Rob Arnott: Asset Allocation And The Dark Side Of Bull Markets

Rob Arnott: Asset Allocation And The Dark Side Of Bull Markets

Q: You have spoken of the “dark side of bull markets.” What do you mean by this expression, and how can the All Asset suite add value in such scenarios?

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Rob Arnott: In 1997, Peter Bernstein and I wrote an article titled “Bull Market? Bear Market? Should You Really Care?”1 The thesis was simple. Bull markets benefit those who want to spend right now. Bear markets benefit those who are setting money aside for future spending. Bear markets allow these – far more numerous – investors to invest at higher forward-looking rates of return. But, most of these legions of investors don’t realize they’re better off after a bear market … they hate bear markets even though they should welcome them!

Bull markets are wonderful fun … but they have a dark side: They lower the long-term forward-looking rate of future returns – unless they’re built on the back of stupendous macroeconomic growth that fully matches the scale of the bull market. In contrast, bear markets feel miserable … but they have a bright side: They boost the long-term forward-looking rate of future returns for each incremental dollar newly invested at the lower levels – unless they’re accompanied by a collapse in the macroeconomy that fully matches the decline in the market. Did the U.S. GDP collapse 50% in 2008–2009? I don’t think so.

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We believe capital markets in developed nations are currently priced to offer inadequate forward-looking returns. The best example of this paucity in forwardlooking returns is the U.S. equity market, where the real 10-year expected annualized return for U.S. large-cap stocks is a measly 0.4% and for small-caps, a negative 0.1%!2 As was the case at the end of the tech bubble, or before the 2008 crash, stocks are, once again, being used as a safe-deposit box, but they’re not safe, as we all know; they’re just not assured of losing investors’ money, net of inflation and taxes, as are mainstream bonds and cash, instruments of expropriation.

A quick glance at Figure 1 shows that a wide spectrum of asset classes is currently priced to provide a paltry 1% real return per annum, give or take, compounded for the coming 10 years. Bonds, long Treasuries, Treasury Inflation-Protected Securities (TIPS), U.S. stocks, small-caps, real estate investment trusts (REITs). What do the items on this varied list have in common? They have all enjoyed monumental bull markets. Cast your eyes to the asset classes near the top of the graph, those with improved prospective returns in the 3%–8% range. Emerging market (EM) stocks, bonds and currencies, high yield bonds and commodities. They are seemingly diverse and divergent. What do they have in common? They have all experienced either nasty bear markets or protracted lackluster returns. They are also all assets that have a real-return orientation, a stealth-inflation-protection component. They are – by design – where the bulk of our strategies’ exposure resides.


A healthy economy needs higher forward-looking returns, to provide an adequate return on capital investment. While we may all love a good bull market, a bull market that is built on a foundation of artificial stimulus rather than real macroeconomic growth robs us of this forward-looking return. It robs the capital market system of its raison d’être … capital allocation. Sadly, the only way for the markets to once again offer us sensible forward-looking returns is revaluation, which can happen in the form of a bear market in mainstream assets, or grinding low returns for a protracted span in the years ahead.

Wall Street’s favorite prognostication, the presumption of continued robust earnings growth to match the bull market, is increasingly implausible. Why? Today’s negative real rates discourage investment in the real macro economy (i.e., long-term investing in long-horizon projects with uncertain payoffs). Instead of making bets on the projects that would help them deliver on the growth expectations that their current equity valuations imply, we believe corporate managers are avoiding such investments for fear of rising costs of capital, more stringent tax and regulatory regimes, and labor laws no less stultifying than what they face today.

So, when corporations surveille the marketplace for shorter-term projects with high-odds payoffs to put their free money to work, they spy stock buybacks. Why not park spare money in liquid stock markets presumed to be protected by the Kuroda/Draghi/Yellen put?

The result? Mrs. Watanabe, Mrs. Schmidt and Mrs. Smith all face real returns, or returns after accounting for inflation, that are negative for cash, negative after-tax for bonds and near-zero after-tax for stocks. Their retirement will consist of dissipating the corpus of their portfolio. Their kids, who are (hopefully) earning money in the real economy today and saving for their own futures, face returns on their investments that also round to zero. Hence, they have no incentive to save or to invest.

What if a bear market materializes? For Mrs. Watanabe, Mrs. Schmidt and Mrs. Smith, even if their portfolios are invested in long-term government bonds or stocks, their spending power does not diminish; their portfolios still produce the same income stream as before the bear market. Indeed, not only do bear market drawdowns have little impact on sustainable spending, they also offer opportunities to increase sustainable spending through disciplined rebalancing across asset classes.

Here’s where it gets interesting: We believe any diversification away from a classic 60/40 allocation, accompanied with disciplined contra-trading – the essence of our All Asset strategies – means that their income streams are likely to rise in the bear market! If their portfolios are invested in Third Pillar assets – those designed to diversify away from mainstream stocks and bonds – their income streams should even rise with the inflation that our policy elite are so desperately trying to create. As for their kids, they now face real forward-looking returns on their investments that are at least mildly interesting. They now have an incentive to save and to invest.

Q: In a previous issue, you noted a strong relationship between inflation expectations, as measured by “break-even inflation,” and the performance of Third Pillar assets. If inflation expectations are at a low ebb, doesn’t this mean the relevance of inflation protection is also at a low ebb?”

Rob Arnott: Quite the opposite! We most need to embrace inflation hedges when inflation expectations are at their lowest! Over these past two years, we have experienced tremendous headwinds in the All Asset strategies, as tumbling inflation expectations led to a plunge in many Third Pillar markets. We suggested this risk two to four years ago, though we did not expect it would happen concurrent with a soaring stock market.

Inflation expectations are now 24 months into a severe bear market, having fallen by nearly 40% from more than 2.5% in March 2013 to a low of 1.5% in January 2015. I’ve previously said that in such an environment, a conventional response – especially from those who are anchored on mainstream stocks – is to question the need for inflation hedges. The correct response is the opposite.

When inflation expectations are high, inflation hedges are less necessary, because markets are already priced to reflect higher inflation expectations. When inflation expectations are low, especially when mainstream stocks and bonds are priced to offer negligible or negative real returns, we find it much more urgent to establish inflation protection as part of the portfolio. Why? Because historically speaking, stocks and bonds would be savaged by any whiff of inflation, at a time when it is utterly unexpected.

Until markets turn, contrarian investing is painful; staying the course requires discipline. A continuation of the current environment – continued outperformance of U.S. stocks relative to most other assets, paired with falling inflation expectations – is entirely possible. But, this too shall pass, and perhaps soon. There are a few reasons we believe an inflection point to be near.

Firstly, Fed profligacy, the dominant factor driving a massive run-up in equity prices since 2009, may be on the verge of reversing, as suggested by the Federal Reserve’s signaling of rate hikes in the coming year. This reversal would likely test U.S. stocks, which already face the challenging headwinds of lofty valuations, faltering earnings, a strengthening dollar and sharply lower oil prices.

Secondly, unlike in the U.S., most central banks in the rest of the developed world and emerging market (EM) economies are now easing. Supportive central bank policies in these regions, coupled with the possibility of positive earnings surprises, would tend to support their local stock and bond markets and in turn our returns, as we hold meaningful allocations in European and EM equities, and local EM debt.

Finally, inflation expectations are in the bottom decile of the life of the All Asset strategies, and of the last half-century. They are well below the levels that the Federal Reserve has set as its target. If we believe that the Fed has the ability to create inflation at or above its target level – and we do! – then we believe that inflation expectations are more likely to rebound than to fall further. Since the start of the year, we have already begun to experience an upturn in the market-implied inflation expectation from a low of 1.5% in January to 1.7% in March.

What’s the best predictor for changes in inflation expectations? The current level of inflation expectations. The lower the starting level, the more likely it is to rebound. That’s because when inflation expectations get too low (or too high), central bankers and market participants act in ways that help counteract the undesirable level. So if history is a guide, a small uptick of 0.5% in inflation expectations from current historic low levels is quite reasonable over the coming year. The historical evidence suggests that a rise of 0.5% in inflation expectations tends to deliver double-digit returns for Third Pillar assets, more often than not.

For investors with a too-modest allocation to Third Pillar assets, we believe it’s a marvelous time to ramp up on inflation hedges. Unfortunately, most investors like to sell whatever assets have experienced a bear market (the assets at the top of Figure 1!) and buy whatever assets have experienced a bull market (the assets along the bottom of Figure 1). Human nature – the avoidance of discomfort – has shown to be the greatest adversary of successful investing.

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