Episode #313: Rob Arnott, Research Affiliates, “Modern Monetary Theory Does Not Work”
Guest: 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.
Date Recorded: 4/28/2021
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Summary: In episode 313, we welcome our guest, Rob Arnott, founder and Chairman of Research Affiliates.
In today’s episode, we start with the U.S. stock market and why today’s valuations meet Rob’s definition of a bubble. Rob debunks commonly discussed reasons for why stock valuations should be so high and explains why he doesn’t agree with MMT. Then we touch on value stocks and Rob’s recent piece on the lofty valuations for electric vehicles stocks.
As we wind down, hear why Rob is bullish on emerging markets value, and what his new trade of the decade is – UK value stocks.
Please enjoy this episode with Research Affiliates’ Rob Arnott.
Links from the Episode:
- 0:38 – Intro
- 1:26 – Welcome back to our guest, Rob Arnott
- 2:26 – General thoughts on the US stock market in 2021
- 7:13 – Is passive market cap weighting to blame for US stock valuation?
- 11:58 – Episode #18: Rob Arnott, Research Affiliates, “People Need To Ratchet Down Their Return Expectations”
- 12:58 – How value and factors are looking in the current landscape
- 17:03 – Big Market Delusion: Electric Vehicles (Arnott)
- 23:14 – Research Affiliates’ Interactive Tools
- 23:33 – Rob’s perspective on emerging markets
- 29:10 – How COVID-19 Vaccines and Brexit Create the Trade of the 2020s (Arnott)
- 30:53 – Comparing the US and UK stock markets
- 34:03 – Why it’s important to having a selling discipline
- 35:48 – What Rob believes that most other investors don’t
- 38:35 – Time horizons and whether or not stocks always beat bonds
- 40:56 – Rob’s most memorable investment
- 44:28 – Things Rob is thinking about as he looks to the horizon
- 48:18 – Learn more about Rob; researchaffiliates.com
Transcript of Episode 313:
Welcome Message: Welcome to “The Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: What’s up, y’all. We got a fantastic show for you today. Our returning guest, one of my favorites, is the founder, chairman of Research Affiliates. In today’s show, we start with the U.S. stock market and why today’s valuations meet our guest’s definition of a bubble. Our guest debunks commonly discussed reasons for why stock valuations should be so high and then explains why he doesn’t agree with MMT. And then we touch on value stocks and our guest’s recent piece on the lofty valuations for electric vehicle companies. As we wind down, hear why our guest is bullish on emerging markets value and what his new trade of the decade is. It is… You got to listen. Please enjoy this episode with Research Affiliates’ Rob Arnott. Rob, welcome back to the show.
Rob: It’s a privilege. I really enjoy these.
Meb: Rob, you know, last time we had you on, it’s been almost five years. I miss getting to see you in person, but we’ve had, I think, more people from the Research Affiliates’ family on the show than probably any other company. Maybe GMO, it’s going to be close, but with you, you probably are the tiebreaker. Last time you were on, you were in California. You’re a Florida resident now.
Rob: I’m a Florida resident. I’m a tax refugee.
Meb: You’re always a little bit ahead of the curve. Have you noticed the big influx of venture capitalists descending on South Beach in Miami now? If that’s the Twitter sentiment, they’re all moving there in mass. It’s the big tech scene.
Rob: I bought in early ’18 and I’ve already had offers 40% more than I paid if I’ll just vacate the house. It’s not going to happen. I’d have to buy another house.
Meb: My goodness. Well, I’ll come rent out a room and it could be like the Research Affiliates’ WeWork. A lot’s gone on in the last five years, Rob. It’s been a lot of weirdness, a lot of crazy times, and markets as always. We’ve got to start with U.S. stocks. I’m sure you’re tired of talking about them, but everyone wants to talk about, as they call them in 2021, ‘stonks.’ What’s going on with the U.S. market? Any general thoughts here in early 2021?
Rob: Certainly, stimulus plays a huge role. Now, a lot of people think cash on the sidelines means markets go up because the cash goes into the stock market. It doesn’t quite work that way because for every buyer there’s a seller. What happens is the cash on the sideline increases the willingness to pay up for stocks and the willingness to sell stocks diminishes so it takes a higher price to get a transaction to happen. So that’s really what happens, but stimulus has been massive for the stock market. The retail community has been massive for the stock market. I don’t think the retail community made as much difference as in 2020. Going all the way back to the 1970s, you’d have to go back to the 70s to find retail being as important a participant. And part of that is stimulus going to people who didn’t need it. You’re gainfully employed, you’re not thrown out on the street, and the stimulus isn’t needed to pay your mortgage, and so you just take the stimulus and pop it in the market. And hey, Robinhood makes it not only easy but a game.
And so this goes on until it doesn’t. And right now you have earnings soaring. We spoke last summer about earnings pointing out that stimulus is highly correlated with subsequent corporate profits. In fact, every trillion dollars of stimulus shows up as roughly a quarter trillion more corporate profits per year for four years. So the notion that this helps Wall Street is utterly naive. The question then is, does the stimulus persist indefinitely? Well, modern monetary theory does not work. It’s been tried under different names, again and again, going back centuries. Printing money and using it to spend on chosen projects, cherry-picking winners, and shunning selected losers as a form of a central control that takes the decisions of what do we want to buy and sell out of the hands of consumers so we don’t control our own destinies, it’s bad for business, it’s bad for the economy, but it’s not bad for the stock market because it does flow into corporate coffers, either indirectly through people’s pockets and then going out as spending or directly because a lot of this makes its way into the economy through the financial services sector.
So I view this as basically a game that will break at some point. Think of Thelma and Louise as they hurdled towards the edge of the Grand Canyon, they were fine, they were fine, they were fine, and then they weren’t fine. All right. That’s the way these things break. There’s a, what John Malden likes to call a bang moment when it breaks. So I look at Shiller PE Ratio of 34 and I think, “Gosh, higher than that, only in the year 2000, market cap-to-GDP higher than ever in history, price-to-sales higher than ever in history.” These are daunting multiples. They’re also propped up by low-interest rates. But if inflation kicks in, the interest rates aren’t likely to stay low for long. And the prop-up by interest rates is in the mind of the investor. If you go back historically, you find that low-interest rates don’t help stocks except on a short-term basis. Why? Because low-interest rates help debtor companies, and those are mostly on the value side. So on a short-term basis, growth stocks are propped up by low-interest rates, but on a long-term basis, they aren’t really helped. If low-interest rates help the stock market as an aggregate, why on earth is Europe priced at half our multiples? Why is Japan priced at two-thirds of our multiples? Why was the U.S. stock market in the 1950s, on average, priced at one-third today is multiples? So low interest rates aren’t the panacea for stock market valuations people think. I worry. I don’t predict a market crash, I just predict depressingly anemic stock market returns for the 2020s.
Meb: I think if you were to tell most advisors and listeners, you said, it’s not a crash but depressingly anemic, I think they probably hear the same thing. You know, you touched on a few things, Rob, that I think are on point. I think a lot of investors always think they can get off the musical chairs, get off the merry-go-round before the party ends, right? They can leave the party before it’s over. But as this valuation multiple keeps creeping up and getting higher, and higher, and higher, it feels like it’s certainly getting more dangerous. And there’s sort of two ways to think about it. You know, you were, I think much closer to John Bogle than I was, but he would use valuations. A lot of people from the Vanguard camp, the Bogleheads, may not like to hear this as much, but he would use valuations as a way of framing expectations. Now, he may not say he timed the market or whatnot, but I’m going to give you a Twitter poll. Now, this may give you a heart attack, so just be prepared, okay?
Rob: My heart’s pretty robust.
Meb: I asked my followers. I said, look, “Do you own U.S. stocks?” Everyone said yes. I said, you know, “Here’s the multiple, their long-term CAPE rat, one of the highest ever. Would you continue to own U.S. stocks if they hit a CAPE ratio of 50 higher than we’ve ever had in the U.S.?” Close we hit high 40s in the ’99 bubble. And I think it was…over half said yes, they was still continue to own them. And I said, “Would you still own them at 100?” Which is back to Japan bubble territory, and I think it was over a third said yes. And so there’s a certain amount of people that will own stocks regardless of the valuation. How much of that do you think plays a role in the stock market? The continuation, expectations, the multiples moving up, can you just blame it all on passive market cap weighting or what?
Rob: Passive certainly plays a role. If money pours into the stock market through SPY or Vanguard, it’s going to push multiples higher, and most particularly the poles push multiples higher on the stocks that are members of the index. And so you get this spread between a membership effect. Are you in the S&P, are you not in the S&P? That looks to be about a 2000 basis point valuation spread. That’s part of it and part of it is that perceptions are sticky and are trend-following. People become more optimistic if they’ve been making money. One of the things I think is just fascinating about human nature is, “Okay. We want more of whatever’s given us great joy and profit.” Well, when you look at something that’s overpriced and poised to perform badly, it usually got there by creating joy and profit. So there is a reluctance to sell or to even have a sell discipline.
We mentioned earlier the notion of don’t want to miss out, the FOMO thing, fear of missing out, and investors being reluctant to lighten up or even to set a sell discipline. They want to wait until things are breaking. But we know from the COVID crash, from the tech bubble bursting, from the global financial crisis, that when things break, they break fast. And so you can be looking six weeks or two months into it with the major losses already done. So the issue really is when somebody says, for example, “I don’t want to miss out on Tesla, it still is going up,” my response is, “Okay. What is your sell discipline? What would prompt you to sell?” All too often the reality is it’s an 80% drop is going to prompt them to sell after the 80% drop. Human nature conditions us to do the wrong thing all the time. Flipside of that is just as powerful.
Bargains got there by inflicting pain and losses. Nobody wants to double down on pain and losses. The result is that the stock market is a classic Giffen good. A Giffen good is something where demanding increases as the price goes up. Common examples are jewelry or fashion, high fashion clothes. A designer dress for $1,000 dollars isn’t going to sell, a designer dress for $10,000 will. And same thing applies to the stock market. Economists are reluctant to treat stocks and bonds as Giffen goods, but they are. Demand goes up as the price goes up. It’s a little bit like if Tiffany’s had a banner sign saying post-COVID sales, everything marked up 20% and people were breaking down the doors to get in and Cartier across the street, post-COVID sales, everything marked down 20% and people think, “Oh, they’ve got something wrong with their product. I’m not going in there.”
Meb: How much of this…you know, we talked about this last time were on years ago and some of these discussions are timeless. You know, thinking about the construction where you mentioned, I think it was Fortune years ago, talking about building indices based on actual fundamental metrics like revenue and sales.
Rob: I think that’s a fun thought experiment.
Meb: If Fortune had just simply started managing money, they’d be like the biggest asset manager on the planet because they would’ve stomped the S&P last 70 years.
Rob: Yeah. The S&P 500 was introduced in ’57. The Fortune 500, not the index, the list, was introduced in 1954, three years earlier. If Fortune had said, “Hey, we’ve gone to all this work to create this list of the 500 biggest companies by sales, why don’t we create an index that weights companies this way?” They’d own the asset management world. They’d be the first $50 trillion asset manager because they’d have ripped all the money away from conventional indexing and all the money away from active managers.
Meb: The market cap-weighted indexing is a curious animal. You know, it does represent the market as we talked about last time. But as an investment strategy, it’s certainly a little bit of a head-scratcher. It’s great because it requires no effort, it can be delivered at a very low cost or no cost, essentially. But in my mind, thinking about the market in those terms allows the extrapolation of, in some cases, price is irrelevant. And you’ve mentioned this in certain areas where you’re talking about value and factors and how at sometimes they’re really attractive and other times, maybe not so much. How’s value looking after the drubbing we’ve had over the past, I don’t know, 10 years, 7 years in the value factors?
Rob: Depends how you measure it. If you use price to book, the classic Fama French method, the value peaked in 2007 and had a 13-1/2 year series of bull and bear markets, but mostly bear market going from relative cheapness, relative to growth, of one-fourth the valuation of the Fama French growth portfolio to one-thirteenth, a drop of 70%, the performance was a drop of 55%. And so ironically, the value factor works during those 13 years. That is to say the under-performance was less than the cheapening of value, it’s just that the cheapening of value overwhelmed the value effect and led to terrible results. Now if price-earnings ratios, value peaked in 2013. If you use price-to-sales, 2017, if you use RAFI, end of ’17, early 2018, fundamental index versus cap weight. But they all cratered from ’17 to late 2020 and they all hit bottom at the end of August 2020.
The snapback has been tremendous. The snapback and value indexes that are still cap-weighted has been impressive on the order of 12% give or take. I haven’t checked it in a few days. The snapback for things like fundamental index has been much bigger. And so value does seem to be coming back finally, but value had a drubbing. It had the biggest drawdown and the longest drawdown in its history, worse than the drawdown in the great depression, worse than the drawdown in the tech bubble, and value got cheaper relative to growth than even at the peak of the tech bubble. So you had stocks at the peak of the tech bubble, the big ones like Cisco, multiples of 100, 150, 180 times earnings, but that doesn’t compare with the multiples of some of the FANG-type stocks, Tesla notably, during this bubble. And I do refer to it as a bubble. One of the things I’m proud of is, since the last time we spoke, we did a paper in 2018 in which we came up with a workable definition of bubble that you can use in real-time, simple definition. One, if you’re using a valuation model like discounted cash flow, you have to make implausible assumptions, not impossible, but implausible assumptions to justify today’s price, and two, just as important, the marginal buyer, none of the marginal buyers is using a valuation model. So you can look at that and say, Amazon’s priced to reflect aggressive assumptions, not implausible, may be unlikely, but not implausible. Tesla is priced at levels where the growth would have to be beyond anything that is remotely plausible to justify today’s price and there are people who buy Apple on a valuation model. There are no people who’d buy Tesla on a valuation model.
Meb: It’s timely as we’re talking because the charismatic CEO of Tesla is going to be on “Saturday Night Live.” And it’s been…of the entire history of the show, there’s only been a couple, you know, non-musicians/athletes on the show as…or politicians. You know, and this cult of, you know, the CEO, I mean, if you look at sort of all the things going on with romping stomping bull, we talked about the valuations, we mentioned the retail participation. We mentioned the unrealistic expectations, I saw a survey recently that had U.S. stocks, the highest expectations in the world at 15%, you have IPO’s SPACs apply, short interest low, interest rates potentially going up and who knows what taxes, it’s a pretty significant list, but at the peak you have this cult of personalities, and you guys have talked about this, not just with Tesla, but the entire electric vehicle space too, which was a pretty cool piece. Can we touch on that before we skip over across the pond to the rest of the world?
Rob: We wrote a piece very recently, in which we looked at electric vehicles as a bubble and not specifically Tesla. Interestingly in 2020, the eight automakers that exclusively focus on electric vehicles, Tesla was the second-worst performer in 2020, isn’t that astonishing. There’s something that a fellow named Brad Cornell coined the expression, ‘big market delusion.’ And that’s where you see a big market where you’re optimistic about its possibilities and where the marketplace prices every asset in that market as if it will be a winner. So in electric vehicles, there are eight producers that do only electrical vehicles. There are at least 10 existing producers of autos that also do electric vehicles. Here’s a shocking stat. The conventional automakers who also make electric vehicles make more electric vehicles than the electric-vehicle specialists. Over half of the market is conventional automakers that also make electric vehicles and the electric vehicles are priced at levels…those eight electric vehicles utterly dominated by Tesla, of course, are worth more than the 15 largest automakers in the world collectively. Okay. That’s pretty astonishing.
Now, what makes it doubly astonishing is big market delusion. Not all eight are going to win. There is going to be two, three, four of them that survive, half at least won’t. They have competition from the existing makers, many of whom have much deeper pockets than even Tesla in terms of cash reserves and ability to invest and have ample history. Toyota’s been a pioneer in hybrid, which means they’ve been a pioneer in electric power. Counting them out and saying, “Tesla’s worth four times what Toyota’s worth,” strikes me as a little nonsensical. So the whole notion that you price an industry as if they’re all going to win, it’s the same as the tech bubble in 2000 where tech stocks that competed against one another were priced as if they would both win.
Well, it doesn’t happen that way. So that’s another sign of a frothy bubbly market. I look at today’s market and I don’t predict a crash. Crashes happen, but often they don’t. Lousy returns also happen and they happen with bull and bear markets, bull that are anemic, bear markets that are daunting and nasty, and so you sputter and go sideways. Our outlook for U.S. stocks for the coming decade is a 2% return or a little less than 2%, and it’s based on…the yield is 1.6%. Historic real growth and earnings and dividends is 1.5%, that gets you to a 3% real return, which would be 5% to 5.5% notional return. Not particularly good, but not awful, but that requires the Shiller PE ratio to still be at 34 times earnings 10 years from now. And historic norms are 18, so we take the view that maybe they may revert, maybe they don’t. Let’s split the difference. If they go from 34 to 26, what’s that going to cost you? It’s going to cost you 3.5% a year from lower valuation multiples. And that’s enough to take you down from five or 5.5% to below 2%. So we’re looking at a 2% expected return for U.S. stocks, 2% for bonds. How many investors are going to be happy if they earn 2% on their money over the next 10 years? And the irony is that there are lots of markets that are a lot cheaper and priced to give us much better returns than that. Emerging market stocks and bonds, plain old EFA international stocks, and the list goes on.
Meb: I like how you added that little bit of positivity at the end because otherwise we’re just going to depress everyone. I did a presentation the other day where I had a big if of…I said, my expectations for U.S. stocks and it had a doughnut. I said, “Normally I would use a bagel.” That’s probably what people say when you get big zero. But I said, “I grew up partially in with Winston-Salem, North Carolina, home of Krispy Kreme.” So I had a bunch of doughnuts, but there’s ways that try to make this digestible from investors to give them perspective because if you look back in history, we’re up in the mid-high thirties on the CAPE ratio, like you mentioned, I said, “There’s different ways of looking at it. If you look at it all the prior, just decades, decade in, so even if you just start with this decade, we’re in the top two highest ever and you’ve never had positive returns, you know, going forward and then if you look at the…same thing, the other major indices I got about seven times the U.S. EFA EM have ended a year up around where we are. And on average, the future real returns, like you mentioned, were Zippo. The good news is you just mentioned EM. And so, listeners, Research Affiliates has an awesome tool. I spend a lot of time on there playing around with beautiful charts. It’s called the Asset Allocation and Smart Beta Interactive. It’s interactive.researchaffiliates.com. Check it out. And you can go play around with their models for expected returns and everything else. And emerging markets looks like a bright spot. Tell me about it. I know you actually allocate an outsized amount on your own as well, or at least I’ve heard you mention it. You still an EM shareholder, you crazy, or what, Rob?
Rob: I have a little half of my liquid assets in emerging markets deep value stocks.
Meb: You’re the only person on the planet. I thought I was outsized. I posted on Twitter a while back that my whole 401k goes into EM and, man, if you could read the replies. I mean, they were not just like disbelief replies, but a lot of people were angry, you know, it’s straight-up angry.
Rob: You know, that’s interesting. One of the things I’ve noticed in my career is when I challenge conventional wisdom, the reaction is not, “Oh, that’s interesting. Let me look at the evidence,” or, “Oh, that’s surprising. Let me learn what’s this guy thinking?” The reaction often is anger. And I think the reason for that is very simple. You’re basically saying your belief system that drives your investment decisions is wrong and you’re badly positioned for the future. And people get angry when challenged in that way. So I’ve found it fascinating throughout my career when I write provocative, but well-demonstrated, well-documented views that are out of mainstream, how it angers people and has even cost me a handful of friendships over the years, which is weird. But be that as it may, how many people put half of their money in U.S. growth stocks? Is that controversial? Is that going to make people angry? We might say, is it wise? It’s riskier than putting half of your money in EFA and EM. It’s much more volatile and has much less likelihood of delivering the kinds of returns that you want.
So let’s look at emerging markets and international as two examples. EFA is priced at a Shiller PE ratio of about 18, half that of the U.S., emerging markets is about 15, less than half that. Now, in emerging markets, they have their equivalent of our FANG stocks. They’re called the BAT stocks, Baidu, Alibaba, and Tencent, but they’re really kind of a metaphor for that whole hyper growth part of the market. They’re priced very similarly in valuation multiples to the FANG stocks. So if emerging markets are cheap, less than half the U.S. multiple, gosh, that must mean the emerging markets value has got to be about one-fourth the U.S. multiples, and that’s in fact exactly the case. So emerging markets value is priced at a Shiller PE ratio of about 10, fundamental index, it’s about 9 as the active fundamental strategy we run for PIMCO, it’s about 7.5 or 8. You can buy half the world’s GDP for less than 10 times long-term sustainable, 10-year average earnings. Why wouldn’t you do that? Now, let’s suppose there’s mean reversion. Let’s suppose emerging markets go back to their norm of 18, that’s a 20% rise. Let’s suppose EM value goes from its deep discount to a more normal discount, 20%, 30% cheaper than EM, that’s a doubling. And so the notion of EM producing a doubling of your money in five years isn’t a stretch at all. It’s very plausible.
Meb: You and I have been doing this long enough where we’ve seen a few different cycles. You’ve seen a few more than I have, but, you know, it’s funny about emerging markets because let’s rewind, let’s call it 15 years and I used to go to all these institutional conferences, and my God, there’s nothing people wanted more than the BRICS, right? Brazil, Russia, India, China, and the emerging market CAPE ratio was close to where the U.S. is today because it had just finished a decade of just smashing the S&P, 2000 and 2007, my God, it was, you know, everyone wanted emerging markets back then.
Rob: Shiller PE ratio for EM at the end of 2007 was 38 and U.S. was 28. So it was a 40% premium. Now it’s a 60% discount. These are the same companies, the same countries still facing daunting headwinds and political instability, but still facing the opportunity to emerge, to catch up. And as we’ve seen in many countries just by catching up by imitating and stealing ideas. All right, well, it’s a time-honored way of catching up for emerging economies.
Meb: You know, it’s so funny how the narrative and mood changes over time. I mean, you have conversations about EM and it’s just a laundry list of excuses, reasons why it can’t possibly work in the future. You know, you had a good quote in one of your pieces that says, you know, most investors are transfixed by current events, but surprisingly if you ask, will these events matter much in five years? And thinking about markets on that timeframe, you know, in a Robinhood world of minutes, hours, days, weeks, not even quarters and years, but decades is hard to do. You guys had a really good piece. I’ll give the preview of where I was over in a British pub, pre-Coronavirus, having some pints with some friends over there, and man, the mood was sour. You talk about people that…I tried to get them to explain Brexit and spent about an hour and could not figure out what the path forward was. No one seemed to know. It was confusing. We talked about their markets and everyone was selling and depressed and things had no upside. Talk to us about your recent piece on one of the best ideas for the coming decade.
Rob: We described British stocks, specifically British values stocks as the bargain of the decade back from roughly August. And we decided to write it up in February, I think it was because even though they’d snap back a bunch, they were still really, really cheap. And apropos earlier conversation, I was shocked how many people from the UK commented on the piece with anger, angry that someone would suggest that British value stocks were remarkably cheap. And the anger seems rooted in a belief that these companies are awful, can’t get out of their own way, won’t get out of their own way, doomed to eventual oblivion…well hell, we are all are doomed to eventual oblivion, but on a five or 10-year horizon, I think we can plan ahead. And so the whole notion of it being a bargain, which I thought at least the UK readers would say, “Oh, somebody said something nice.” No, that wasn’t the reaction. It was interesting.
Meb: If you look back in history, UK certainly has one of the longest track records of functioning markets and, you know, at times things zig and zag where their market has done better than the U.S., but both have a lot of similarities. And looking at such a huge spread on valuations, in many ways, for two markets, the reaction I get most from people is they always say, “Well, the sector composition is different, therefore you can’t compare, it’s apples to oranges,” and/or, “The market’s too dynamic. Things have changed because of COVID.” What are your responses to kind of those comments?
Rob: My responses would be you’re absolutely right. Sector composition is different. Look at it with and without sector compensation adjustments. You find UK is almost the cheapest of the developed economy stock markets. I think Spain edges it out, but has more important structural challenges. If you sector adjust, that’s still true. It changes the relative valuation a little bit, but it doesn’t change the rankings. Basically, narratives like that one gain traction because they’re true. What’s not always true is the conclusion, that is to say, you take a factoid and you spin it into a very plausible and interesting story without asking the question, how much is the market already discounting this? Is the market unaware of this narrative? Low-interest rates are great for growth stocks. Okay. Is the marketplace unaware of that or at least on aware of the narrative? Of course not. So isn’t it already priced in? Of course, it is. Is it going to help you in the future? Doubtful.
Meb: I look forward to getting back on airplanes and heading over to the pond to see what the mood is currently. But my unscientific thesis, and I’m a quant, so, listeners, none of this plays in, but the big value rebound we’ve seen, I saw a buddy from Robeco post this on Twitter where he said the traditional French Fama, going back to the high minus low, going back to, I think the 20s, said the biggest underperformance of the high minus low was in 1999 but then the best performance was in 2000 until 2020, which was the biggest on performance and then in Q1 was, I think, one of the best quarters ever. I think you’re going to see that rotation move around the rest of the world for the rest of the year. Very unscientific.
Rob: U.S. hit relative valuation bottom for value versus growth September 2. Emerging markets rebounded, value rebounded with the U.S. a little bit in Q4, gave a lot of it back in Q1 and is not that far from its lows. Does that mean I’m going to look at my big emerging markets value bet and say, “Oh, this isn’t working? Get me out of here.” No. I’m going to look at that and say, “Oh, I have another chance for another bite at the apple. Maybe I should put more here.”
Meb: You talked about that this earlier, referenced it. And I was trying to find it, but I’ll post it in the show note links, another poll. I love polling the audience, but you mentioned the concept of so many people think about the buy decision but don’t really have a sell discipline and we were talking about Tesla or other things where their sell discipline is, well, they wait until it’s down 80 and then they sell it. And we asked, we said, you know, people spend 90%, 99% of the time thinking about the buy and I said, “How many people, when you make a investment, do you write down or do you establish the sell criteria?” And it was almost no one, which is kind of crazy when you think about it because that’s when the emotions come in and fracture everything because if you don’t have a plan…and it’s not just for the downside too, it’s like what happens if you have a market that doubles or triples, how do you play that? And not having a process seems like such a painful way to invest.
Rob: My son’s a momentum investor and he follows my advice on one important component, and that’s that he thinks about the sell discipline, at least somewhat. And when he’s got enough gains to take out his initial investment and let his profits run, he does that.
Meb: Listeners, we’ll post Rob’s first chat from years ago where…everyone wants to think in binary terms so much, “Am in or out? Should I buy, should I sell? Are U.S. stocks too expensive? Do I have to get out, you know, tomorrow?” And we talked about it at length last time but this concept of, what you talked about, over rebalancing to where look, we have a target and rebalance it. But if things are particularly under overvalued, maybe rebalance a little more. Doesn’t have to be zero or 100%, but somewhere in between, I think that’s a thoughtful piece of advice. I got a question for you, and this one is a little more…starting to get a little more philosophical, but from someone who’s authored, I don’t know, hundreds of papers and articles, you love poking the bear, not necessarily the bearish, but stirring up the pot and are willing to think differently, what is an idea, and I’m sure you have a million and you can name a few if you want, that you think you believe in the investing space that the vast majority of your professional peers don’t believe? So let’s call it like something you believe that 75% of people have the opposite opinion on. Anything come to mind?
Rob: Well, one thing I think I’ve made a career out of just being curious. If there’s a bit of conventional wisdom that’s making the rounds, I just instinctively say, “Has anyone tested that?” And as often as not, no. Nobody’s tested it. And I’ll test it. And is this narrative, is this popular view demonstrably correct historically or does history say, “No. It doesn’t work that way.” And I’ll publish a paper and people will get annoyed. What I believe that I think most investors don’t believe is hold your beliefs lightly, study them, test them. And it doesn’t mean test just historically to see did it work in the past, but did it work for the right reason? I mean, case in point, if you said 10 years ago, value is going to be terrible in the 2010s you were right, but where you write for the right reason? Value got cheaper by a bigger margin than it underperformed. How many growth and momentum players would have predicted that? I think far too many people, and there are some notable exceptions, a lot of wonderful long-term strategic investors who hold their beliefs lightly and who are constantly asking, “What’s the evidence?” Constantly showing curiosity, not just about the markets, but about their own beliefs. So we talk on our website in our core views, we talk about long-horizon-mean-reversion as being a core anchor of everything we do. Well, we’ve tested that again, and again, and again, and it tests to be accurate again, and again, and again. We believe it, but we reassess it regularly. And I think most people, once they anchor on an idea and say, “This is our core principle,” view it as immutable and really won’t countenance the question, are you right?
Meb: So many people attach, you know, their identity to their ideas and trying to separate the two is hard. And it’s probably amplified by, of course, social media and the modern world where it’s easy to spend all day looking for confirming evidence when in reality, as good investment analyst 101, like, if you’re bullish a stock, you should spend a lot of time going through the bear case. And how many people do that? They just surround themselves by people that have the same views. And it’s a great exercise. It goes back to the time of Keynes, right? When the facts change, I change my mind. And I think that’s useful. You touched briefly on a topic that is so important, and that is time horizon. You know, I’ve heard you mentioned this. There’s probably no more universally held belief in all of investing in my mind. If you had to ask what is the singular most held belief that everyone I know believes, I don’t know anyone that doesn’t believe this, which is stocks outperform bonds. And you need a caveat, which is over time. And most people think over time means two to three years.
Rob: There’ve been spans as long as 40 years in which bonds have beat stocks. And here’s a shocker. Since the peak of the tech bubble, long bonds have beat stocks. How many people on this call know that or even believe it when I say it? If you look at 20-year treasury bonds, performance since the peak of the tech bubble exceeds that of the S&P. Now, that’s not to say it will exceed in the next 10 years or 20 years, but the yields weren’t bad and stocks were in the stratosphere. Now the yields are awful and stocks are in the stratosphere. I’ve been called a permabear, but in my entire career, I’ve never had a cash reserve of any meaningful size other than just liquidity to be tactical. But I’ve always been fully invested. So if I’m a permabear, why would I do that? It’s because there’s always something attractively priced. People don’t notice my bearish calls because they’re on things that everybody owns. They don’t notice my bullish calls because they’re on things that people think, “Why would you do that?”
Meb: Goldman said the average emerging markets allocation in the U.S. for advisors is 3%.
Rob: And so a 10% allocation is seen as aggressive, but a 10% allocation to the FANG stocks is seen as very normal.
Meb: It’s like the home country bias. When you ask people, you say, you know, “Would you allocate 80% to Brazil?” They’re like, “That’s crazy. Why would anyone do that?” But say, “Well, you do it in the U.S?” So that’s the average, the market cap is just half. But real quick before we start to wind down, last time we were on, we asked a different ending question and we talked about solar eclipses. As a fellow star-focused person, I got to go see my first rocket launch yesterday.
Rob: That’s on my bucket list. I’ve never seen one.
Meb: Yeah. It was fun. Well, you got the Cape Canaveral not too far away, but we have Vandenberg right up the coast. And so the weather didn’t look great, but we got to see the Delta Heavy IV. I took my 4-year-old and my wife and hilariously in Meb style, we were facing the 180 degrees the wrong direction, so thankfully there was like 1,000 other people showed up and said, “Why are you looking that way? It’s going to come out over here.”
Rob: Sometimes there is wisdom in crowds.
Meb: Yeah, exactly. But so we have a new closing question now, which is over your career, good or bad, what’s been your most memorable investment seared into your brain? Usually, the first thing comes to mind anything. Anything pop up?
Rob: My most memorable investment was also a very good lesson when 9/11 happened. I didn’t talk about this for years after 9/11 because I didn’t want people to think that I was making light of the terrible human catastrophe that happened and focusing on my investments and their performance in 9/11, when way more important things were happening. But my biggest investment at the time was a short vol bet. I had about 10% of my net worth in a short vol strategy. And by the time the markets reopened, I’d lost 40% of my net worth. Now, I didn’t feel badly about that. I was still alive and I had friends that weren’t. But I looked at that and realized, “Okay. I made too big a bet. Risk management matters.” In fact, both Warren Buffet and Ben Graham said, “Asset management, it’s more about management of risks, the management of returns.”
So what did I do? I decided liquidating these positions is absolutely stupid. So I moved the strike prices so that my downside risk was slightly reduced and the upside opportunity slightly reduced, but I hung in there. And as volatility they started to fall, I used the profits to ironically ramp the aggressiveness of the strategy back up and wound up six weeks later recouping with room to spare. And at that point took my exposure to that strategy way down. And so the lesson was go into a crisis without having bet too much on any particular thing, diversify. And the…I don’t know if it’s a lesson, but my response to that was to say, now is not the time to put risk control into place in the portfolio. I made my bed, I’m going to sleep in it. And it worked out beautifully, but it was the most memorable investment I ever made.
Meb: As you look out to the horizon, you know, you got a curious mind, anything you guys are working on brainstorming? I miss the Research Affiliates family and the annual conference. Anything you guys curious about, wondering about, scratching your head about, excited about?
Rob: We’re doing work on momentum in factors. Factor momentum turns out to create sector momentum. Sector momentum doesn’t exist without factor momentum. Stock momentum, individual stock momentum almost doesn’t exist without factor momentum and factor momentum is powerful. So if you think value is really cheap, don’t buy value. Wait until there’s some hint of a turn, then buy it. But don’t wait too long. Just a hint of momentum plus cheapness is fantastic. We’re doing work on investible factors. Most factors, net of trading costs don’t make money. Now, you can mitigate, you can change the factor to trade more cautiously and swing most of them back into the black. One notable exception is momentum. Momentum is very high turnover. No matter how you trade it, it loses money net of trading costs. So does that make it useless? No. You can use momentum to block trades and reduce your turnover. If a stock is headed to the stratosphere and is super expensive, you can use momentum to say, “Well, I’m not going to trade this. I’m not going to sell it. And if a stock is in free fall, I’m not going to buy it until freefall show some signs of stabilizing.” And that’s a way to use momentum that doesn’t incur any trading costs, simply reduces your existing trading costs. So this work I think will be pretty eye-opening when it’s published.
And just as another breath of fresh air, I’ve been tracking the whole COVID mess very closely. I have an op-ed coming out shortly that there’s some really good news right now. The CDC tracks excess deaths. We had 52 weeks in a row of excess deaths totaling 640,000 above normal run rate. Excess deaths have given away over the last six weeks to less than normal deaths at a run rate right now of about 10,000 a week. Now, we’re still losing 500 people a day to COVID, so that means net of that death toll is 2,000 a day less than normal. How can that be? It’s very simple. People who would otherwise have died last week died in December instead. So it drives home, one, there’s good news. Media won’t report it. They don’t like good news. Two, this is winding down and it’s winding down fast. And three, the vast majority of COVID deaths were people who were going to die fairly soon, something that got way too little attention although it got acknowledged. If you look…instead of lives lost, if you look at years lost, I think ultimately the analysis will show that our policy responses to COVID took away more years of lifetime than COVID did.
Meb: That’s not going to be something any politician is going to want to talk about after this is all said and done, that’s for sure. I’m excited to go to the movie theatres and see my friends and get some beers.
Rob: This is one of the beauties in Florida. I’m doing this call from California, but I’m here for two days. I live in Florida. Everything’s open. You’re a grownup. If you’re vulnerable, hunker down, take care of yourself. If you’ve been vaccinated, go have dinner, enjoy.
Meb: Just watch out for the crocodiles and all the bugs. I love Florida. I need to go back down there. Rob, best place for people to follow your writing, where to go, what you’re up to, where should they go?
Rob: Researchaffiliates.com. And if you want those interactive tools, can say Asset Allocation Interactive or Smart Beta Interactive and Google will take you straight there.
Meb: Awesome. Rob, thanks so much for joining us today. Always a pleasure.
Rob: Thanks for the invitation.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at email@example.com. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.