Arnott: ‘Peasants With Pitchforks’ Seen If Profits Get Any Fatter

Rob Arnott, chief executive and co-founder of Research Affiliates LLC, recently picked up the phone to share some thoughts on the current state of the stock market. 

Arnott is a pioneer of investing strategies that could be considered “unconventional” if they weren’t slowly but surely becoming more conventional. Among them is the idea of “fundamental indexing,” or weighting stock portfolios by economic metrics like sales, dividends and cash flows rather than the market value of the companies. (The term “smart beta” came later.) 

As such, fundamental indexes tend to lean toward value stocks instead of growth stocks. How are they doing? Well, the FTSE RAFI U.S. 1000 Total Return Index returned 140 percent in the 10 years through 2014 compared with 114 percent for the Russell 1000 Index, even though growth far outperformed value in the same decade. 

Anyway, when talking to a person like this, sometimes it’s best for a reporter to just shut the heck up, save the bad jokes for the next happy hour, and let the smarter person do all the talking. So here goes. 

Q: Does it seem like the market will move back to a value orientation? 

Bubble ‘Echoes’ 

A: “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. 

‘‘There is a flight to safety 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.” 

(Note: Created by economist Robert Shiller, Shiller P/E ratios measure the price of an index divided by average inflation-adjusted earnings from the previous 10 years. Traditionally, P/E ratios measured either just the prior year’s earnings or forecasts for the next year’s profits.) 

Q: What do you think about the Shiller P/E? Do you give it a little less weight considering the really bad earnings years during the recession? Does that skew it, or is that exactly what it’s meant to do? 

Peasants, Pitchforks 

A: “That’s exactly what it’s meant to do. It includes good times and bad times. Back in 2010 it included good years and two recessions, the ’02-’03 recession and the ’08-’09 recession. Now it includes two boom times and one deep recession, so I’m not troubled by including ’08-’09 at all. 

‘‘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. 

‘‘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.”