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- According to Rob Arnott, the founder and chairman of Research Affiliates, the market contains some big bubbles.
- In an exclusive interview, he shared where he was seeing opportunities and finding value now.
- The investing pioneer and “godfather” of smart beta also said the banking and energy sectors were “extraordinary bargains.”
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Rob Arnott has been practicing what he calls “sensible social distancing” these days.
“I bump elbows instead of shaking hands, stand 2 feet away from somebody and chatting with them instead of 1 1/2 feet away,” Arnott told Business Insider in an interview. “Most of the time I’m either alone in the office or just with my family at home.”
“I’m not practicing an intense form of lockdown because, quite frankly, I’m not that afraid of COVID,” said Arnott, the founder and chairman of Research Affiliates, which advised on $142 billion in assets as of the end of June.
The 66-year-old investing pioneer is in good health, but he said he was concerned about “a market that has quite a few bubbles going in it.”
According to him, the stock market is being driven by stimulus-fueled asset bubbles, soaring retail trading activities incentivized by platforms such as Robinhood, and an unsustainable tech boom propped up by the lockdowns.
“We are going to see some big shifts in the coming three to six months,” he said.
Arnott is considered the godfather of smart beta, an investing approach that seeks to earn excess returns over a cap-weighted benchmark by combining active and passive strategies.
The tech boom, whose prowess is characterized by the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Alphabet/Google) briefly reaching 27% of the S&P 500 index, is a bubble waiting to burst, according to Arnott.
“So tacitly the market was saying Apple is going to generate more profits for its shareholders than the entire UK economy,” he said. “Well, that’s pretty wild.”
At its peak, Tesla was worth more than twice as much as Toyota, which produces 30 times as many cars as Tesla and has not had a losing year since the 1970s, according to Arnott.
“So at its peak, Tesla is worth $500,000 for every car they have ever produced,” he said. “Meanwhile, Toyota was priced at $20,000 for every car they’ve made in the last 10 years. On that metric, Toyota is the most expensive of the major automakers, but Tesla’s reached 25 times that valuation.”
While Arnott has warned of the tech bubble before, he has yet to convince investors who are paying up for the tech darlings.
“The next move in a bubble is more likely up than down, but when they burst, they burst fast. And there’s very little opportunity to get out of harm’s way,” he said. “I liken purchases of bubble stocks to picking up nickels in front of a steamroller: The nickels are reliably there, but you just don’t know how close the steamroller is.”
But a key statistic related to COVID-19 could well be the catalyst that turns the hot tech trade around.
While the number of COVID-19 cases in the US is on the rise because of increased testing, deaths related to the disease are distinctly slowing, Arnott said. He added that the death toll was about one-third of what it was at the April peaks and falling 5 to 10% a week over the past six weeks.
“If that’s the case, we may be seeing herd immunity kick in even before we get a vaccine,” he said.
“If we get herd immunity, then our addiction to Amazon shopping and to Netflix movies will diminish,” he added. “And the threat to the thin-profit-margin value stocks will diminish, which means we could see some shocking mean reversion with the tech stocks falling back down to vaguely sane prices and the value stocks recovering as they shed some of that bankruptcy fear.”
Where Arnott is seeing opportunities
Because the US is a “particularly expensive market,” Arnott is finding bargains in emerging markets and developed ex-US stocks these days.
Based on the Shiller P/E ratio — or price relative to 10-year average earnings — emerging-market stocks are about 40% as expensive as stocks in the US, he said, adding that emerging markets’ value is just about one-third of the price of US value stocks.
“So they’re really priced for oblivion, and most of them aren’t going to go into oblivion, so those represent some pretty extreme bargains,” he said. “It’s worth noting that bargains become bargains by inflicting pain and losses. And the result is that the investors have just a very natural reluctance to buy what’s out of favor.”
The reluctance to buy low and sell high may be human nature, but investors could lose out on a profitable trade, given the current market conditions for value stocks.
Historically, growth stocks have been about 4.5 times as expensive as value ones. In 2007, growth was four times as expensive. During the tech bubble, growth was about 9.5 times more expensive than value. These days, growth is about 12 times more expensive than value, Arnott said.
“I find that shocking. I never thought I’d see that stretched relationship again in my lifetime,” he said. “And here it is just 20 years later, and we’re seeing the relationship 30% more stretched than it was in the tech bubble.”
“When the valuations got more than a 5-to-1 ratio, value has won by an average of 12 to 14% per annum compounded over the next five years. Well, that’s stupendous outperformance,” he said. “So I look at current market conditions as just a remarkable gift to the value investor. But like most bargains, we got here by inflicting pain and losses.”
Sectors to play the market
Given the market conditions and macro backdrop, Arnott said he wanted investors to “look around at what’s performed badly and ask the question: Are the underlying fundamentals as awful as the price action would suggest?”
In his view, the banking and energy sectors are two unloved areas of the market where the fundamentals are probably not as bad as their prices would suggest.
“The banking sector is badly disadvantaged by zero interest rates, but that can change in a new administration or a changed set of priorities for the Fed in the years ahead,” he said.
“The banking sector is a necessary part of a well-functioning economy, so well, it’s under intense pressure today,” he added. “Will it still be under intense pressure in three years? Not so sure, in which case they would rebound handily.”
Energy stocks are another group that’s “hugely out of favor and very unpopular for all of the usual reasons,” he said.
“Do I think that we’re going to have a carbon-free economy in my lifetime? No. In the lifetime of my kids, we’ll be getting there,” he said. “So roll the clock forward two generations: It’ll be a largely carbon-free future, but it’s a thing that takes generations, not years. So I view energy as perhaps the most extraordinary bargain out there now.”
For investors who balk at the depressed prices of bargains such as bank and energy stocks, Arnott said: “Investing is the only major business in the global macroeconomy in which people hate bargains.”