The Opportunities Investors Are Overlooking with Rob Arnott

[00:00:39] Doug Heikkinen: Before we get started, can you share a little bit about Research Affiliates with our audience?

[00:00:44] Rob Arnott: Sure. We're probably the only $170 billion asset manager that doesn't run money. We are in the business of creating investment strategies and products, and making them available through distribution partners. Organizations like Schwab, PIMCO, Invesco, and the list goes on. And each of these has tens of billions run using our ideas. Think about it this way, if you're creating product for investment management and you're making them available through others, to us, our distribution partners are our marketing, our client relations, our product delivery team. To our distribution partners, we are an extension of their R and D and product innovation capabilities. So, our distribution partners. Will want to work with us if our product ideas are complimentary to theirs and break new ground that they hadn't thought of. And so we're best known for our work in Global Asset allocation with the PIMCO All Asset Fund Suite, product suite, the RAE Active Equity Product Suite at PIMCO, the Fundamental Index Product suites at Schwab and Invesco. And, best known perhaps for as the inventors of Fundamental Index. It's a 20 year history and it's a history that I'm very, very proud of.

[00:02:06] Doug Heikkinen: That's fantastic. So we're in the right spot because I have a number of questions about the market for you today. What indicators are you watching most closely for signs of a market bubble in US equities today, and how should advisors translate that into portfolio guidance?

[00:02:22] Rob Arnott: I'll be a little provocative here. I think an advisor who adds no value for his clients is doing a great job. What do I mean by that? I mean that absent the advisor, most of our clients would chase recent trends invest in accordance with fads and narratives and do horrific damage to their portfolios.

If all you do is to dissuade clients from doing crazy things at the wrong time, selling out after the market's down 30%, buying into stocks at a hundred times sales. If all you do is persuade clients to avoid fundamental mistakes, you've added tremendous value. Anything additional on top of that is like icing on the cake. It makes the cake taste a little better, but the essential cake is help your clients avoid horrific blunders. We're in an industry that, hates bargains. Imagine if Tiffany's put up banner signs saying it's Christmas, all jewelry, 20% off. And, Cartier across the street says shiny bling up only 20% from last year. And, people flood into Cartier and shun Tiffany's that would make absolutely no sense. People wouldn't do it in a mall, but they do it in the stock market all the time. And you gotta remember that anything that's newly expensive got there by creating great joy and great profit. Anything that's newly cheap got there by inflicting pain and losses. So people of course don't want more pain and losses. We didn't, our ancestors didn't survive on the African veldt by running towards a lion. But at the same time, shaking off human nature and being willing to look with fresh eyes at something that's newly expensive or something that's newly cheap can be a marvelous way to add value.

Now, bubbles. In 2018, we came up with a definition for the term bubble that can actually be used in real time. Anybody can look back at the .com bubble and say, yep, that was a bubble. The Japan bubble, yep, that was a bubble. But to identify it in real time is a little trickier. Our definition was really simple. If you're using discounted cashflow. Now think about discounted cashflow. The price of any stock is supposed to be the market's best guess at the net present value of all future profits that the investor in that stock can expect to earn from that company in the decades ahead. If that's the definition of the fair value of a company, then think about stocks from the vantage point of discounted cash flow. What growth assumptions would you have to make to justify today's price? I'll use a specific example. Palantir, bit over $3 billion in revenues in the last year. Recently topped $500 billion in market value. If you've got a stock that's 150 times its trailing 12 month sales or revenues, how does it justify that? It can justify that only if those sales grow from $3 billion to $6 billion, to $30 billion, to $60 billion, to $200 billion in the years ahead, and profit margins rise accordingly, so that the profits to the shareholders become a respectable fraction of that $500 billion market cap. If that is implausible, then you probably have a bubble. The confirmation is, does the marginal buyer care at all about discounted cash flow? If they don't, then you got a bubble. So I look at Palantir as a pretty clear bubble. I look at Nvidia as a probable bubble. I look at companies like Apple as expensive, priced to reflect lofty expectations, but not implausible. Entirely possible. So you can use this to differentiate bubbles. Another red flag is GE at the top of the market bubble in 2000 was the second most valuable company in the world after Microsoft. That was just on the eve of their dissent into irrelevance. What was the red flag? They had to lend money to customers to buy their product. What's happening with AI companies? They're lending money to their customers to buy product. What else is happening? Just about two weeks ago, a member of the press asked Sam Altman, you've got $13 billion in revenues in the last year and you've committed $1.4 trillion in future spending on behalf of clients and distribution partners for your AI. Now, the the implications of that are pretty straightforward. They've committed a thousand times their annual revenue in future spend. Sam Altman's answer to that was, well, if you don't like our stock, I'm sure I can find you a buyer. That's a non-answer to a very legitimate question. Yes, I think we have a bubble. Yes, I think it will fizzle or burst, I'm not sure which. But my highest confidence is that the forward-looking returns on a long-term horizon on 5 or 10 year horizon will be pretty bad in these companies. It doesn't take anything away from them being magnificent. the Magnificent Seven are magnificent.

They're run by visionaries. They're creating brilliant product that will be, will massively alter our world. So were the .com companies in 2000. They changed our world. But they were priced for perfection. They were priced as if competition would not arrive and disrupt the disruptors. These companies were massively disruptive to our world. They were subsequently disrupted with very few exceptions.

[00:08:27] Doug Heikkinen: Very interesting. Next one is cap weighted indexes have led to a greater concentration in major stocks. How do you advise their clients to rethink index construction and diversification as we head into 2026?

[00:08:41] Rob Arnott: Sure. Mike Green has done some wonderful work in this area. His prognostications are a little alarmist, but I would agree with his prognostications, just maybe not on the timeline that he has in mind. His observations are that as money pours into index funds, it drives a wedge in valuation between members and non-members. We're seeing that in real time. Members of the S&P and Russell, if you look at price to sales or price to cash flow are priced at two and a half times the valuation multiples of the non-members. Now the narrative is these are wonderful companies. These companies are irrelevant. They're uninteresting, they're not changing the world. The growth is here. That narrative doesn't stand up to history. 30 years ago, the relative valuations of members of S&P and Russell and non-members was roughly parody. The index members were at a small premium. Now it's 150% premium. What about the growth rates? If you look at earnings and dividend growth for non-members of S&P and Russell, the dividend and earnings growth over the last 30 years has been faster for the non-members than for the members of the indexes. Now, if you're paying 60% discount for faster growth, you're going to get a higher internal rate of return on the non-members. So basically what the market is saying is these companies that historically haven't grown faster, will grow faster. Maybe the market's right. Will grow faster by enough of a margin to justify 150% premium, likely the market's wrong. Where this breaks down is really quite interesting. Right now half of US market cap is in the cap weighted index funds. Imagine it's 80%. Imagine there's still 5% turnover. People think of index funds as passive. They mostly are, but that 5% turnover is wildly active. It doesn't look at all like the market.

It's buying frothy growth stocks at premium multiples. It's selling deeply unloved deep value names at shocking discounts to the market. In the last five years, the spread in valuation between additions and deletions has risen to about six to one. Six to one ratio in valuations. The stocks you're adding are six times as expensive relative to the fundamentals as the stocks you're dropping. That gets pushed wider and wider by the mere act of indexation.

Now, if indexing is 80% of the market and you have 5% turnover. That's four out of 80 is 5%. It's going to be four out of 20 from the active managers or 20%. Now, that means the active managers have to be induced to sell their favorite stocks to the index funds. 20% turnover per year moved out of their opportunity set. And they have to be willing, induced to buy the deeply unloved names that the index funds want to kick out. And market clearing price moves in the direction of infinity for the buys and zero for the sells. Now, it doesn't get there obviously. But that alone can break this fad of moving into index funds.

I describe it as a fad, not because it isn't real, it's very real, but because it creates market inefficiencies. And one of the fun things to me is finding where those inefficiencies are and how to exploit them.

[00:12:28] Doug Heikkinen: Value investing has faced challenges for a decade. Do you see a turning point ahead, and what catalysts might revive value strategies?

[00:12:38] Rob Arnott: Looking for catalysts is kind of a fun parlor game. I describe it as a parlor game because any catalyst will be by definition, a surprise to most of the market. If it's not a surprise, it's not a catalyst. But could a recession induce a break in the growth cycle. Could a major, one of the magnificent seven or two of the magnificent seven, getting disrupted from outsiders be a catalyst. Any of these things is possible. I wrote a paper in 2021 in the FAJ: Reports of Values Death Have Been Greatly Exaggerated. And in that paper I showed that values under performance from 2007 to 2020, the relative valuation spread for growth versus value reached an all time extreme in summer of 2020. Even wider spread than at the peak of the .com bubble. And we've been, value has been bottom bouncing since then.

It hasn't made a new low. In fact, from August of 2000 to date, value has actually beat growth. People don't notice that because it's looking at it from a trough to a trough. But it may be that August of 2020 was the all time trough for value. And it may be that the turn already happened. It may be that the second and third turn of that cycle could be happening right now.

I don't know. But, the main catalyst may be the same one as turned the market in the year 2000, and that is simple gravity. That some of these expensive stocks are priced too high. Disruptors get disrupted. Google's core business model is sponsored links and pop-up ads, and that's been disrupted by AI.

I've been using perplexity as my search engine for a couple years. Lots of people now use AI as their search engine. That's disrupting Google's core model. Meanwhile, OpenAI itself has been disrupted just this year by DeepSeek coming up out of nowhere, ostensibly built with 1/100 the resources of OpenAI, and with an AI that's ostensibly as powerful as ChatGPT 4.5. Now ChatGPT 5 breaks new ground. ChatGPT 5 is really quite breathtaking. But disruptors get disrupted. People forget that. The disruptors of the year 2000, almost all of them were disrupted. Not one of the 10 most valuable tech stocks on the planet in the year 2000 beat the S&P over the next 15 years. Not one. People say, what about Microsoft? You had to wait 18 years for Microsoft to get into to finally get ahead of the S&P on a cumulative basis. Today, two stocks, Microsoft and Oracle have beat the S&P people say, what about Apple? What about Amazon? And point well taken, but Apple was barely in the top 40 tech stocks.

It was thought to be at death's door in the year 2000. And Amazon was struggling with the Amazon dot bomb narrative from 1999 and was barely in the top 30. So they came out of nowhere to disrupt the leaders of 2000. They were the disruptors of the then disruptors.

[00:16:07] Doug Heikkinen: It's all so interesting. How should asset allocators adjust their expectations given your warnings about low risk premiums and stretch valuations across US large caps?

[00:16:18] Rob Arnott: We have a website, Asset Allocation Interactive, which gets about a half million unique hits every year. People love using it. And that website provides forward-looking return expectations for 160 different asset classes around the world. How do you forecast future returns? What's the yield? That you know. What's the historical growth in income. For fixed income, it's zero. For stocks, it's about CPI plus two and a half is a good guess. And if valuations are stretched relative to history, what could mean reversion due to us? For US growth stocks, be a pretty hefty drain on performance. Taking our return expectation for Russell growth to around one and a half percent per annum for the coming 10 years. That's not a real return. That's a nominal return.

Now, at the other end of the spectrum, you've got emerging markets RAFI. Fundamental index and emerging markets. Emerging markets are priced to give you about 9.5% per annum. Emerging markets value about 10 point a half to 11. And RAFI and emerging markets, about a percent and a half higher than that, around 12% per annum for 10 years. How accurate are these forecasts? Historically, they tend to be within about 2% of what actually happens subsequently over the next 10 years. So US growth stocks one and a half, plus or minus two. Emerging markets, RAFI fundamental index or emerging markets value, 10 or 12 plus or minus two. That's, I'll take the latter bet any day, but with very low confidence that it will necessarily work in any given year.

Will it help us in 2026? 60/40 odds, but that's 40% chance that it'll disappoint.

[00:18:05] Doug Heikkinen: Are there global regions or asset classes where you see especially compelling opportunities right now compared to the US market?

[00:18:15] Rob Arnott: I look at the whole array of non-US markets as an interesting opportunity set. On the equity side, just plain old EFA is priced to give us about 8% returns. Three of that is income, five of that is growth in income, and it's trading cheap relative to history. So you get another percent from that. Well, that's pretty cool. Relative to the US, we're expecting, where we're expecting about 3%. I view plain old EFA, emerging markets, as good value opportunities. The narrative is American Exceptionalism. Narratives have the advantage of being largely true. Yes, American Exceptionalism is a very real thing. It's not that we're smarter than the rest of the world, it's that we have been fortunate enough to reduce, to avoid the seduction of overregulating and stifling growth and stifling innovation as happens across the developed world. So, if you're stifling growth and stifling innovation, you're going to have slower growth. The marketplace will notice that and will price you at a deep discount. And if you're encouraging growth and encouraging innovation, the marketplace will notice that and we'll price you accordingly. So the spread in valuation between US and non-US is nearly two to one between the US and emerging markets. Is more than two to one. And between the US and international, or emerging markets value is nearly three to one. Alright, that's a huge spread. All these companies have to do is bumble along with ordinary GDP growth, and their discounted cash flow will be better than these companies. So, I look on non-US as an interesting opportunity set. I look at emerging markets local currency bonds as an interesting opportunity. Why local currency? Because emerging markets currencies are relatively cheap. They're likely to appreciate relative to the US dollar. Their, meanwhile, their yields are higher than US junk bonds. Isn't that interesting? So I see great opportunities. I've described this as an opportunity rich environment, one in which there's lots of places to earn 6% or 8% or 10%. Folks who anchor on, I want double digit returns aren't being realistic. The opportunity for double digit returns is out there, but it requires a seriously unconventional portfolio to get there.

[00:20:51] Doug Heikkinen: What are the biggest risks for investors who chase the latest ETF trends, such as AI focused funds, and how can fundamental research help protect them?

[00:21:03] Rob Arnott: You gotta ask, is this crowded space? It's a very simple question. You've gotta ask if you're investing in past returns or future returns. AI is the real deal. The narrative that AI will change our world is already happening. The narrative that AI will destroy millions of jobs is already happening. The non narrative that AI will also create millions of jobs is already happening, but goes unnoticed because people like to focus on bad news. And so the AI revolution is very real. It's also fully reflected in the share prices of these companies. So I think performance chasing is and always has been endemic. We are in the only major industry in the global macro economy where people hate bargains. And, if it's crowded space, if you're investing based on a narrative, the narrative may be true. It's already a hundred percent reflected in share prices. It's not going to help your investments. The way you help your investments is to identify where there's asymmetric risks around that narrative. The asymmetric risks for AI are, one, the evolution of AI happening a little slower. The embrace of AI happening a little slower than the narrative suggests. People embrace change grudgingly and gradually, so that'll slow that down. And the other part of the narrative that's off target is disruptors get disrupted.

If you look at the top 10 market cap stocks on the planet in the year 2000. Microsoft's the only one that's still there in the top 10. The next was GE on its way to oblivion. The next was Cisco, expected to grow 40% a year? No, it grew 8% a year for the next quarter century. Eight percent's terrific growth. The next was Intel, had a moat, was the dominant provider of chips. Nobody could beat them except maybe ASML, maybe Taiwan Semi, maybe AMD, maybe Nvidia. Now Intel's the fifth biggest producer. It's been disrupted massively. Next on the list was Lucent. It's gone. Next on the list was Nokia.

It still makes phones, but it's not the sixth most valuable company on the planet. Of the top 10 tech names in the world, only one has beat the S&P 500, and the majority of those top 10 have had negative returns if they even still exist.

[00:23:38] Doug Heikkinen: As inflation and interest rates shift, how can advisors use index innovation to better manage clients' expectations and risk for the long term?

[00:23:48] Rob Arnott: One of the more exciting developments is one that we're part of, and that is a better way to construct an index fund. We launched RACWI, Research Affiliates Cap Weighted Index in 2021. What's the difference? As I said earlier, indexing is thought to be passive. And 95%, it is passive, but that little 5% turnover looks like a wild-eyed emerging growth manager on steroids. You're buying frothy growth names, you're dumping deeply out of favor big companies, bigger companies than the frothy growth names, but at trading at deep discounts. What if you just make that part of the passive portfolio a little more passive. You include companies that rise into the 500 largest businesses in the US economy.

You focus on the businesses, not on the stock prices. You don't add a stock because it's soared. You add a stock because the company has steadily grown big enough to matter. You don't drop a stock because it's tumbled massively in the last couple of years. You drop a stock because its overall business has shrunk to be no longer terribly important. So if you just change the decision rule for adding and dropping stocks, in historical testing, at add 69 basis points per annum relative to the S&P over the last 35 years. How has that gone unnoticed? Two reasons. One, the turnover is small, so it doesn't draw a lot of attention. Two, the index is its own benchmark. If you measure yourself against yourself, you're never going to underperform. And so, this index went live in 2021. It has outperformed the S&P by 81 basis points a year with 56 basis points tracking error. Tiny tracking error. Roughly half the tracking error between Russell 1000 and S&P 500. That pair has about twice the tracking error of us versus the S&P. And ETF architect launched an ETF based on RACWI about eight weeks ago. As of yesterday, we're already 24 basis points ahead of the S&P.

[00:25:59] Doug Heikkinen: Alright, last one for you, and looking forward, which I think is really hard to do with the crazy world we live in right now, what's your outlook for market volatility and markets in general through 2026, and what actions should advisors and investors take to prepare?

[00:26:14] Rob Arnott: In any given year, you have about a chance in seven of a bear market. I would say in today's market with today's frothy pricing, it's more like a chance in three. Could there be a bear market next year? Absolutely. Could there be a continuation of a bull market? Absolutely. Could there be markets that just kind of quietly move higher?

Absolutely. Anything is possible. I would say that market volatility is more likely to tick up than down next year. Why? Because volatility mean reverts and we've had a relatively low volatility year. I would say there's an asymmetric risk in the direction of higher chance of a bear market than normal.

Why? Because the market's expensive. One of the lessons of the .com bubble that's also very much overlooked. The .com bubble burst in March of 2000. Roll the clock forward two years. Nasdaq was down 50% on its way to an 80% drop. Russell 2000 value, the small cap value stocks, were up 53% in those two years.

The bull market of the 1990s for the median stock in the Russell 3000 didn't end until March of 2002. That was not a bear market that was a crash, a tech crash, that did not infect the rest of the market until the middle two quarters of 2002, which was a take no prisoners bear market. Kind of classic.

It pulled everything down. But it was only six months long. The bear market of 2000 to 2002 for most stocks was only a six month bear market. The same thing could easily happen again now.

[00:27:58] Doug Heikkinen: Rob, this has been great. It's been informative, relatable, and fun. Easily one of my favorite podcasts we've done on the markets. Thanks so much for being with us.

[00:28:09] Rob Arnott: This has been a real pleasure. You can tell that I love what I do and find it to be enormously fun.

[00:28:16] Doug Heikkinen: Exactly. For more information about Rob, his team, and Research Affiliates, please visit ResearchAffiliates.com.

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