In this week’s episode of Stansberry Investor Hour, Dan speaks with Rob Arnott.
Over his career, Rob has endeavored to bridge the worlds of academic theorists and financial markets, challenging conventional wisdom and searching for solutions that add value for investors. He has pioneered several unconventional portfolio strategies that are now widely applied, including tactical asset allocation, global tactical asset allocation, tax-advantaged equity management, and the Fundamental Index™ approach to investing.
His success in doing so has resulted in a reputation as one of the world’s most provocative practitioners and respected financial analysts.
When Rob talks, we listen. And right now, he’s saying that the market cycle is turning from one predominated by growth to one predominated by value. That presents an exceptional opportunity for the patient contrarian value investor.
Most investors fall victim to two deeply ingrained attributes of the human psyche that work against successful contrarian investing and in favor of pursuing comfort. But, as Rob tells Dan, the markets rarely reward comfort…
“Contrarian investing is inherently painful. It goes against human nature, and it’s deeply uncomfortable. That’s why it works for the patient investor. There are years, there are quarters, there are even cycles where contrarian investing doesn’t work particularly well. But over long periods of time, it’s relentless.”
In this vein, Rob discusses his two “core investment principles” and his forecast for out-of-control inflation (including a few “inflation fighter” places to consider putting your money today).
He also covers a proprietary definition of the term “bubble,” what’s going on with electric vehicles, the “best way to read the news,” and much more.
Founder and Chairman of Research Affiliates
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.
Announcer: Broadcasting from the Investor Hour studios and all around the world, you're listening to the Stansberry Investor Hour. [Interlude plays] Tune in each Thursday on iTunes, Google Play, and everywhere you find podcasts for the latest episodes of the Stansberry Investor Hour. Sign for the free show archive at investorhour.com. Here's your host, Dan Ferris.
Dan Ferris: Hello and welcome to the Stansberry Investor Hour. I'm your host, Dan Ferris. I'm also the editor of Extreme Value published by Stansberry Research. Today, we'll talk with Rob Arnott of Research Affiliates. Rob has done some incredible groundbreaking research over the years. Can't wait to talk with him. In the mailbag today, questions about natural resource scarcity and selling newsletters versus giving rational advice.
And remember. You can call our listener feedback line, 800-381-2357. Tell us what's on your mind and hear your voice on the show. For my opening rant this week, we'll talk about profit margins and the Russian invasion of Ukraine. That and more right now on the Stansberry Investor Hour. So last week, I said we were going to talk about some bottom-up parameters that we like to use – that I like to use – to pick individual stocks. And of course, that [laughs] was before Russia invaded Ukraine.
I'm going to continue talking about one of these parameters each week. There are five of them. And so, last week, we talked about the first one – free cash flow. This week, let me say a few words about margins, and then of course, we will have to talk about Russia and Ukraine. So, margins. The watchword here is consistency. And what I look for is a company that generates consistent margins up and down the income statement over a period of several years... usually five to 10 years.
Actually, let me say that differently. I look for consistency over 10 years or more, but then I realize, "You know businesses change, companies make acquisitions, and maybe the recent period of five years is more representative of what I can expect for the next five years or so." You see? But I do want to see a longer history than five years because in capitalism it's normal for profit margins to sort of winnow away over – to be competed down over time. Right? A company makes a nice, thick profit margin, it's a signal that there's lots of value to be had there.
And so, other companies come in, they compete and one of the things they do to compete is lower their price a little bit. So they accept a little bit less profit. And that process can continue until there's [laughs] none left. If it's like a commodity-type product that is hard to differentiate, you can get – you know, you can wind up with zero margin left or a highly cyclical margin. It shows up for a few years and it goes away for a few years. Right?
And we try to stay away in general... as long-term investments, those highly cyclical businesses aren't great. You really have to wait until nobody wants them and they're dirt cheap. But really businesses. Like Costco is one of my favorite examples of margins. Because it's very consistent. The gross margin is a consistent right around 13%-ish, and the net margin is a consistent right around 1% and – just call it 1.5%. It's just in that ballpark. Right?
They do fluctuate somewhat but pretty consistent around those numbers. And, you know, the consistency tells you something. The consistency says, 'What we're doing is really special to our customers, and we can do it again and again and again and they'll keep coming back and they'll keep rewarding us with this consistent margin. They don't mind paying what we're asking to do what we're doing for them."
And that can be a big hint that maybe this is a company that you'd want to look at. Maybe it’s a company with a competitive advantage. And maybe if it's gushing free cash flow – which we talked about last week – and it's got really consistent margins, maybe you look at the other parameters and see, "Wow. OK. Maybe this is something I should own." So that's pretty much all I have to say about margins.
Just – I don't want to dilute the point about consistency. That's the important thing. Right? That's the example of Costco, is a consistent but very thin margin. And it's the consistency that's important. Obviously, [laughs] we'd love a consistently thick margin, wouldn’t we? You know? Like Apple or Microsoft or something like that. You know, these software-based companies... Google. But it's the consistency. OK? Look for consistent margins.
Now, let's talk about Russia and Ukraine briefly. Be prepared [laughs] to be slightly disappointed here. Because what I mostly want to say is that I have consistently said – have I not – "Hold plenty of cash and hold some gold and silver." And I've said bitcoin too. And you'll notice what happened here. When the invasion became imminent and then when it was announced that it was on – Russia was invading Ukraine – you saw gold go up and you saw bitcoin go down rather sharply.
So I don't know if you remember our recent guest several podcasts ago – but fairly recently – Mike McGlone, Commodity Strategist from Bloomberg. Mike McGlone said he thought 2022 would be the year when bitcoin would go from being a risk-on asset to a risk-off asset. In other words, he thought this was the year that, when things got difficult in the market – you know, maybe gold would go up, silver go up and bitcoin would go up with them. Well, this was a test of that and it failed.
So far – I realize it's early days. We're only in the second month of 2022. But so far, that has not been the case. Bitcoin went, you know – it's a risk-on asset and people sold. I looked at one point. It was down 9% or 10% – close to 10%. And of course, when the market rallied, right, it rallied with the market... with stocks. With the Nasdaq, of course. Nasdaq had that huge – you know, 3% down, 3% up in the same day.
And bitcoin behaved pretty much the same way but, you know, 9%, 10% down... 9%, 10% up. So that's bitcoin. Obviously, having plenty of cash served you because your cash didn't drop [laughs] 9% or 10% or 3% in value. And your gold and silver did really well. And they're holding on to the price that they gained. So they're holding their value. They're up and they're staying up, pretty much. You know?
And that's really all I have to say about that, is that there's no need – I feel no need to trade specifically around this event and to try to find some, you know, Ukraine-focused or Russia-focused company that might be a good buy at this moment or that might be a good sell or something. I feel no need to do that. If you do, good luck to you... it's not my thing. Right? So that relieves me of the need to be some kind of geopolitical expert on exactly what's happening on the ground there in Ukraine.
Which I don't think is necessary to be a very successful investor. Right? I always say, "Prepare, don't predict." And if you did what I've consistently recommended – yes, your stocks were down when the market was down but they rallied when [laughs] the market rallied again... and when your stocks were down, your cash was holding value and your gold and silver were up. OK? That's all I have to say about that. You know, continue as I've recommended.
If you are taking my advice, then you're just not doing anything different... Russia/Ukraine is not making you do anything different. All right. That's all I have to say about that. Let's talk with Rob Arnott of Research Affiliates. Can't wait to talk to him. Let's do it right now. [Music plays and stops] As we all know, Russia has just attacked Ukraine. Stocks have plummeted earlier this week as a result, but oil stocks – including this Texas oil player – could skyrocket.
The shutdown of a major energy pipeline to deter Russia, limited production capacity by OPEC, and Biden's determination to rely on alternative energy in 2022 are adding up to one thing: a historic shock in oil prices is coming. Biden says, "I want to limit the pain the American people are feeling at the gas pump. But a war in Ukraine would be Kuwait 1990 all over again, so how to play it? Well, don't buy Chevron or ExxonMobil.
Instead, Marc Chaikin just published the full details on a small Texas-based oil company that could hand you gains of 100% or more as the oil crisis escalates. To find out more, visit www.oilwarning.com. But this story is moving quickly. Even as you're listening today, Biden is announcing new sanctions. So be sure to position yourself now before Russia's next move. That website, again, is oilwarning.com. [Music plays and stops] Today's guest is Rob Arnott of Research Affiliates.
Rob 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. Rob, welcome to the show.
Rob Arnott: Delighted to be here. Thanks for the invitation.
Dan Ferris: I'm really, really delighted that you could be with us. I've been – well, I've seen your stuff on the Internet here and there, and I've seen you speak at Grant's conferences and enjoyed your comments.
Rob Arnott: Oh, wonderful.
Dan Ferris: One of the things I've most enjoyed about you is that, like myself, I have to say, when other folks really don't want to hear anything about the word "value," and are saying that it's dead and buried and will never return, that's when I start listening for you to start talking about it again.
Rob Arnott: Yeah, yeah.
Dan Ferris: [Crosstalk] in the past [crosstalk].
Rob Arnott: [Crosstalk] it goes back to Warren Buffett's famous comment, that you should be greedy when others are fearful and fearful when others are greedy. And the most feared trade, in the last three, four years, has been value. It has been so ferociously out of favor, so what better time to buy than during those lows.
Dan Ferris: One of the topics that has come up, and if you have no opinion on these things, it's fine, we don't have to deal with them. But one of the topics that's come up, I wrote about value, growth, and commodities versus stocks, and also, ex-U.S. stocks versus U.S. stocks, and all of these things, the cycles in all of them seem to be at or near pretty big inflection points, or at least attractive levels, as far as I'm concerned. And a reader of mine wrote back and said, "You know, Dan, this is all just the U.S. dollar, that's what's happening here. And the U.S. dollar is so utterly popular, that, you know, these cycles, they may not happen as they once did." And I thought, "Wow, I want to double my allocation this split second," [laughs] because –
Rob Arnott: Well, it's fair to say that when people say, "This time is different," they're always correct: this time is always different. The question is, is it different in ways that the market hasn't noticed and hasn't already priced in? And is it different in a way that is likely to make a material difference relative to what we've seen in the past? One of my core investment principles is the long-horizon mean reversion, the other is value something – when you pay for something does matter. If you think in terms of long-horizon mean reversion, profit margins mean-revert if you've got high margins, competitors will come in and lower those margins. If you've got skinny margins, there won't be many competitors, and some competitors will fail and drop from the scene, leading to higher margins.
And so, anything you look at, whether it's valuation multiples or margins or sales growth or – they all tend to be mean-reverting, long-horizon, mean-reverting. The key here is patience... Long-horizon does mean long-horizon and a willingness to accept discomfort. What do I mean by that? Our distant ancestors didn't survive on the African vale by running toward the lion. But running toward a paper lion, something that looks scary, and is cheap and sensibly priced, works for investing. So investing goes against human nature. Anything that's newly expensive got there by creating great joy and profit for its investors. No one wants to walk away from that.
Anything that's newly cheap likely got there by inflicting pain and losses on the way to becoming cheap, and no one wants to dive in and buy what's caused them pain. So these are deeply ingrained attributes of the human psyche, that work against successful investing, against contrarian investing, and in favor of pursuing comfort. The markets rarely reward comfort.
Dan Ferris: Right. And if we just take, for example, if we just use the value-growth cycle, what I tend to wonder then is, it gets difficult, doesn't it? Because the cycle doesn't just turn and then outperform consistently, every week, month, year. But you do get the ebbs and flows are very obvious on the chart, you can see it plain as day, but that's looking backward. As you move through it, forward in time, allocation to it is a real challenge. If that's the way you want to allocate, if you're not a Warren Buffett who says, "I just want to buy a fantastic company and own it for the rest of my life," if you really want to allocate to these cycles, man, it's difficult. I mean, being patient through that – do you have any advice for me? Do you have anything for me that can help me out?
Rob Arnott: Well, it's very difficult [crosstalk] if something is cheap relative to its fundamentals, and you buy it and it goes against you, you're going to look and feel stupid. And because you're never going to catch the exact turn, you're always going to go through a period of looking and feeling stupid. Picking that bottom tick is nigh on impossible. So, the only way to make sure you have maximum exposure when the turn happens is to be willing to amp up your exposure as it's going against you, and be willing to look even more stupid for a period of time. [Laughs] This is why contrarian investing is inherently painful: it goes against human nature and it's deeply uncomfortable, that's why it works for the patient investor. Emphasis on "patient." There are quarters, there are years, there are even cycles where contrarian investing doesn't work particularly well, but over long periods of time, it's relentless.
Dan Ferris: Right. What I'm thinking, specifically, Rob, is you just basically addressed, you know, let's say, the inflection point, the turn when growth begins to underperform, let's say, let's just use those two for our example, and value begins to outperform. And that's not going to be a straight line... it will be painful, you'll be early, especially if you're a value guy, right? [Laughs]
Rob Arnott: Yeah.
Dan Ferris: And it's practically your job to be early, as a value guy. But then, what I believe, just based on interactions with Investor Hour listeners and watchers, you get to a point, all too early on, when human nature takes over again and you want to rip that profit off, usually, again, way too early.
Rob Arnott: Right.
Dan Ferris: So, allocating and sticking with the trend is at least as difficult as riding out, let's say, your entry in the inflection. Let's say you're satisfied you've got that right, what has affected me personally [laughs], and I know has affected some of our listeners and watchers personally, is sticking with it. It's the sticking-with, even beyond, even if you get it right and you get past that initial turn, that is really, really hard. It's like it's the same example as, you know, buying Amazon at $6 or something, and not selling it when it draws down 35%, 50% or more, 17 times or something.
Rob Arnott: Yeah, that's exactly right, and just as I said, what's newly high got there by giving us great joy and profit, and it's painful to sell those assets. Well, if you buy something that's out of favor and it rebounds 50%, is it painful to take your profits and run? Not yet. [Laughter] When it's painful to take the profits, that's the time to actually do it.
Dan Ferris: I see. So, at both ends of this thing, to allocate –
Rob Arnott: Aim for maximum discomfort.
Dan Ferris: Yeah, [laughs] aim for maximum discomfort, across the cycle, you know, you're never resting on your laurels, if you're investing this way. [Crosstalk]
Rob Arnott: Now, here's another thing on the value-growth cycle that I think is just fascinating is, as I said, anything that's newly cheap got there by inflicting pain. Well, if you look at the performance of a strategy or a factor, it's just like looking at the performance of a stock: if it's gone down, performed badly by dent of getting cheaper and cheaper, anything that just looks at performance price action is going to look back at that and say, "Oh, this is a bad idea, it performs badly." And we have an academic world that happily looks at past returns for factors and strategies, and I have yet to see any major journal articles on any factors where they said, "This factor's relative cheapness, relative to the market, changed by X percent during our period that we were studying. And so, that part of the return is a revaluation alpha that's nonrecurring. Let's take that away and see what's left."
No, they just look at the past returns, and the result is, the strategies that are most beloved and most popular are the ones that have the wonderful backtests. Those wonderful backtests may be because it's a wonderful idea, or, much more likely, because it got popular and got more and more and more expensive. And by getting more expensive, created a wonderful past return, setting you up, if there's mean reversion, for a negative future return. This is, I think, the No. 1 Achilles heel of factor investing and multifactor investing, the notion that what's worked over long periods in the past will work in the future. No, it won't work in the future if it got there by revaluing upward, and it won't work in the future if it's now crowded space with so much money allocated to it that it's arbitraging away the opportunities.
Dan Ferris: Right, I feel like, once again, you're finding a different way to look into factors and just simply say, "Price matters a lot."
Rob Arnott: Yeah, price matters.
Dan Ferris: Yeah. Another thing I wonder about when I look at the value-growth cycle, I wonder, and I've seen some commentary about this, about relative valuation versus absolute. It seems to me like, even when the relative valuation can be very attractive, the absolute valuations may not be as attractive versus past instances when the relative was, let's say, equally attractive. And that creates an interesting dynamic for me, because that absolutely valuation, that tends to really mean something. I am a bottom-up, you know, generally one-security-at-a-time kind of investor, and the intrinsic value of the asset that, you know, my expectation for the net cash flows over time that I'm going to get out of it relative to the current market price, that means a lot to me. And simply seeing the relative assessment, it doesn't always get me there. And yet, in the case of the value-growth trader, I feel like you can really, you can miss something really spectacular [laughs], potentially spectacular, by getting bogged down in that.
Rob Arnott: Well, a case in point is the tech crash in 2000 and 2002, S&P peak to trough was down something on the order of 45% to 48%. And it began in August of 2000, or January of 2000, depending which index you were using. S&P peaked in August of 2000... Nasdaq peaked at the beginning of 2000. So, what we're looking at is a bear market that lasted two to two-and-a-half years. Now, the median stock in the Russell 3000 was up in 2000, was up in 2001, was up in the first quarter of 2002. If you equally weighted the Russell 3000, you had a continuation of the bull market for over two years, and then had a short sharp bear market of about 25%.
The difference was that, with cap weighting, you had most of your money in the highest-priced high-flyers, the tech stocks, the bubble stocks. Well, doesn't that sound familiar today? A fourth of the S&P and its top five names, nine out of the 10 top stocks in the world stock market are, in some fashion or other, tech stocks. I mean, Amazon's a retailer and Tesla's a carmaker, but their competitive edge is tech. So nine out of 10 of the largest market-cap companies on the planet are tech. Now, these guys are competing with one another, so they can't all achieve stupendous success, and yet, they're priced as if they all will achieve stupendous success.
So I look at this as a wonderful example of bubble behavior. Do I think they're all bubbles? No. We actually came up with a definition for the term "bubble," back in 2018, that can be used in real time. One, you'd have to make implausible growth assumptions, in order to expect a risk premium for that stock. So, last fall, I debated Cathie Wood, from Ark Investments, at the big Morningstar conference, and I pointed that definition out to her and I said, "Show me how, using that definition, Tesla isn't a bubble." She said, "Well, our price target is $3,000. We think Tesla's going to grow 89% a year for the next five years, and we think at the end of the five years, it'll be priced down at multiples similar to today's FAANG stocks."
OK, 89% a year for five years is 25-fold growth. Amazon has achieved 50-fold growth in the last 12 years, so she was saying Tesla will, in less than half as many years – excuse me, not 50 – they've achieved 12-fold growth in 12 years. She was saying Tesla will achieve more than twice as much cumulative growth in the next five years as Amazon has over 12 years. Implausible, for sure. So, second part of the definition is just as important, and that is that the marginal buyer of the asset doesn't care about valuation metrics. And, so, using that definition, you could comfortably say Tesla and a variety of other FAANG-type stocks are in bubble territory, and Apple is priced aggressively, it's priced for impressive long-term growth, but not implausible.
So I would view Apple as an expensive stock that's probably going to underperform, but not a bubble. The other thing that I think is fascinating, when you propound a theory like that, is the exception that proves the rule. There is no such thing as a rule of thumb that'll be 100% accurate. Amazon, in the year 2000, would've met those criteria.
Dan Ferris: I knew you were going to pick that example. [Laughs]
Rob Arnott: Yeah, and in point of fact, over the next 10 years, it underperformed the S&P by a big margin. It's over the subsequent decade that it just hit its stride and took off. So, when it wasn't a bubble stock, it achieved the growth that made it look like it wasn't a bad stock to own in the year 2000. Way better stock to buy in 2010 than to own during that entire decade.
Dan Ferris: The example is great because you look in the rearview mirror at that and you think, "Yeah, that's what I want, you know, who doesn't want that."
Rob Arnott: Of course.
Dan Ferris: And investors, they spend way too much time believing that they will find the next Amazon. Or the next Apple. [Laughs] Apple didn't do too bad, either. And they don't realize how implausible that is, how unlikely it is, for example, that – I could pick on any stock now, but continue to pick on Peloton, maybe. You know, it's an exercise equipment company that billed itself as being everything but that, and was not, you know, it is not the Apple of exercise equipment. And yet, [crosstalk] –
Rob Arnott: Right, and of course Tesla did much the same [crosstalk].
Dan Ferris: Exactly, yeah.
Rob Arnott: It did not say, "We're an auto [crosstalk]."
Dan Ferris: Right.
Rob Arnott: It said, "We're a pioneering innovator that will create transportation tubes, missions to Mars, batteries the likes of which you've never imagined, and so forth." Never mind that each of these is its own entity.
Dan Ferris: Sure, you've got to get 10 things right instead of one.
Rob Arnott: Tesla [crosstalk].
Dan Ferris: Right, exactly. [Laughs]
Rob Arnott: And buying Tesla doesn't buy you those other enterprises. It doesn't buy you – you don't own SpaceX if you own Tesla... it's a separate entity.
Dan Ferris: Yes, and meanwhile, we have – we're experiencing, firsthand – we're starting to experience, firsthand, certainly with Peloton we have, what happens when you mistake the narrative for a more capital-intensive, low-margin, highly competitive industry and brand-new products create their own set of risks, rather than – people buy the dream instead of focusing on the simple, you know, what might be viewed as the outside case. [Laughs] How often do we get a new car company that goes, what was it, 25X in five years? [Laughs] Ah, doesn't happen that often.
Rob Arnott: Yeah. And we wrote a paper, early last year, called "The Big Market Delusion," that specifically looked at the electric vehicle market. And what was fascinating to us was, out of nine companies that specialize in electric vehicles and do nothing other than electric vehicles, Tesla was the second-cheapest, at the end of 2020, in price-to-sales ratio. It was priced only 25 times its annual run rate sales. The highest-priced one was well into the thousands of times, because it had, essentially, no revenues in 2020. So, a big market delusion is when everything in an industry is priced as if it's going to be a big success, and yet, they're all competing against one another, so one or two may survive, may thrive, but the rest won't.
And so, you look at that whole segment, yeah, Tesla was the lion's share of the market cap of the segment... about 70%, if memory serves correctly, but it was also 90% of the sales, so its price-to-sales ratio was pretty crummy compared to the others. Anyway, bubbles are a fascinating topic, and I just find it hilarious when efficient-markets types say they don't exist. Come on. [Laughs]
Dan Ferris: Oh, sure, yeah, I agree, bubbles are an obvious facet of human nature that manifest in financial markets. But I'm glad you brought up the big market delusion, because, in fact, if you kind of make a study of these things and don't allocate based on narrative and so forth, you will recognize this common sort of a thing that happens where a new company comes in, and it's a typical thing, "If we just get X percent of this gigantic new market," you know, that's tangential, I think, to that narrative, right?
Rob Arnott: Yeah.
Dan Ferris: "If we just get X percent of this." Rather than saying, "We're new and different and we're going after a rather small market, but we think we can dominate it, realistically, because it's only, you know, x tens of million or hundreds of millions." Rather than a new one that's tens or hundreds of billions, potentially. It's a flag. It's a red flag, in fact, that argument.
Rob Arnott: Yeah, yeah, it is. Now, one of the other things about bubbles that's fascinating is, they're attempting to short-sell, be careful. Bubbles can go much further and last much longer than any cynic or skeptic might reasonably expect. Tesla would be [crosstalk] example of that. The most vivid example, to me, is the Zimbabwe stock market during their hyperinflation. As you came into the summer of 2008, in six weeks, their currency went down 10-fold, but their stock market went up 500-fold, which means 50-fold in U.S. dollar terms. Now, somebody at the start of the summer might've said, "Hyperinflation's clearly underway. I don't want to own companies in this economy. They can't possibly sort their way through hyperinflation with any likelihood of performing relative to companies based in other countries. So I'm going to short, but I'm going to short – anything can happen, only short 2% of my portfolio."
Well, that 50-fold rise just wiped you out, completely, bankrupted you. What happened over the next eight weeks, the balance of the summer? The currency fell another 100-fold, and the stock market basically went to zero and stopped trading. So you were right but bankrupt. Be really careful of bubbles. – they can go a long way. Another observation about narratives is that narratives are seductive because they're usually true. [Crosstalk]
Dan Ferris: Right, [crosstalk] makes that point all the time, the bubble is rooted in reality, is it not?
Rob Arnott: Yeah, right, yeah. And narratives induce us to invest in things where the story is fantastic, because people buy the story, the narrative. But they don't ask the subsequent key question, which is: "Is this narrative unknown to the stock market and not already reflected in share prices?" If you can't answer affirmatively to that, the narrative is useless.
Dan Ferris: Yeah, this is classic Howard Marks, isn't it? Who doesn't know this?
Rob Arnott: Yeah.
Dan Ferris: Right? [Crosstalk]
Rob Arnott: [Laughs] Exactly. So, narratives, you need to ask the question, "What in this narrative is not already known to the markets." We wrote a paper called "Nowcasting," back in 2019, in which we observed that the news, whether it's financial news or conventional news, generally engages in nowcasting: they describe what's already happened, they describe why it's happened, they sound insightful because they've just done that, they've just explained why it happened, and then they present it as a forecast. Now, roll the clock forward a year: suppose they're wrong, the forecast is wrong. People will remember it as if it had been made before what they nowcasted about had happened. They'll think, "Well, they were right, but not for long."
If they're right, they'll be seen as prescient geniuses. Flip it around, let's forecast something that hasn't happened, that's not highly correlated with recent market moves, that doesn't depend on momentum, on what has worked continuing to work. Now roll the clock forward: if you were wrong, you were wrong retrospectively and prospectively: you were an idiot. And so, there won't be a tendency to remember you as having had that view while it was happening, because what was happening was at odds with your forecast. And if you're right, you'll be perceived as, "Wow, they got that turn right, that was pretty lucky." Because it's contrarian, because you won't have had a lot of company in making that forecast, it'll be seen as an out-of-mainstream forecast... that you were just lucky.
So, nowcasting, if you go through the newspaper and read articles and just ask the question, "Is this person nowcasting or forecasting?" nine out of 10 it's a nowcast, you might as well cross out that article and ignore it. And I know people who do that with the news, they go through and they ask, "Is this a forecast or is it a nowcast?" I think it's just fascinating, when it comes to narratives, markets move based on narratives and based on changes in those narratives. And narratives are always accurate retrospectively.
Dan Ferris: Yeah, but there's nothing like a good story. [Brief silence] Wow, yeah, I'm taking in the phenomenon of nowcasting. It's a very interesting way to screen news stories, which is essentially what it is, a screen for news stories, as you described some people doing.
Rob Arnott: Yeah, yeah.
Dan Ferris: And just top of my head – I actually did – I didn't read that piece. I saw it, I was looking through – and our listeners need to know: you can find all these pieces on Research Affiliates' website – really good stuff, there.
Rob Arnott: Thank you.
Dan Ferris: But it's a very good screen, a very good way to read the news, because, as investors, we can't avoid – news is really – it's an interesting topic, because so much of it – I want to say so much of it is so bad, but that really doesn't – that's not – that doesn't do the situation justice. So much of it –
Rob Arnott: No, it gives bad a bad name [crosstalk].
Dan Ferris: [Laughs] Gives bad a bad name, right, right, there's just this tendency to think – it's all too human to think that what is in the headline is important to you. To think that what is being portrayed is really important to you. I think when you fall prey to that, that's one of the clues, that's one of the hints to you, whether you're an institution or an individual, that you really don't have a strategy, do you, yeah.
Rob Arnott: Right, right. And we see this sort of thing happen again and again, the narrative has been the Fed will remain easy as long as they possibly can, and then inflation crossed 7.5% and all of a sudden the narrative flipped. With the result that bonds are down, stocks are down, and break-even inflation rates are up. OK, well, was that a surprise? It was to the market. And, yeah, there's elements of CPI inflation that are very sticky, that – you know how they calculate shelter inflation?
Dan Ferris: No.
Rob Arnott: Well, first break it into homeowners, renters, and then travelers. Travelers, they use actual hotel and motel rates, so that's a market price, it's up over 20% in the last 12 months. Homeowners, they ask thousands of homeowners, "What do you think your home would rent for?" What do you think your home would rent for? I have no clue on mine. So, if I'm in that survey, I'll pick a number out of thin air, and then the next time I'm surveyed, I'll ask, "Well, what did I say last time? Oh, I said $3,000 last month? Let me say $3,100." OK, that's not a market rate, and home prices are up 19% year over year. So, if home prices are up 19% and rent, as of the end of – excuse me – owners' equivalent rent, as of the end of last year, was up 3.8%, well, gosh, that OER has a lot of catching up to do.
What about renters? Do they ask landlords, "How much are you charging for rent?" No, they ask tenants, "How much are you paying for rent?" It's behind the curve, because they signed a lease six months ago or a year ago or three years ago, and rents charged by landlords were up 14% last year. Rents paid by tenants were up 3.2%. That's quite a gap. Now, the reason for the gap is a lot of people haven't renewed their lease, yet. They're in for a rude surprise in the coming year. So, you're going to see a rent inflation up 10% this year, owners' equivalent rent, this year and next, up 5% to 10% back to back, record levels not seen since the early '80s. And it's all because they calculated in a fashion that introduces smoothing and lagging recent events.
So, when I see inflation soaring, I think, "Oh, this is going to take the market by surprise." But that's not a nowcast. The nowcast would be, "Well, it's surged. Now it's likely to settle back down." Because that's the conventional wisdom, that's what always happens.
Dan Ferris: That is fairly – that narrative is fairly consistent out there, right now, and for me, the real question, there, if it isn't a mere nowcast 100%, there may be a question, there, wouldn't there, Rob, as to comparisons starting around, let's say, June, which is when we – I think that's when we eclipsed 5%, last year? For the first time in many years.
Rob Arnott: Yeah.
Dan Ferris: So, do you expect the comparisons to fall off? Or you think this is going to stay pretty stout?
Rob Arnott: Well, here's where it gets kind of interesting. Firstly, people don't look under the cover to see which components are smoothed survey numbers as opposed to actual market prices. So, 99 out of 100 people in the finance world don't know that one-third of CPI, shelter, is severely lagged and severely smoothed. OK, so that can give you insights into what's coming. Now, the December inflation was just over 7%, 7.1, January 7.5. What moved it up 40 basis points? January this year was up 80 basis points, and January last year was up 40 basis points. So you drop 0.4, you add 0.8, and you're at 7.5.
OK, April through June, we're going to be replacing monthly inflation reports that averaged 0.7 per month. That's 8.5 per annum. That means that April through June, we're likely to see inflation moderating, we're likely to see politicians crowing and saying, "We got it under control," and then, the summer months, you're replacing three months that average 0.3. So if you come in at 0.8, you're going to see inflation go up a half, up a half, up a half, and then there's the election. So I think the No. 1 economic narrative in the November election will be, "Oh, my god, inflation's out of control again." No, you're just replacing some low prints with some higher prints. [Laughs] It's already out of control. [Laughs]
So, long term, I think it could be transitory in the sense that it could revert back down to low single digits, in three or four years, but not in three or four quarters.
Dan Ferris: OK, well, that's a forecast. [Laughter] Rob, before we –
Rob Arnott: And it's a moderately high-confidence forecast, which, like any forecast, could be wrong. And if I'm wrong on this, it'll be self-evident to people who are hearing this podcast that, "That idiot Arnott got it wrong." [Laughs] Where, if it was a nowcast, they might be kind enough to remember it as if I said it in November instead of February.
Dan Ferris: Right, but let's also look at it a different way, though. It's not only, you know, whether that very smart guy, Arnott, got it right or wrong. It's, "How is he allocated?" isn't that the real question? You know, it's one thing to predict, right?
Rob Arnott: Of course.
Dan Ferris: You make a prediction, maybe you're right, maybe you're wrong, but how are you allocated? Right.
Rob Arnott: Mm-hmm. And I would have to say that, on the equities side, we're overwhelmingly allocated toward value. Value is cheap, and just like in the years 2000 and 2002, you could have the market go down and value go up. Non-U.S. assets, Europe trades at half the multiple of the U.S. emerging markets, at 40%, as expensive as the U.S., and value in emerging markets is substantial discount to the EM broad market. Why? Because the EM has its own FAANG stocks that utterly dominate their market cap indexes. It's called the BAT stocks: Baidu, Alibaba, and Tencent. And a variety of other similar. So, I look on emerging markets' value as a great place to be.
There's also the inflation narrative: inflation helps some asset classes. Commodities, TIPS, and REITs are the obvious choices, but shockingly, stealth inflation fighters have an even better response to inflation than those three do. REITs are equities... rising inflation doesn't help equities, but helps REITs relative to equities. TIPS are rise-with-inflation, but inflation shocks, they only contribute to the return, they don't amplify the return. Commodities, they do amplify the return, but if you're looking for stealth inflation fighters, assets that people don't think of as inflation fighters, you've got high-yield bonds, emerging market stocks and bonds. Emerging market economies do well when U.S. has inflation. And so, if we are going to surprise to the upside on inflation, I want outsized commitments outside the U.S., outsized commitments on inflation-sensitive assets, outsized commitments on value relative to growth.
If I had it in my toolkit to go long value and short growth, I might be tempted to do that, at least to a modest extent. And so, the opportunities are there to profit from this kind of environment.
Dan Ferris: Rob, I heard "Europe," I heard "emerging" – I thought I was going to hear "Japan" in your next breath.
Rob Arnott: Mm-hmm. Japan's in there with Europe. It's interesting –
Dan Ferris: [Laughs] [Crosstalk]
Rob Arnott: I don't mean it's part of Europe. [Laughter] But Japan's valuations are richer than Europe, but cheap relative to the U.S. They're basically 40% off relative to the U.S.... Europe's 50% off, EM is 60% off. And in all three of them, value is, historically, cheap relative to growth. Summer of 2020, the spread between growth and value was the widest in history, 20% to 30% wider than the spread at the peak of the tech bubble. Wow. That's come in and – but it's still, value is still at its cheapest decile ever, relative, back to your issue of relative valuation versus absolute valuation. So value is cheap relative to growth, relative to the cap-weighted stock market.
It is not cheap relative to its own long-term history. It's fair-priced. OK, I'm OK with that. Emerging markets and international stocks, value is cheap relative to history, and cheap relative to the market.
Dan Ferris: Sounds good to me, man. [Laughs] So, let's say, a listener could probably do worse, listening to us talk and trying to express some of this with, you know, the available ETFs. There's value Europe, and value Japan, and value emerging, and all those things. Is there a better way?
Rob Arnott: Absolutely.
Dan Ferris: [Crosstalk] [Laughs]
Rob Arnott: We invented the concept of fundamental index. [Laughter] Fundamental index weights companies according to how big they are, not how popular and beloved and expensive they are. So it's going to take the growth stocks and say, "Thanks for that lovely growth, thanks for the premium multiples," that growth is in the price, it's known to the market. I won't benefit from this stock unless it achieves growth that's larger than the lofty expectations, so, I'm going to reweight it down to its economic footprint. Value stocks, they're trading cheap, for good reasons, but they won't hurt me, unless they perform worse than the bleak expectations in the market, so let me top that up to its economic weight.
And as prices move, if the underlying fundamentals don't move to the same extent, you're going to contra trade against those price movements. You'll be selling, trimming recent winner, topping up recent losers. And in so doing, you have a rebalancing alpha. Right now, RAFI is deeper value in the U.S., international, and, most particularly, emerging markets... deeper value than the value indexes. And, so, we partner with other companies for distribution of our ideas. PIMCO, Schwab, Invesco, they all have ETFs and funds that are tied to our fundamental index ideas. So, I have over half of my liquid net worth invested in emerging markets deep value, by way of a fundamental index-based strategy.
Why over half? Isn't that reckless? Well, you have some people who put half their money in Tesla and think that that's not reckless. No, value stocks tend not to be terribly volatile, and deep value, out-of-favor deep value, tends to have way more upside potential than downside risk, so I don't feel it's risky at all. Our website, we have two important websites. Anyone who goes to researchaffiliates.com will see, on the upper-right of the screen, an invitation to go to our Asset Allocation Interactive website, or our Smart Beta Interactive website. Asset Allocation Interactive gives you forward-looking expected returns for 130 different asset classes. Smart Beta Interactive gives you the same, forward-looking expected relative performance for 160 different smart beta strategies and factors.
And these, collectively, would point to emerging markets value stocks as having an expected return of about 12% to 14% per year for the coming decade. Well, that's not bad, especially when U.S. stocks are priced to give you maybe two –
Dan Ferris: So, Rob, I was going to ask you, when you talked about the discounts, the relative discounts among Japan, Europe, and emerging, if there was some risk adjustment. But I think you answered that one pretty well [laughs] with your personal allocation. I don't think we need to talk about that. [Laughter]
Rob Arnott: Well, I don't have an investment committee, although there are times when my wife thinks I'm an idiot.
Dan Ferris: And that can be the buy signal, right? A relative thinks you're an idiot is a buy signal. [Laughter] Of course not, [crosstalk].
Rob Arnott: I would never say that, I would never say that. [Laughter]
Dan Ferris: All right, Rob, I feel as though I could talk to you for another hour or two, but maybe I'll get to my final question for you, which is the same for every guest, and no matter what the topic. Sometimes we don't even talk about investing... every now and then, we find somebody on a different topic. But they always get the same final question. And that is, simply: If you could leave our listeners today with a single thought, what would it be?
Rob Arnott: It's overwhelmingly tempting to buy what's done well for you or for friends, and that is not a path to long-term success. It's a path toward chasing what's already expensive. It can work for a little while and make you feel good, but on a long-term basis, it's a disaster.
Dan Ferris: Perfect, perfect. [Laughs] Thank you. I hope everyone takes it to heart. Listen, thanks so much for being here. I've been a fan of your work for years and I still read it. I'm always rifling through your website for ideas [laughs], and recommend that our listeners do the same. And, you know, thanks very much, and I hope we'll check back in with you in six or 12 months, too, maybe.
Rob Arnott: Thank you so much.
Dan Ferris: All right, thanks, Rob.
Rob Arnott: That would be wonderful fun. Thank you.
Dan Ferris: [Music plays and stops] All right. Well, it's been a goal of mine to get Rob onto the show for some time because – as I told him – I go to the Research Affiliates website all the time. I'm always rifling through because the research is very deep. It's meticulous. The stuff appears in scholarly journals. It's really, really good. And if you're looking for that kind of work, especially on these topics that we talk about – value, growth, and bubbles and things – that's a place you need to check out if you haven't done so already.
And other than that, talking with Rob for almost an hour is like – you know, it's like talking with someone like Warren Buffett. He's just been around for a long time, he's done a lot of work, a lot of pioneering kind of work and the insights are always of the highest caliber. And I feel like he really delivered on that today. So I hope you enjoyed it as much as I did. Let's take a look at the mailbag. Let's do it right now [music plays and stops].
Have you ever hear do Jeremy Grantham? If you haven't, he's the billionaire who called the 2000 and 2008 bubbles perfectly. And recently, he said that "The situation today is crazier by a substantial margin than 1929 and 2000, in my opinion." And the chief strategist at Jones Trading even just wrote a commentary saying, "Since the U.S. financial markets have achieved new levels of insanity, we wanted to make sure we document this moment in time for posterity's sake."
When smart people are making sure they're on record warning about a dangerous bubble, it is time to pay attention. I'm definitely in the same camp, but I'm not looking for any credit for predicting a market crash. I just want you to prepare... starting right now. That's why I gave up my typical privacy recently to give a rare new interview, telling you exactly how to prepare today while you can still actually do something.
I know I lose my cool, even use some salty language. But I'm not sorry. You see, I just gave away the entire strategy I'm recommending to my subscribers to crush inflation and come out ahead in a market crash. I also gave away the name and ticker symbol of one of the best ways to play gold today and why you should.
And I accused Janet Yellen of double-speak, trashed the Fed and called out the idiots selling hats online that say, "Buy the dip and cash is trash." Of course, [laughs] I know most folks won't pay attention to any of this until it's too late. It's human nature, unfortunately. But today, you can do yourself a huge favor and avoid having to feel like you did in 2008 with this simple, one-step plan I've outlined for you. Visit danupdate.com for full details. That website, again, is www.danupdate.com.
[Music plays and stops] In the mailbag each week, you and I have an honest conversation about investing or whatever is on your mind. Send questions, comments, and politely worded criticisms to [email protected] I read as many e-mails as time allows and respond to as many as possible. Or call our listener feedback line, 800-381-2357. Tell us what's on your mind and hear your voice on the show.
First up this week is Paul. And Paul says, "As a pillar of the Stansberry community and brand, how do you deal with the duality of needing to pull on the" – quote – "'Fear and greed emotional heartstrings,'" – end quote – "of subscribers for good marketing versus calming those emotional sensors to make them better investors? Thanks. Keep up the great work. Paul."
Thank you, Paul. I will keep up the work [laughs] – great or not, I'm going to keep going as long as you'll have me. But yeah. So how can you – you know, how can you get excited enough and pull on the fear and greed emotional heartstrings to have enough subscribers to have a business that's worth doing on the one hand and then give them calm, rational advice – which I'd like to believe I'm known for – on the other hand? It's a reasonable question. And those two things meet up in the middle, Paul.
They meet up because the calm, rational advice that gets me the most excited is the stuff that I – when I get an idea that really excites me, I contact the marketing people and say, "Wow. I think this is a 10-bagger or something over the next several years." Or "I think it's a 20-bagger over the next couple of years." I said that a couple of years ago about the stock that is still my number-one recommendation. And it's more than doubled. So I think it's probably a 10, maybe 15, bagger maybe at the most at this point. But, you know, that'd be great – right – over the next five to 10 years.
And so, that is what happens. You know, I find something that's so cheap and such a good business and so attractive that I just want to scream it from the highest mountaintop. And, you know, [laughs] buying things that are really cheap and really attractive, that's sane and rational advice. Right? So that's where those two things meet up. But it's a good question and I'm glad you asked. Next up and last this week is Zack A.
And Zack A. says, "Longtime listener here. I recently read a book published about a decade ago by Richard Heinberg, titled, The End of Growth. It's about peak oil and peak resources in general and how the global debt combined with getting on the backside of peak extraction rates on key resources – which is hard to predict but at some point bound to happen – as well as the cost of moving to replacement resources in terms of money and energy creates a very different story for the economy... versus our energy and credit-abundant economy the last 200 years."
"I thought there were a lot of good big-picture ideas he presented and that you would enjoy the read as well. Maybe he'll come on the podcast too. Keep up the great work and thank you for all that you do. Zack A." Zack, I'll never invite this guy on. I'll never read that book because it's pure baloney. Peak anything is baloney. The Stone Age didn't end because we ran out of stones. Right? We didn't stop using coal because we ran out of it. You see? We didn't, you know – we're still using oil and there's plenty of it. And we're still using coal and there's plenty of it... and natural gas, plenty, plenty, plenty all over the place.
The problems are created by governments. They're not created by nature. and these things – this peak idea, this peak resource idea, comes from an ignorance about economics. We live in an energy-abundant universe and our ability to harness energy is a function of technology. It is not a function of this the, you know, relative endowment on our planet of some particular resource. It has never been that way and it never will be. This is Malthusian. Even Malthus recanted, during his lifetime, because he knew he was dead wrong. Right?
He said, "You know, geometrical population growth versus arithmetical resource growth, we're going to run out of everything" – no, we're not. We're not going to run out of anything. The universe is never going to run out of anything. And we're never going to run out of ideas to harness the stuff that the universe is never going to run out of. OK? I'm glad you asked, though. I know a lot of people harbor these ideas, but they are foolish. And if you invest based on them, you are guaranteed to lose money.
Over time, resources become cheaper in inflation-adjusted terms. You know? There was a very famous bet between Julian Simon – a very good economist – and another guy named Paul Ehrlich, who was a terrible economist... not an economist at all as I recall. I think he was some kind of a scientist. Scientists are usually [laughs] the ones who say this stuff, which is hilarious.
They're the ones who get this dead wrong every single time. We didn't run out of anything that Ehrlich said we're going to urn out of when all the prices are lower... and just the way Simon said they would be. He won the bet. It wasn't – there is some nuance to it. I think it wasn't as cut-and-dried as that, but he did win the bet. Well, that's another mailbag and that's another episode of the Stansberry Investor Hour.
I hope you enjoyed it as much as I did. We provide a transcript for every episode. Just go to www.investorhour.com, click on the episode you want, scroll all the way down, click on the word "transcript," and enjoy. If you liked this episode and know anyone who might enjoy listening to it, tell them to check it out on their podcast app or at investorhour.com. And do me a favor... subscribe to the show on iTunes, Google Play, or wherever you listen to podcasts.
And while you're there, help us grow with a rate and a review. Follow us on Facebook and Instagram. Our handle is @InvestorHour. On Twitter, our handle is @Investor_Hour. Have a guest you want me to interview? Drop me a note at [email protected] Or call the listener feedback line, 800-381-2357. Tell me what's on your mind and hear your voice on the show. Till next week. I'm Dan Ferris. Thanks for listening.
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