies and underweight all of the undervalued companies even though you can't know which companies are which Rafi offers a contrarian approach the underweights overvalued stocks and favors out of favour more appropriately valued stocks as such does have a distinct value tilt and it works remarkably well in most market environments in which value is is winning which hasn't been the case in recent years but boy values gotten off the inexpensive lately so <hes> I think this is an interesting strategy for folks to look at today we also offer single and multi factor indexes. We also do a a lot of working asset allocation to learn more about us and to sign up for research insights feel free to check our web sites at research affiliates Dot Com and Rafi R._A._F._i.. Dot Com. I've been asked to read you an excerpt from I'm a piece that we published a year ago entitled. Yes it's a bubble so what I wrote this with my colleague Chain Shepherd and with Brad Cornell professor emeritus at Caltech back in April of two thousand eighteen but it still applies today in fact we've just written a follow up article bubble bubble toil and trouble which you can access on our website again. The website is research affiliates Dot Com. Let's dive right in the excerpt reads as follows the relentless rise in the U._S.. Stock Market since it's low in two thousand nine has been dramatic U._S.. Stock Market Valuations now exceed all historical valuation levels except for those hit at the peak of the DOT COM craze. This raises an obvious question for investors sisters is the U._S. stock market in another bubble. The answer is yes. The more important question then becomes how should investors react we recommend for actions that investors can take in response to current bubble conditions which should did allow investors to benefit from the bubble what constitutes a bubble pancer these questions. Let's begin by offering a definition of the word bubble we all hear the word thrown around carelessly often but it lacks a formal definition. We define a bubble as a circumstance in which asset prices one offer little chance of any positive risk premium relative to bonds or cash using any reasonable projection of expected cash flows and to there's sustained because investors believe they can sell the asset to someone else for a higher price tomorrow with little regard for the underlying fundamentals notably there are markets in which few if any buyers care about the discounted future cash flows to value and asset the nineteen ninety nine to two thousand tack or Dot Com bubble is the poster child for a broad market bubble at the height of this bubble aggressive assumptions were required to believe that the entire U._S. stock market would deliver a positive premium relative to then prevailing bond and cash shields for the tech sector in particular to deliver a risk premium compared to the six percent bond yields available at that time most tech stocks would have had had to produce rapid growth far into the future even though few could have succeeded unless they're fierce competitors were also struggling in hindsight using our simple definition. The tech bubble was indeed a bubble and could have been identified at the time more importantly Lee many observers in the midst of the bubble correctly perceived it for what it was at the beginning of two thousand ten largest market caps tech stocks in the United States collectively represented a twenty five percent share of the S. and P. Five hundred Microsoft CISCO INTEL IBM A._O._l.. Oracle Dell Son Qualcomm and Hewlett Packard didn't live up to the excessively optimistic expectations over the next eighteen years not a single one beat the market five produced positive returns averaging three percent of your compounded far lower than the market return and two failed outright of the five that produce negative returns the average average outcome was a loss of seven point two percent a year compounded or twelve and a half percent a year less than the S. and P.. Five hundred eerily similar to the New Economy Dogma. The DOT COM bubble is today's CRYPTO. uh-huh currency craze it boggles the imagination to hear people speaking of investing in Bitcoin an electronic entity that offers no hope future off operating profits or dividends is little used as a surrogate for money and transactions his actions offers an uncertain longer term use case and has no objective basis to determine its fundamental value. How many investors are holding crypto currencies for any purpose other than the expectation that someone else will pay a higher price at some point in the future? We see bobble in the U._S.. Stock Market Today. I'll be albeit less extravagant than the growing swarm of cryptocurrencies reasonable observers can disagree but we believe we are experiencing a tech bubble based on relatively rigorous definition of the term at the end of January two thousand eighteen the seven largest market cap stocks in the world. We're all tech flyers alphabet apple Microsoft facebook Amazon tencent and Alibaba never before has any sector so dominated the global roster of largest market cap companies now. Let's focus on how investors should should react in response to a bubble. A reasonable first step is to sell her great relieve reduce our holdings of bubble priced assets the two most dangerous things about Bob or that one markets can go far beyond any objective evaluation regulation measure and to investors can never know with any confidence when the bubble will pop the market will turn whereas the bubble is not as hard to identify in real time as is commonly perceived transforming a bubble into a profit even for investors who correctly discern it is a tremendous challenge because late stage bubbles can take valuations into the stratosphere investors can actually provide their own most appropriate response to a bubble by answering a very simple question. How much shortfall can I tolerate for two consecutive years without panicking each investor has a unique threshold for maverick risk the difference between their manager's performance and the performance of the managers peers above all? Whatever bets we take should not be sized to exceed our our clients tolerance for Maverick risk we recommend four actions of investor can take to protect themselves and even benefit when the bubble eventually bursts first? I an investor can materially reduce or eliminate their exposure to bubble assets. If we cannot construct a reasonable scenario in which the bubble assets could offer an acceptable risk premium the greater fool rationale someone will pay more for it later resembles picking up nickels in front of the steamroller at a minimum we can underweight these assets second an investor can seek anti bubbles in the market and invest in them anti bubbles are sectors or markets priced at levels that cannot plausibly deliver anything but a large risk premium anti bubble cannot exist in a single asset because almost any assets price can drop to zero but considered junk bonds financials and in consumer durables in early two thousand nine these asset classes weren't going to disappear each failure of a single company not that the survivors in that sector had less competition higher margins and a clear runway collectively the sector itself couldn't fail to deliver a very large risk premium barring a handful of genuine armageddon scenarios emerging markets value stocks in early. Two Thousand Sixteen were a similar example Raffi. The fundamental index emerging markets fell to Schiller P._e.. Ratio of five point six times earnings and earnings yield of eighteen percent in a world of zero yield bonds and cash emerging markets value was an obvious anti bobble similar to the trajectory of a bubble an anti bubble continues to collapse until it doesn't until it turns therefore averaging into our positions with an eye towards not exceeding being an our investors tolerance for maverick risk is a prudent way to invest an anti bubble can be a rich source of profit for the patient investor third an investor can diversify into investments that are not in bubble territory. For example as of early two thousand eighteen emerging market equities in many developed countries stock markets are trading discounts to their historical valuations rather than the extravagant premium of the S. and P.. Five hundred as a paper cheaper by Arnott Kolesnik and Mistero entitled Cape Fear noted many arguments advanced to justify a schiller price earnings P._e.. Ratio also known as quickly adjusted P. E. or tape ratio of thirty three times. Each of these arguments applies equally to the European in emerging markets which both Sport Cape Ratios less than half as expensive as those in the U._S.. Market other markets offer better places to take on market risk seek them out fourth and investor can remember lessons learned from past bubbles such as the collateral damage done to the technology lead cap weighted indexes yes and P.. Eighty five hundred was savaged in the aftermath of the DOT COM bubble down twenty three percent over the twenty four months from March two thousand to March two thousand two on its way to an eventual forty-nine percent decline just six months later today in the U._S.. Stock market value stocks are trading at quite an attractive level especially in comparison to gross stocks. This is even true or an international markets and the growth value spread in emerging markets is very near an all-time extreme if investors investors significantly reduce equity allocations away from traditional market cap exposures especially in the United States and into value based smart Beta strategies especially in the half priced European and emerging urging markets they are likely to enjoy significant in insulation against the next eventual but inevitable market downturn one final note. I'd love to see US transform the industry from fixation on past returns and performance chasing to focus on forward-looking returns and a willingness to buy whatever is newly cheap are a asset allocation interactive and S._B._I..