Rob Arnott, chief executive and co-founder of Research Affiliates LLC, sat down for an interview with Bloomberg Business earlier this week to share a few thoughts on the current state of the economy and the equity markets. Arnott did not pull any punches in calling for a bounce back in value stocks, and pointed to emerging markets as a sector that is currently notably undervalued.
More on Rob Arnott
Rob Arnott has been a ground breaker in the investing industry for a long time. His once unconventional ideas are slowly but surely becoming conventional. Investing innovations by Arnott include “fundamental indexing” (weighting stock portfolios by economic metrics like sales, dividends and cash flows instead of the market value of the companies).
Fundamental index analysis techniques tend to identify value stocks rather than growth stocks. Furthermore, history has prove Arnott right. He notes that the FTSE RAFI U.S. 1000 Total Return Index returned 140% in the decade through 2014 compared with 114% for the Russell 1000 Index (although growth actually outperformed value during the decade).
When asked what he thought about the market rotating back to value soon, Rob Arnottreplied: “I think the market’s stretched both in terms of valuation levels and the spread between growth and value. It doesn’t feel like the tech bubble to me, it feels a little bit more like ’98 or early ’99 in terms of the magnitude by which things are stretched. But you do have some relatively extreme examples, companies that are trading at large multiples to revenue, let alone multiples of earnings or cash flow. And that hearkens back to the ’98-’99 experience. So I think we’re seeing echoes of the bubble in today’s global market behavior.”
Emerging markets undervalued
Rob Arnottalso highlighted emerging markets as a place to look for value right now. “There is a flight to safety [ongoing right now] and the snapback from that, when it comes, will reward the value investor handily. You also see a huge spread between the comfort markets, the United States at a Shiller P/E ratio of 27 times earnings, and the fear markets, emerging markets, where a fundamental index in emerging markets is currently at a Shiller P/E ratio of 10 and a half. My goodness, 60 percent discount to the S&P 500. That’s startling. Why would it trade at such a vast discount? Because people are afraid. Fear breeds bargains. You cannot have a bargain in the absence of fear.”
Peasants and pitchforks
When asked about the Shiller index, Rob Arnott riffed right into an analysis of current record corporate earnings. “Right now we have earnings coming off of record highs as a percentage of GDP and yet you have Wall Street saying ‘don’t worry, it’s going to soar to new highs.’ Pardon me, but when did the peasants with the pitchforks come out and start rioting? Society at large has to enjoy some of the largesse, or else the pitchforks come out. So earnings as a share of GDP can’t really advance materially from current levels, or at least it’s not healthy if they do.”
Rob Arnott extended the argument to end on a warning note: “So we’re looking at a likely mean reversion on earnings. What happens if there is mean reversion? Is the market ready for that? A strong dollar also points to mean reversion, when you get a strong dollar you usually get weak earnings, and the reciprocal for emerging markets and for Europe.”