Arnott on Bubbles and Valuation Gaps

Published Nov 5, 2021, 5:03 PM

Rob Arnott, chairman and founder of Research Affiliates, discusses how he identifies stock-market bubbles and how to use valuation gaps to identify attractive equities.  

Hello, and welcome to What Goes Up, a weekly markets podcast. My name is Mike Reagan. I'm a senior editor at Bloomberg and Humble Donna higher Across Asset Report at Bloomberg, and this week on the show, Well, crypto is raging again. Stocks are near record highs thanks to just a handful of companies really, and Tesla's market cap has surged past the one trillion dollar mark. It really makes you think, do you have to worry about being in a bubble again? What? We'll get into it with one of the best known experts in fundamental investing. But first, Phil Donna, I have to ask you about your adventure in n f T Land this week. I know, they actually allowed you to turn your computer off for once. I think it's the first time your computer has been off in about eighteen months or so, a year and a half, a year and a half and you you you literally stopped typing and they let you go to the n f T Non Fungible Token Conference in New York. What was that like? Yeah, it was my first conference where I actually was with other people, because I've been to a bunch of you know, virtual conferences over the last couple of months, but um, it was it was strange to be around people. First of all, the second of all, the big the main event really was the after parties after the conference, and I hadn't realized that going in. So they were like twenty or thirty or some crazy amount of parties and everybody was just party hopping afterwards and talking about n f t s and cryptos and all kinds of stuff. I think that's the deal with all crypto conferences. It's just some whatever panel and then some big nightclub spectacle. Yeah, exactly, I had I had no I do you going in? So you know, I got invites to parties for the first time in my life, the first time. I do wish you here is our guest. Let's bring him in built out a britroduce our guests. Yeah, I'm so happy to have Rob are not joined us. He's the founder and chairman of Research Affiliates. Thanks so much for coming back. Oh it's a privilege. And Rob, you're in Austin. I believe right, you're getting some some traveling this week, Is that right? I have been on one of my first business trips in the last eighteen months and visited Arizona in Texas, and I have a couple of sons in tech in Austin, so I'm spending the weekend here. Oh good, enjoy, Robert. I want to bring you in on that notion of bubbles Uh. I was reading one of the slide deck guy. I think you had his a presentation recently. We're maybe it's just on your website. I'm not sure, but I was sort of fascinating by one one slide in the deck. Say, uh, we're talking about the notion of bubbles um. You say, We'll offer a simple two part definition. One, we're using a value valuation model, for example, discounted cash flow model. We must make implausibly optimistic assumptions in order to justify prices. And then number two is the marginal buyer doesn't care about evaluation models. I wonder to me, number two seems to be usually the case when you enter bubble territories, people just turn off the logic, They turn off, sort of turn these models off or just ignormal. Is that is that that your opinion of what usually happens? And are we seeing any any signs of that right now? Um, of course we're seeing signs of that, and when it comes to people ignoring valuation models, that is characteristic of bubbles. That's there really is a cross check on the first one. I mean, there are people who will say, gosh, you'd have to make implausible assumption is about Microsoft to justify its current market cap? Um? Okay maybe, But is the marginal buyer uh an unsophisticated investor who doesn't care about valuation hardly, and so you can readily scratch that off the list. With Apple, uh, you don't even have to make implausible assumptions. You just have to make moderately aggressive assumptions and you can easily justify the price. When it comes to things like Tesla and Zelo and u uh, Netflix, you have to make very, very very aggressive assumptions. Uh I debated Cathy would about a month ago at at morning Star conference and um I asked her, what's your valuation model that would justify a target price of three thousand, and she said, well, that's simple. Um, it's gonna grow eighty nine year for the next five years, and um, at the end of the five years, it will be valued at the same multiples as today's fang stocks. And I was thinking at the time, I've been asked to play nice, but I was thinking at the time, Uh, a year for five years, that is umfold growth. So is she really saying it will be twenty five times as large in just five years as it is today? Amazon, the biggest growth story of a generation, grew fourteenfold in the last ten years, So tescitly, she's assuming twice Amazon's growth um in half as many years. That's really aggressive. So when I hear numbers like that, I think, Okay, that's implausible, and therefore it's potentially bubble territory. How many people use a valuation model to justify buying hardly anyone, and so that qualifies for the definition. Well, Rob just I'm gonna pull up Mike greag in here and ask you a multipart question. But I was I was really listening to the episode the last time you were on on this podcast, and I believe you had mentioned the Tesla example. Uh, and I think you had said in the market, we're seeing microbubbles all the time, and correct me if I got the term wrong. And then I was what I was looking through one of your your slide decks that you had put together recently, and you had said something like, you know, what is an anti bubble? So I'm hoping you can describe to us what you're what you see going on, what you might consider a bubble or a microbubble. Uh and uh And what exactly is an anti bubble? Well, firstly, microbubbles are single asset bubbles um tesla. If you buy into the notion that it's a bubble, as we do, um, there's a microbubble, is just one asset? Tech? Is it a bubble? Nope, Tech, there's lots of companies where people use valuation models to justify buying uh and uh. You have to make aggressive assumptions to collectively justify today's tech waiting in the indexes. But you don't have to use implausible assumptions. So it's not quite like the tech bubble of two thousand in that regard um. Anti bubbles are markets or investments where you would have to make implausibly pessimistic assumptions in order to not earn a decent return. So let me give you an example. Um state owned enterprises in China and Russia. The narrative is, don't buy these. These are state owned. The state has the right and the power to appropriate your wealth at will, and you could put money there and get nothing. Absolutely true, Like most narratives, that's true. But if they want continued access to global capital, the likelihood is they'll continue the current dividends, they'll increase them with the growth of the economy, and you won't get much more than that. Okay, what's the yield on s O s in China and Russia? It's about five If it grows with inflation, let alone growing with the economy. That's a five percent real return. M hm our work suggests that real returns in bond markets around the world are negative and in stock markets in the US barely positive. So is a five real return pretty good? Yeah, you'd have to make implausible assumptions not to justify buying. And does the marginal seller care about valuation models? No, they're selling because of the narrative. They know they're cheap. So if you're in either a bubble or an anti bubble, and you this notion that the marginal buyer seller just is ignoring the valuation models, at least that's part of it. I mean, I'm guessing eventually, you know, what happens is something sort of you know, shakes people up and you sort of revert to caring about valuations again and correct me if I'm wrong about any of this. But you know, to me, the main candidate that would do that in this instance, a lot of people would would claim would be the Fed changing policy. And um, we did get a little hint this week, uh more than a hint. You know, the Fed is basically coming out and saying they do plan the taper asset purchases. Um, is that enough to do it? Or you know, is the policy still for the foreseeable future so loose that it shouldn't really sort of slap some sense back into the market right away, Cattle. This question is a fun one, um, because whatever the catalyst is, it's got to come as a surprise to the market. And what the market is unsurprised by is already baked into the price. So FED tapering, No, that's not a catalyst because it's totally expected. Um, But it is a fun parlor game to guess what the catalyst could be rising interest rates in the years ahead if that happens. There's a narrative out there that says growth stocks are worth a lot of money because you're discounting future growth at a very low rate, well below the growth rate, and so the value of future growth goes through the roof. No wonder these stocks are expensive. Well, it turns out if you go back historically and asked did changes in real rates effect the relative performance of growth and value, the answer is no. It's a right random relationship. There is no evident linkage in the data. So when you have a narrative that says growth stocks are starting because interest rates are falling, UH, it becomes a self fulfilling prophecy until it doesn't. And if it's a narrative that is incorrect, the self fulfilling prophecy is a self fulfilling prophecy that is in error, creating an inefficiency, creating a miss price, and creating an opportunity. So I look at that and I think, well, one catalyst for um FANG type stocks to take a hit would be rising interest rates. Another catalyst would be gosh, these companies have done awfully well partly because of COVID. Most of them are extraordinarily well positioned for a world UH with a pandemic. Most of them are well positioned for the aftermath of the pandemic because behaviors will change in their favor. Well, that's good, um. But by the same token, uh, I love to ask the question, what's what problems are we facing today that will be facing still in five years and what are going to be irrelevant in five years? Is COVID going to be uh stalking the world as uh a lethal death machine five years from now? No, We'll have global herd immunity by then. It'll still kill people, but not in vast numbers. Um. Is our supply chain disruption is going to be uh make breaking havoc with global economy five years from now? No? No, I mean that's a perfect example of the kind of thing that that a healthy economy figures out a fixed reasonably quickly. Are demographics still going to be an issue? Uh five years from now? My goodness? Yes? How often do you hear the media talking about the demography um our, debt and deficit going to be an issue five years from now? My goodness? Yes? And so it helps you focus on which relationships, which narratives deserve attention and which may just be roiling markets creating opportunities for you to contratrade. I want to take us back to something Mike mentioned in your introduction, which is that we're being pulled higher by just a handful of stocks, And I know it's something you focus a lot on and you've written about this quite a bit, so I'm I'm hoping you could break down for us what the concerns are around that, and then maybe you slightly hinted at the next part of my question, which is something we don't really hear about very frequently, which is what what actually might make that trend come apart? If that makes sense, it's under what what what would need to happen for the Big five to not be pulling stocks higher all the time? Well, firstly, plain old gravity can come into play. Uh. I'm often asked, uh, what finished off the tech bubble in the year two thousand. I have yet to hear are really compelling, uh, catalyst that could have caused the tech bubble to burst other than gravity? And so part of it may just be gravity. Now, you've got to be careful with bubbles because they can go far longer and carry much further than anyone might expect. My favorite example is the Zimbabwe stock market during their hyper inflation in two thousand eight. As you came into summer, you might have said this, country's got hyper inflation. It's a mess. I want to not only do I want to not own that that stock market, I'm gonna short sell it, but I don't know much about it, So I'm going to short sell two percent of my net worth. Well over the next six weeks, their currency fell tenfold and their stock market went up five hundred fold, five hundred fold, which means in US dollar terms, fiftyfold, which means you're short position just cost you a percent of your net worth. Eight weeks later, the currency had fallen another hundred fold and the stock market basically went to zero and stop trading. So you were right, but bankrupt. Be very careful about bubbles. Now the we look at the fangs, we actually broaden it to include Apple and Microsoft, the big winners from the first tech bubble. And what we find is those six companies, which we refer to as the fan mags, are worth more than the top five companies in the SMP five hundred. Why because the top five are all in the fan mags. Five of the six are the top five companies in the SMP UM. This level of concentration has not been seen since the late forties or early fifties. Um. And what's interesting is the total value of these six companies is approximately eight and a half trillion dollars. All right, that's just a really big number. Um. How do we put it into a context. Well, the entire stock market of Japan is six trillion, So you can buy Japan for these six companies. Uh. The three largest economies in Europe Germany, France and the UK, with collectively nearly two hundred million citizens, worth less than the fan max. So I look at that and I think, gosh, that seems awfully stretched and so um, I view that as kind of classic bubble territory. But like I said, bubbles can go on for a long time and can carry a long way. This is not a totally serious question, but I have you know you mentioned fanmags, and I know on Twitter there were so many jokes after Facebook changed its name to Meta. I don't know if you guys are reconsidering a new acronym. Uh no, um uh. We may want to replace Netflix with Tesla uh, which would turn it into fat mag. But never mind that that's a nice ring to it. Rob. So for listeners who aren't familiar with research affiliates, I mean a lot of your pioneering work is fundamental indexing, UH waiting an index based on the true fundamentals of a company rather than just a market cap index, uh like the sp F under um. But with so many investors just going passively into an S and P five hundred fund um regardless of the you know, the collected wisdom of fundamental indexing, does it just make it such an uphill task to to go against that flow? You know what I mean? And and is you know, speaking of self fulfilling prophecies. Does it just you know, it's hard to take the other side of that trade, is what I'm saying. With so many, so much, so much money flowing right into market cap how do you think about that? Here's a couple of observations. Firstly, every billion dollars flowing into index funds, and there's a lot of billions of dollars flowing into index fund involves two hundred million dollars moved from non SMP members to SMP members size weighted or market cap weighted, hence favoring the largest cap stocks, which tend to be underweighted in most active port folios. So you're gonna have two billion dollars flow into large cap and out of non members of the index. So there have been those in academia who try to quantify what's the valuation gap difference of being a member versus a non member UM, and it's pretty large. Now here's another factor that's just fascinating. Stocks that are added to the S and P are companies that have just recently soared UM. They're popular, they're beloved. The index committee is embarrassed that they don't have it in the index. Yet, let's fix that. And what do they replace a company that's in free fall unloved, where the index committee is embarrassed that it is in the index. Tesla and a I V are beautiful case study in that UM. Now what happens to the stocks that are added. Tesla's an outlier. On average, they under form the market by one to two in their first year, not much, but underperform. The stocks that are deleted from the index on average beat the market by two thousand basis points twenty percentage points in the first year after they're deleted. Now that means that if you wanted to create a better index fund, you could just invest in the SMP and then when SMP changes the index, write it down on a post it note, stick it on your fridge, look at it a year later, and say, Okay, now I'll do the trade. That kind of utterly naive approach gives you SMP returns plus eight team basis points a year over the last thirty years. That's pretty cool. So, so indexing creates inefficiencies that can be easily exploited, that can create interesting investment opportunities. So you and I actually talked about this, I think it was over the summer, so a couple of months ago, and it was about Tesla's addition, and you had done some research showing that really large companies that are added to an index tent to lag. You just mentioned Tesla Tesla as an outlier. So what is your thinking on this one, because it did just have one of its best months in the last year and a half and it was one of the biggest advancers in the SMP five hundred in the month of October. So how are you thinking about it? Well, um stocks, whether expensive or inexpensive, go up and down. They just do. You can have cheap stocks that that go get cheaper. You can have expensive stocks that get more expensive, and like I said, bubbles can go further than anyone could possibly man engent um. It's interesting when we last spoke, Tesla was roughly flat from its being added to the index, but the market was up about so it was behind the market. And a I V Apartment investment, so tiny company that does that's a reet for for apartments. My god, have you seen how apartment rents have soared? Okay, a I V, a company that is a reat specializing in apartments, was up six when we last spoke. Now, I think what's happened to rents around the country in the last year. That's a solid found foundation for the rebound in price. And so it was six ahead of Tesla at the time. It's still ahead of Tesla. It's still gone up more than Tesla has. And so when we look at um these patterns of behavior, when we look at um uh the way indexing royals the markets. One of the strangest narratives coming out of the indexing world is we don't move prices. Well, they say that because a stock is added and the price doesn't move when they add it. Okay, that's because it already moved. Tesla was up between the date it was announced and the date it was added. Why didn't some index funds buy it when it was announced in anticipation of it going up. They've got the world very well trained that any tracking error, any mismatch between their performance and the market index, is a sign of sloppiness or even incompetence. And so they zero in on the actual price at which the stock will come into the index. How do they do that? They enter a blocked trade, that is, a market on close trade. Market unclosed means, by it, whatever the price is, no price limit, market prices, anything goes and at unclosed means I want this to be part of the closing price transaction. So well, over a hundred billion dollars of Tesla changed hands in one blocked trade at the close of December eighteen of last year. All right, well, that's kind of interesting. Why why would you do a market trade to lock in the price, not to lock in the best price, to lock in the exact price at which the stock is entering the SMP five kind of interesting, SMP. Don't get me wrong. SMP has done a wonderful favor for the world by creating the world's first and largest index fund that the normal retail investor could buy. They have shaken up the active management arena by demonstrating that the average active manager doesn't win. Doesn't mean that active managers can't win. But an active manager wins only if there's a loser on the other side of their trades. And if you ask most active managers who's the loser on the other side of your trade, they don't have a clue. If they don't have a clue, they probably don't have value. Add Rob, I wanted to before we get to our our crazy things of the week, I wanted to UM ask you about one of the scattered plots I saw in a recent report of years was kind of showing where you know, the attractive expected returns are. I couldn't help a notice Emerging market value seems to screen very well UM on both accesses. Alt to describe it to the chart to two readers. You know you've got your expected return and you're expected volatility on the X axis. UM. I know it's not the first time e M equities have screened attractively, right, I mean they kind of always doing. I'm wondering if those you know, if if the one access is UH is ruining the fun on the other access In other words, is that expected volatility so much that for investors thinking about risk adjusted returns that they just stay away from it, and then you don't get the the expected return that it's screening for. Is there is there a relationship there? Do you think the relationship is actually more in the camp of behavioral finance, and that is UM market prices are set based on narratives, based on think of it as memes UM widely accepted UH opinions that are shared to an extent that it creates the price. Now, the narrative in two thousand eight was emerging markets are emerging, and you have the Arab spring and you have UH rapid growth as far as the eye can see. And so of course you should pay more for an emerging markets portfolio than for U stocks. You're gonna have higher growth. And so the Emerging Markets Index was priced at thirty eight times the valuation UH the thirty eight times it's ten years smoothed earnings. So think of that as a sustainable learning space. UH. The US was at twenty eight times pre crash, and so it was a premium to the US. Where is it now, It's fifteen times the US is at thirty eight. It's a discount. So the question is what's a fair relative valuation. The fair relative valuation when everybody thought there were no clouds on the horizon was premium. The fair valuation when everybody thinks the emerging markets are bumbling towards oblivion, uh is discount. Now once again, think about a five year look ahead. The narrative is, these countries are not well prepared for COVID. The death rates are way higher. Um, they don't even know how many have died, but the numbers bound to be at least twice the reported numbers. And um, they roll out the vaccine slowly. Uh so this is gonna be a big problem for them. And by the way, to supply chain disruptions do more harm to us or to the emerging economies that depend on delivering these goods and goods to the developed world. So these are terrible headwinds. Five years from now, they're immunized. There is no major problem with COVID. Supply chain disruptions are dealt with. So now what's the fair relative valuation discount? Well, if so, then e M is going to double. That's cool. Now what about value the spread between growth and value and emerging markets is an eight to one ratio. That is to say, the valuation multiples of their high flyers is eight times the valuation multiples of their value stocks eight to one ratio. So what happens if that returns to the normal four to one ratio, Well, value doubles relative to growth, and that also means that value on a standalone basis beats the market by another. So now instead of doubling, now you're up a and uh, if you're up a d over the next ten years, this is not this is not tesla at growth. This is this is just modest increments. A few hundred basis points from this, a few hundred basis points from that, and you can pretty quickly get to double digit returns on a tenure look ahead basis. Um, I'm happy to invest in something that's got high odds of double digit tenure returns. And I'm sort of inferring that you would put uh, China's regulatory crackdowns in that bucket of stuff that we're probably not gonna be talking about in five years. I guess, of course, now, is China going to continue down a maoist path? They might, but they're only one emerging economy, and in our strategy, fundamental Index for Emerging Markets UM kinda barely rates in the teams in terms of its weight in the cap weighted market. It's more like uh thirty plus percent, So we wind up giving it a halfway anyway. And that's not because we subjectively judge UH She's policies to be wrong. It's because Chinese stocks are expensive relative to the rest of the world, so we're rewaiting the value down, the growth stocks down UM. The bat stocks, by do all above inten cent they're all Chinese. The fang stocks Facebook, Amazon, Netflix, and Google, they're all us. The tech innovation seems concentrated in these two markets stand clear. Of the craziest things we saw in markets this week, well, the Donna. In our strategy here on what goes up, we put a heavy weight on the crazy things we saw during the week. So let's start with you. What's the craziest thing you saw this week. It's actually tied to my trip to the n f T conference, which is I went to two separate panels. There was big news from the n f T world from Quentin Tarantino, who found his old first handwritten script for pulp fiction and turned it into seven secret n f T s. And so that's the craziest thing I've seen this week. And and the way I understand it is if you buy the n f T, what you're buying is access to this secret content. So the n f T s are going to have commentary from him. You're going to be able to see I guess pages from the script. Uh, some some scenes that had never been seen before. So I think you're just like unlocking secret content. And maybe our our listeners can correct me if I'm wrong. But it's the first time I've really heard of this secret n f T thing. I would need if they if one of the n f T shows you what's inside the briefcase that they carried around the whole movie, that I might be a buyer that. But I don't know if that's that's on the table. That's the other thing about the secret n f T. We might never know, because if you buy it and you choose to keep it a secret, you don't need to. I mean, then you you know, that's like the Japanese billionaire who bought the Van go um Iris's painting and then instructed his um executors to bury it with him, and it's never been seen since, which means one of two things. They either honored his his request or they sold it to some hitge fund billionaires in Switzerland who's got it hidden away and evolved behind his desk in his office. Rob, have you fallen into this crypto and n f T rabbit hole at all? Are you? Uh? Are you thinking about this stuff at all? Two thousand thirteen, I became a were of bitcoin. I thought it was fascinating. Uh. I as a libertarian, UM, I thought this will give central bankers are so called run for their money. Uh, it'll be fun to watch. And so I debated, should I put a hundred grand in or? I said, no, I don't buy things I don't understand. I'll just buy one bitcoin costing two hundred some dollars. Uh today it would be worth um uh today? Yeah today, if I bought the hundred thousand, it'll be worth about million. Let's see, that's amazing. Well, at least you got one, right, you got uh, you got a partial laser. I guess as they say, But how about you, Rob? Have you seen anything crazy this week? Craziest thing This week for me is back to business US as normal, in person meetings all day every day Monday, Tuesday, Wednesday, Thursday, dinner meetings, breakfast meetings, lunch meetings, and the fun of seeing people face to face. I've done a little scattered bits of that in recent weeks, but this is the first time I've done a dedicated week of travel and face to face meetings. Uh. It's in historical terms, it's not a particularly strange thing. But this week it is feels good, doesn't it. It feels wonderful. And I know you're in Austin, so I assume you're gonna stop in and see Elon Musk got the new Tesla headquarters, right, Oh yeah, he and I are having dinner tonight alright, hopefully brisket in Austin. Um. But I'll give you my craziest thing. Uh, and this is I couldn't top to what I got from a listener who goes by the name financial Gambler on Twitter. Vidonna, very very loyal listener. He's good friend of the show, so he thanked. He's a good tweeter. Yes, uh. He put it out on eBay. There's a iPhone X that's being auctioned on eBay, and it's the only known iPhone that has a USB port to it at US B C port to be specific. You know Apple obviously has their own you know, the lightning charger whatever you call that port. So here's where we play the prices, right, Bill, Donna and Rob? What would you pay or what? Now? What would you pay? I know Rob's a fundamentals guy, so he he probably wouldn't pay anything above list price. But what do you suppose the current bid is for this one of a kind USB port phone on eBay? Well, you go first. I was hoping you'd ask me what I would bid because I wouldn't bid very much because nobody who uses USB anymore? Well to U S B C Yeah, compact, So that's the smaller, the smaller one, right, Yeah, that makes a big difference. And that makes that makes at least a million two million dollar difference. And well, I'm guessing seven figures. I'm going to guess three three million. Wow. Uh, you know we're in a bobble bubble with that kind of pricing on this. We'll do it. What's your guest? I was gonna guess like three thousand bucks A true bargain. We got a pretty good spread. I will say the auction is not over so we may get to your three million, Rob, especially when our big, big pocketed, deep pocketed listeners. Here this HERD nine hundred, which I was surprised by. But to your point, Rob, you know, people like to have collectible, one of a kind thing, so I could see this thing going up before the auction is actually closed. When I see when I see people spending sixty million for an n FT piece of art where anyone can view the art on the Internet, and all you have is a document that says you own it. Um, and it's electronic. Uh. And you don't even control distribution or draw licensing fees on that that still all goes to the artist. Uh. And then I think some stupid thing can go for three million. Well, Rob, I think that's all the time we have. I hope you can get some brisket while you're in Austin. I um, I'm drooling thinking about it. Uh and Voltada Um. I don't know if you're a brisket fan, but well, okay, maybe they have tofu brisket. I don't know. Thank you, Thanks Robert, pleasure has always have you on the show and hopefully we can bring you back some day. What Goes Up. We'll be back next week. Let's hope that you can find us on the blue Berg Terminal website and app, or wherever you get your podcasts. We'd love it if you took the time to rate and review the show on Apple Podcasts so more listeners can find us. And you can find us on Twitter, follow me at reg Anonymous. Bildonna Hirich is at Bildonna hi Rich. You can also follow Bloomberg Podcasts at podcast and thank you to Charlie Pellett of Bloomberg Radio. What Goes Up is produced by Tofur forheas the head of Bloomberg Podcasts is Francesco lev Thanks for listening, See you next time.

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