Jon Hartley interviewed Rob Arnott, founder and chairman of Research Affiliates, at the Economic Club of Miami on December 3, 2022. Topics discussed include the recent rise of inflation, macroeconomics, capital market returns, value versus growth stocks, factor timing, and index investing among many other topics.
Jon: “My name is John Hartley. I'm chair of the Economic Club of Miami. We got started just over a year ago, and I know a number of you have been to our events so far. We just had an event last month with Ken Griffin and Mayor Francis Suarez, which was a very popular and well-attended event. I'm the chair of the Economic Club of Miami, and as that would suggest, we are a membership organization. Those of you who are not members here, we highly encourage you to come to our website economicclubmiami.org and to check out some of our programming and what's involved with completing a membership application. And saying that to us, without any further ado, I have the pleasure today, the very special pleasure of introducing and interviewing Rob Arnott. Rob is the founder and chairman of the board of Research Affiliates, an asset management firm. Research Affiliates develops investment strategies for other firms like the famous Research Affiliate Fundamental Indices that are value-tilted indices. Research Affiliates oversees $166 billion in assets under management using their strategies, which are in their indices that other asset managers manage. In addition, Rob has also served as a visiting professor of Finance at the UCLA Anderson School of Management. He's also on the editorial board of several Finance journals, including the Journal of Portfolio Management. He's also served on the product advisory boards of the Chicago Mercantile Exchange, the Chicago Board Options Exchange, and, to say the least, Rob is one of the most prominent quantitative investors in the world. And I say this having worked in quantitative asset management for quite some time. Thank you so much, Rob, for joining us.”
Rob: “Thank you.”
Jon: “All right. So I think we'll just dive into it here. Let's get into inflation. What has the Fed been missing here? What have policymakers been missing? How do you think inflation came about?”
Rob: “Well, inflation's just a matter of supply and demand. If the supply of goods and services is constricted, and demand for goods and services is elevated, you're going to get inflation. It's really that simple. During the pandemic, of course, we had lockdowns. Many people continued to work from home. Many of those who work from home continued to pretend to work from home, meaning the supply of goods and services is diminished. Supply chain disruptions are widespread, no real light at the end of the tunnel for that. In addition to all of that, money's been helicoptered into people's bank accounts, creating a step up in demand. And we're at full employment, so stimulus checks really shouldn't be needed. But anytime you have aggressively stimulative fiscal and monetary policy and exogenous shocks that reduce supply, you're going to have inflation. I was shocked when Jerome Powell coined the expression "transitory inflation" back, I believe, in April of 2021. Inflation was already four percent, and half of that inflation had happened in just three months. So that it was four percent over a year, eight annualized over three months, and he says "transitory." I wondered what he'd been smoking. In November, he decided to retire the term "transitory," although they still talk about it as if it's transitory. And at that point, it was already six percent. So, one of the things I found just fascinating was in December of 2021 with inflation already above six percent, the FED Dot Plot, which shows what Fed Governors believe the FED funds rate should be at year-end, end of the next year, end of the next year, and as a permanent equilibrium. The forecast then was that Fed Governors thought that the fed funds rate should be 0.8 percent. That was last December; they were saying 0.8 percent for this year-end, and inflation was already over six years at that point; it was already over six, I might have been seven by then. It's astounding how far behind the curve they are, and I'm fascinated at the obsession with listening to their forecast for the macro economy or for inflation when their track record is unbelievably bad.”
Jon: “Yeah, I mean, it's fascinating how quickly the FED has pivoted, you know, just beginning someone later this year, in around March when they started tightening, and they've tightened very, very quickly. So, it seems like a very about face from the FED of 2021 that was very resistant to start increasing rates amidst what seemingly became entrenched inflation after October when it became more than just a story about used car prices going up but really also about housing, which is 30 40 or so of the CPI basket. I'm curious, sir, pivoting this a little bit to forecasting and capital markets. Like how long do you think sustained inflation in this five to ten percent range over the next two three years, how does that in your mind affect the economy in capital markets?
Rob: “Let me break that into two questions. Five to ten percent over the next several years is inflation that's not transitory. We did a study; we published it about a month ago in which we took the 14 OECD countries that have been developed economies for the last 50 years—I mean, there's a lot of newcomers; leave those out; they're not our peer group—focus on the ones that have been developed economies going back to 1970. And we then asked the question: how transitory is inflation? What we found was that if you get four percent inflation, half the time it's transitory, which, by our definition, means it goes below two percent within two years. Half the time it's not. So basically, when you get an exogenous shock that creates a small burst of inflation, then as soon as the shock passes, so does the inflation, which is great when it goes above six percent; you start to have more daunting odds. Only about 30 percent of the time is inflation transitory above six percent, only about 15 percent of the time above eight percent, less than ten percent above 10 or higher. And this is based on surprisingly large numbers of cases because we're looking at 14 economies spanning 60 years. And what we find is that there have been 28 times that one of these economies has seen inflation above eight percent. Now eight of those 28 are underway right now, so we don't know how they're gonna play out; the other 20 only two came back down in reasonably short order; eighteen lingered for anywhere from two and a half to 26 and a half years, median of 13 years. So this is not to say we're forecasting a long bout of inflation. What it is to say is who uses transitory, return to normal within two years, as their central expectation, is being very naive. That is well within the realm of possibility; that's the optimal best quintile. The worst quintile is 10 years and beyond. Oh, back to the second part of the question: what does this mean for Investments right now? Break-even inflation, which is the difference between the TIPS yield and the treasury bond yield, stands at 2.3 percent for 10 years. What that means is that if inflation is less than 2.3 percent, you're better off holding treasuries; if it's more than 2.3 percent, you're better off holding TIPS. So, one immediate takeaway that's very simple is, do you really believe it's going to be 2.3 percent from now for the next 10 years, or do you believe it'll go seven, six, five, four, three? Our forecast is four percent inflation for the decade, five percent inflation for five years. And if you get four percent, then TIPS will produce 1.7 percent more return per annum, working out to 17 percent more wealth after 10 years than if you used treasury bonds. That, to me, is a slam dunk; that's a simple strategic bet that for the patient investor should work out beautifully well.”
Jon: “It's a and you're my likely entrenched inflation or potential a good potential for entrenal inflation averaging about four percent over the next 10 years. I'm curious and sort of putting me to investing specifically here what asset classes do you think investors should consider to help them amidst this sort of sustained potentially sustained period of inflation in the coming years. I know some people talk about I bonds; there's sort of a $10,000 limit per person on that so you can't really scale that up but things like TIPS or Treasury Inflation-Protected Securities, real estate, short-term interest rates. I mean, what asset classes do you think should be part of an investor's portfolio in this new era of inflation?”
Rob: “Well, um, I've been called a Perma bear for the simple reason that I don't hold things that are fully priced or expensive. I like holding things that are cheap, and that created some difficulty in the late 2010s because value was having its worst drawdown ever, but viewed within equities, the spread between growth and value is still the largest quintile of spread ever. It's no longer the largest percentile, as it was in the summer of 2020, but the largest quintile; that's pretty good. So, for starters, if you're going to hold stocks, hold value stocks. If you're going to hold stocks, don't be easily focused on U.S. trading at Schiller P/E ratio, price relative to tenure smooth earnings, about 30 times.”
Jon: “That's a Cape ratio.”
Rob: “That's the Cape ratio. Where was it at the peak in 2007 and eight? It was 28 times, so it took a six-year bull market to get to 28 times back in the mid-2000s, and it's taken a bear market to get it down to 30. Now, what about Europe? Europe said 14 times; is it 15 times? Emerging Markets are at 14 times; they're half off. Are there prospects for growth worse than the U.S.? Of course, they are; prices are set based on narratives, and those narratives have the wonderful advantage of usually being true. So, they also have the daunting disadvantage of being utterly useless because they're already reflected in share prices. So, you want to figure out where the narrative may be exaggerated or may have room to change. The 2.3 Breakeven inflation rate is a beautiful example, the notion that if Emerging Markets deserve to be half off relative to the U.S, is one where there's ample room for change. Emerging Markets local currency debt currently yields more than U.S junk bonds, and the default rate historically is much, much lower. So, there are pockets of opportunity out there, and the backdrop on all of this is the inflation surge. Inflation is wonderful for value. If you go back historically and look at decades over the last hundred years, anytime you had inflation above four percent for a decade, value beat growth by six to ten percentage points per annum during those decades. Why should that be very, very simple? Firstly, high inflation usually means a higher discount rate. A higher discount rate hurts growth relative to value because most of the value in owning a growth stock is in the distant future, and that distant future becomes less valuable with a high discount rate. Secondly, there is absolutely no such thing as high but stable inflation; it doesn't exist. Which means that if you have elevated and turbulent inflation, you have elevated economic uncertainty. Isn't it nice if you're in a period of elevated uncertainty to have a low P/E ratio, low price to sales ratio, and so forth? A foundation of underlying fundamentals that can sustain the value of the assets. So, this is an opportunity-rich environment; it's just not the opportunities people are mostly looking at.”
Jon: “But this is good to note. Value stocks, high book to value, Warren Buffett type investing works well in historically has worked well in these sorts of inflationary environments because it's very helpful and good to know. So, I guess jumping a little bit deeper into macroeconomics and macroeconomic narratives, which you're alluding to. I'm curious how should investors think about things like rising deficits, national debt, aging demographics, yeah, in the sort of post-COVID world. This has become seemingly a very important issue when thinking about whether it's inflation or thinking about capital market returns in general. How do you think these issues are going to weigh on both figures like GP as well as long-term real returns?”
Rob: “I wrote a paper in 2009 called the 3D hurricane, the interconnected influence of deficits, debt, and demographics. The point of the paper wasn't that any of this play out fast but that they represent a strong current going through the macro economy. If you're wanting to swim across the Mississippi River, it's useful to know which direction the water is flowing in order to not wind up too many miles downstream. The same applies to things like deficit spending. John Malden likes to say there's a bang moment when things go along just fine and then bang; you suddenly realize your Wiley Coyote running off of a cliff. That kind of situation happens again and again in the macroeconomy. Deficits, of course, create that and the debt burden of the U.S interestingly if you think of the country as an individual family. If it has an income of a hundred thousand and has debt of 500,000, they're probably in trouble. The income that the federal government has to work with is just under 20 percent of GDP. The debt is ballpark 120 to 130 percent of GDP, depending on how you measure it. That's like the family with a hundred thousand incomes having 600,000 in debt. But there's hidden data, off-balance-sheet spending, off-balance-sheet debt, unacknowledged debt. The unfunded portion of Social Security and Medicare and Medicaid are enormous; they dwarf the national debt. Include those, and you're looking at hidden government debt that takes you to four times GDP as the income for the government to service those obligations. Alright, well, that's more akin to having six million dollars of debt on a hundred thousand dollars of income. What can't happen won't happen, and so I don't worry about this. There will be a reset, and the reset can take any of a number of forms. Default is theoretically possible, but why default when you can do the backdoor default of reducing the real value of the debt through inflation. Demographics then enter into the picture as a very slow-moving macroeconomy. For the cap structure because 30 years is an extraordinarily large roster of mature adults, the baby boom generation at a stage in life when they are valuation-indifferent buyers of financial assets. What do I mean by that? Those who think ahead and are worried about their future golden years are likely to be saying, "I need to set aside money," and setting aside money means you've got to put it into capital markets. And putting it into capital markets, you're not going to ask the question, "Is this too expensive or is this too cheap?" except perhaps on a tactical basis. You're going to set money aside, and this creates a dynamic that permits extreme situations. Roll the clock forward 20 years, even 10 years, and you're looking at an environment where you have an enormous roster, the largest ever of valuation-indifferent sellers. If you have assets set aside and you want to convert those assets into goods and services during retirement, you're going to sell. And you won't be somebody who can choose whether to sell based on whether it's expensive or not. The result is valuation-indifferent sellers; rates go up, markets come down. And so, I think we will have those headwinds over the coming 10 to 20 years. For people, that 3D hurricane is only a serious issue in a mindset. Today's economy is what things are going to look like for the next 20 years. For those with a more flexible mindset, all you have to do is boost your savings 10, 20 percent per year, extend your expected work span by two or three years, and reduce your expected expenditures in retirement by 10 or 20 percent. And if you make that mental transition, saying, "I'm going to work a little longer; I'm going to save a little more, and I'll spend a little less in retirement," it all of a sudden becomes very manageable. Most people won't do that, and the economics profession and our policy elite are complicit in encouraging them not to think about those things.”
Jon: “Fantastic. I love that 3D hurricane, deficit, and demographics. I feel like we're very much in the eye of that hurricane, or maybe the eye, I guess, is more peaceful. But I guess it's the edges that are the milder. We know a lot about hurricanes in Miami, and you wrote this paper before you moved to Miami.”
Rob: “I did. I moved to Miami in 2018 when federal tax law made state income tax no longer deductible so that my state tax burden went from 7 percent to 14.”
Jon: “Oh, fantastic. Well, you're not only are you predicting capital market returns, but you're also predicting your own future location as well. That's fantastic. I want to get more a little bit into the stock market specifically here. I know that you've had some pretty famous disagreements with Cliff Asness about AQR on the topic of market timing. I think he's sort of the opinion that you can't really time the market well, and I think your opinion is somewhat different from that. I'm curious, how should investors set their expectations for the future even where we're at now? Are there any sort of compelling bargains today for a long-term patient ambassador? The S&P 500 is down 15 year-to-date; we've been sort of in this range this year-to-date range of anywhere between 25, 15 for a while. And I think there are some people out there that say, you know, now's a great time to get in if you have dry powder on the side or maybe even if you're fully invested to lever up a little bit and take a position that has an equity market beta greater than one. I'm curious, what do you think about this kind of reasoning? Around market timing, do you think now is a good time to lever up a little bit and get some more equity exposure to harness that long-run risk premium?”
Rob: “First, just a quick observation on the controversies with Cliff. He and I agree on about 90 percent of everything. I think what's going on is he gets annoyed that we agree on so much that what we disagree on suddenly matters more to him than it ought to. It is what it is. The paper that got him really angry was a paper in 2016 called "How Can Smart Beta Go Horribly Wrong." Fundamental index, which we invented back in 2004, was actually the original inspiration for the label smart beta, which was coined by Towers Watson back in 2007.”
Jon: “These are the Research Affiliates fundamental indices, which if you own an equity fund at PIMCO or several other asset managers, you're actually invested in exactly what Rob is telling you to be invested in.”
Rob: : “That's most of our 100 plus billion. The performance since 2016 for multi-factor was terrible; for a fundamental index, it was terrible unless you correctly used a benchmark of value indexes relative to value indexes, we did really, really well. But the essence of the paper was really simple. If you have a stock and its price has soared and its underlying fundamentals haven't, so its valuation multiples of sort, its past return will be brilliant. And if there's any mean reversion, its future return is going to disappoint. We said the same dynamic holds true for strategies and factors. The value factor, the spread in valuation between growth and value, widens and contracts. When it widens, you have rising relative valuation of growth and you have lousy performance for the value factor. But it's a revaluation alpha; it's from the valuation tumbling, not from the underlying fundamentals softening. What we observed was that every single factor and every single strategy out there goes through these cycles. People are drawn into strategies when they've performed well without doing the added homework of asking, "Did it perform well because it got more expensive or because it has structural benefits embedded in it?" In 2016, most factors were expensive; value was the one outlier. And in 2016, sure enough, value did well, low vol, momentum, quality did badly. The point of the paper was when factor or strategy valuations are abnormally high, you might want to go easy on using them. I would agree with Cliff that you don't want to make heroic, huge bets on factors and strategies; you want broad diversification. But just at the margin, if one factor is dirt cheap and the others are expensive, you want to tilt. I'm working on a paper called "That Was Then, This Is Now," which points out that the situations changed. Most factors are trading cheap now, abnormally cheap. So, the fact that multi-factor had a dismal five years is part of the reason that they're trading cheap now. While money was pouring into a factor, multi-factor, and smart beta strategies in 2016 at a time when the valuations for most of these factors were high, that's just common sense. People will pile into what's given them great joy and profit without necessarily thinking about whether that profit came because of a structural advantage of the strategy or because it just got more expensive. Today, we're in the opposite situation. Money's pouring out of smart beta, out of multi-factor, and they're poised to perform beautifully in the next five years.”
Jon: “Fantastic. So, factors are cheap.”
Rob: “I think this is great for value investing and diversification outside the US, particularly in Emerging Markets value and developed ex-US value. If you own US stocks, make sure it's with a value tilt. In bonds, yields are still inadequate for most of the world, except in Emerging Markets where local currency debt is yielding more than US junk bonds. Those currencies are now cheap because the Dollar's been so remarkably strong.”
Jon: “It's a fantastic time to consider getting into the market if you're not already in it and tilting toward these sorts of factors. I think that's a great, very compelling thesis. Perhaps the bottom isn't already in, so you may want to act soon if you're entirely in cash.”
Rob: “Though I like to buy at a period of peak fear, I think in Europe, we may be there. People are terrified that good German citizens will freeze to death this winter due to difficulties in getting oil and natural gas at a time of great need. There's a worry of the European economy cratering because the industries also need energy to function. Usually, when you have elevated fear, the company validates that fear but isn't as bad as the fear would have suggested. If it's not as bad, the narrative shifts, and things are pretty bad but not as bad as feared, which means that the markets will rise handily. So, I think the US probably will have another leg down. This doesn't feel like peak fear; it doesn't feel like we've had a capitulation. Non-US stocks, if US stocks go another leg down, non-US will test their lows. But if I'm wrong about the US having another leg down, you want to be risk-on in the markets that are cheap. So, averaging in now makes sense; keeping some dry powder now makes sense. I'm often asked if you think there's another leg down, should I be getting out? My response is you should have been getting out a year ago. The market was a lot higher than now; you should be thinking about entry points.”
Jon: “Fantastic. I know just yesterday the EU announced this new price cap on energy prices. It's very, very interesting to see.”
Rob: “How enforceable that will be.”
Jon: “Yeah and I mean, it's amazing, just this perfect storm of a war in Ukraine at the same time as this biggest inflationary burst since the 1980s.”
Rob: “The latest NATO estimates are that Putin's killed a hundred thousand of his own citizens already, just by sending them to be cannon fodder.”
Jon: “So tragic. My thoughts and prayers are with everyone in Ukraine and affected by this conflict. I just want to shift to tech because when we talk about value, I feel like we're implicitly talking about growth, and so I want to talk a little bit about bubbles and what's been happening in tech. There's been a lot of announcements about tech layoffs recently, something we really haven't seen in over 20 years. It seems like we're almost potentially at the end of this second tech bubble, the last being in the early 2000s. We've had these acronyms over the past decade, like FANGs (Facebook, Amazon, Netflix, Google). I'm curious, given that some of these companies, Facebook, Netflix, have seen like 70% or more sell-offs in their stocks, how do you think one can identify bubbles or anti-bubbles in real time? This is a huge debate; folks like Robert Shiller have a very certain view on one side, and efficient markets folks like Eugene Fama have a very different view on the other side. I'm curious about your thoughts on the sort of behavioral economics and behavioral finance question of being able to identify bubbles.”
Rob: “People bandy around the term bubble very liberally, usually without defining their terms and usually in retrospect - tech bubble, dot-com bubble 2000, FANG bubble. I'm starting to hear people say FANG bubble. In 2018, we thought wouldn't it be nice if there's a workable definition for the term bubble that can be used in real time. We came up with one that I think makes good sense, and that is if you're using a standard valuation tool like discounted cash flow, you have to make implausible assumptions for the future growth to justify today's price. As a quality check on that part of the definition, the marginal buyer doesn't care about valuation models at all. And if you use that definition, then for quite some time, FANG stocks have been bubble stocks. I was debating Kathy Woods a year and a quarter ago at Big Morning Star conference, and at one point, I briefly described that definition, and I said, "So given your fondness for Tesla, what justifies a $3,000 target price in terms of actual future growth?" She said it's going to grow 89% a year the next five years, and then it'll be priced parapasu with today's FANG stocks. I had been asked to play nice, so I bit my tongue. What I wanted to say is 89% growth for five years is 25-fold growth. You're saying Tesla will be 25 times as large in five years as Amazon over the last 10 years has grown 12-fold. So, you're saying that Tesla will have twice as much growth in half as many years as Amazon. I bit my tongue and said, "Well, that just sounds pretty implausible. Anything's possible, but that sounds implausible," and let it go at that. But using that definition, there's plenty of bubble stocks out there even now. I view this as a deflating bubble, much like the 2000 to 2003 unwind of the tech bubble.”
Jon: “Well, I mean, I feel like I've watched some of that interview with Kathy Wood from over a year ago. I feel like very prescient and it's fascinating just to see this Tech collapse, and it feels very much like the end of a bubble too, seeing all these issues around fraud and FTX. I don't think it's quite a coincidence that perhaps the Enron Scandal of the early 2000s sort of coincided with the end of the last tech bubble. The fact that we see this frothiness and arguably fraudulent things going on at the same time, crypto controversies and things of that nature. It's interesting that the timing of these things seems to occur together, and it's not coincidental; maybe mania sort of comes in and drives in a sense. So we talked a little bit about growth in tech stocks. Let's get back to the value side of things here. The idea that investors should invest like Warren Buffett, finding good deals like stocks that have high book to market values. What gives you confidence in the long-term prospects of value investing? Value investing has had a really difficult past 15 years or so that I think has been humbling for a lot of value managers and a lot of quants that are big into value investing. What's the thinking and evidence behind your outlook? I think you're very bullish on value, and how have, I know you spoke a little bit before about how value stocks have fared fairly well in inflationary times, but say we are able to get out of inflation over the next few years or so and the FED is effective in achieving that goal. I'm curious, what's driving your thesis behind value investing being a big winner in the coming years?”
Rob: “Well, firstly, value has two main sources of alpha long term. One is what Fama and French call migration - growth stocks, high valuation multiple companies. One or another of them falls out of favor, drops off the list, and is replaced with a new high flyer. So that means something with a more moderate valuation multiple is replaced with a higher valuation multiple company, which means that there's this constant, with every rebalancing, there's less and less earnings, dividends, sales for every hundred dollars you invest. The value side has the other opposite happen: stocks percolate up out of value, come back into favor, and are replaced with new unloved deep value names. So, you get this constant rebalancing out of companies that are no longer cheap into companies that are deeply cheap. And in so doing, you get more earnings, dividends, and book value for every hundred dollars you invest with every rebalance. Now, this matters because growth stocks do grow faster than value stocks. That difference historically has been about 12-13% per annum - pretty big. The migration effect has been about 18% per annum, enough to swamp that with room to spare. In addition to that, you have a yield difference. And so, yield is an important part of returns for value stocks, and that yield kicker is real. The advantages of value are structural and powerful. The disadvantage is that there's a cycle; it falls out of favor. We wrote a paper, "Reports of Value's Death May Be Greatly Exaggerated," which came out at the beginning of 2021. And that paper won Graham and Dodd recognition as one of the two best papers of the year. I was really pleased with that.”
Jon: “It's one of the biggest finance practitioner journal awards out there. Yeah, named after the two founders of value investing, for the big Warren Buffett aficionados here. Yeah, it's actually Ben Graham was Warren Buffett's professor at Columbia - ads with it, the grandfather –
Rob: “Right, so in any event, in that paper, we made two points, one minor, one major. The minor one, although it's not all that minor, is the book value is an antiquated measure of a company's assets. If I spend a thousand dollars on a desk, the book value of my company goes up a thousand. If I spend a million on R&D, it doesn't. And I wouldn't spend a million on R&D if I didn't think I was going to get it back in reasonably short order over, let's say, a five-year span or something like that. So, it turns out that if you use price-to-book value, if you just add in R&D to the book value and then amortize it out over 10 years, you have about twice as much efficacy as conventional price-to-book. So that was an interesting finding. The more important one was that value becomes cheap or expensive over time. And when it's expensive, it often doesn't perform very well. People are paying as much for value as they ought to and are not pricing growth stocks at frothy extremes. Then you get to a point where value is dirt cheap; summer of 2020, the spread between growth and value was 13 to 1 on a price-to-book value basis, peak of the tech bubble, it was 10 to 1. The norm is 5 to 1. So, we were saying we've just seen the most extreme relative valuation for value ever. How much of it was because the value companies were doing badly? None. That wasn't a contributing factor at all. The value companies were doing as well relative to growth as they historically normally have; they were just out of favor. People thought, again, that the COVID lockdowns would lead to rolling bankruptcies across the macro economy, and those, of course, would be the value stocks. So, a lot of these companies wouldn't exist. Well, trillions of stimulus made sure that didn't happen. Bankruptcies in 2020 were only modestly above 2019. Shockingly little change. And as people began to realize that, the value cycle turned; people stopped pricing value stocks as an option on their future survival and started pricing them as going concerns. That's all it took to have that first massive leg up. So, I'm a believer in value structurally because of the migration effect and the yield difference. I'm a believer in value, and value is cheap, which it was extremely cheap summer of 2020. Here's a fun factoid: Russell value underperformed Russell growth by 4,000 basis points in the first eight months of this decade. It's now within, um, within two percent per annum of being in the black decade to date. To recover a 4,000-basis point drop, you get outperformed by 6,700 basis points; we're almost there. And the Fama French value factor is already in the black decade to date, and Fundamental Index is already ahead of the cap-weighted markets decade to date. So, when things change, they can change very fast. I'm often asked, "Did I miss my opportunity? Is it too late?" My answer is, for now, no, it's not too late because the gap between growth and value, while it's come in considerably, is still in the cheapest quintile ever, and there's still 4,000 basis points needed for value to recover relative to growth in order to bring just get back to historic norms. 4,000 basis points is worth making the trade.”
Jon: “Well, I know that, you know, despite there was this not so great period for value and you know starting maybe from around the time the global financial crisis to um just 20, you know, 2021, I know this year especially early in the year was just a huge rebound for value. I think, uh, that may, uh, but particularly while in an inflationary environment for the reasons you've outlined, it's very interesting to hear your uh your thesis and and thinking behind why value investing is great prospects in the long run. Sure. I want to pivot next to a little bit more toward uh your business and kind of what makes Research Affiliates different from even other quantitative investment managers in that you're all about indexing and creating thoughtful indices. And what I think is so interesting is, you know, we've seen this massive shift over the past really 40, 50 years in investment management away from active management. Toward passive management and, you know, we have things like index funds and ETFs now. I think it's so interesting about your business is that you have a slightly different take on the, you know, pure market cap weight, right, of, you know, say the BlackRock’s and Vanguards out there that are just weighing every stock by their market capitalization weight. And you're using things like value weights and accounting and book value type weights. And I think that's a very different way to try and capture value than say, you know, traditional hedge fund equity long-short stock pickers who are picking value names that they like. It's very different and also just from a format and perspective, you're able to offer your investment products through things like ETFs and index funds. I'm curious, like, you know, what do you think is, you know, right about index investing in general, investing through ETFs rather than sort of do it at home yourself, finding value names in the newspaper and so forth or doing your own homework. And what do you think are some of the also, you know, underappreciated travails that, you know, indexers may face, and what ideas going forward might improve index fund management going forward?”
Rob: “Absolutely. Well, firstly, two answers to your question. Each of which deserves some discussion. One is Rafi versus cap weight, and the other is, can you do cap weight better? Let's take the first one first.”
Jon: “And Rafi is Research Affiliates' fundamental indexing.”
Rob: “Correct? Fundamental index basically means you look at each company and you ask, what are its sales as a percentage of all publicly traded companies? What are its profits as a percentage of all publicly traded companies? What are its dividends plus buybacks as a percentage of all publicly traded companies? What's its book value plus intangibles, R&D as a percentage of all publicly traded businesses? So, Exxon Mobil might be 2% of all sales and 2.5% of all profits and 2% of all book value and 1.5% of all dividends plus buybacks. You can argue endlessly about whether it's 1.5, 2, or 2.5% of the economy, or you could just take an average of those. Now, if you take an average of those, you get a crude approximate measure of the footprint the company has in the macro economy. Our footprint on the beach has multiple measures - length, width, depth of the footprint. Same thing can be said about companies in the macro economy.”
Jon: “3D footprint, like the 3D hurricane.”
Rob: “Yes, yes, except this is 4D because we're using four measures. Anyway, if you weight companies by their fundamental footprint, a growth stock will be re-weighted down to its economic footprint; a value company will be re-weighted up to its economic footprint, and the market loves the growth stocks, pays a premium, hates the value stocks, prices them at a discount. The market is shockingly prescient in determining which companies deserve a premium multiple and which don't. There's a 50 correlation between the premium paid for a stock and its subsequent future growth. That's cool, except the market overpays for these and underpays for these. So, there's a minus 50 percent correlation between the premium that's paid and the subsequent IRR of the stock. So, the market does a good job of picking the companies and a lousy job picking the same stocks. The implication of that is the value tilt of fundamental index is structural and large. The average value utility is very similar to that of the value indexes. It differs from the value indexes because it includes the growth stocks; it includes the value stocks and the deep value it overweight’s a lot, and the extreme growth it underweights a lot. It also concentrates against the market's constantly changing opinion. So, as the market is changing its mind on what a company is worth, you're going to concentrate against those largest moves unless they're ratified by changes in the underlying fundamentals. Now, what this means is that you have a rebalancing alpha, a value tilt alpha, and an index, an index that studiously mirrors the look and composition of the macro economy much like cap weighting mirrors the look and composition of the stock market itself because it is cap-weighted. So, when we first thought of this idea in 2003 and back-tested it, we first did it with book value and with sales, both of which more or less can't go negative. And by using those measures, we found that over the prior 30 years, choosing the companies by the fundamental size of the business and weighting them by the fundamental size of the business would give you, historically, a two and a half percent alpha. Interesting per annum. One percent of that came from the value tilt, one and a half from the rebalancing alpha.”
Jon: “That's a lot.”
Rob: “Yeah. Now, since we went live, value's underperformed, but we've continued to beat the value indexes by about one and a half percent a year. Two in the more volatile markets like emerging markets and small-cap companies, and that's been persistent. Seven out of ten years, we win. Eight out of every ten three-year spans, we win. 95 percent of all five-year spans, we win relative to the value indexes. So, it's a powerful concept, but I like to think of it as indexing to mirror the look and composition of the economy. So, you have an economy-weighted index and you have a market-weighted index. Both represent perfectly reasonable core holdings. Now, that brings us to the second issue: can cap weighting be smarter? Cap weighting has two Achilles' heels, one which Rafi addresses. Cap weighting guarantees that any stock that's above its future value, future fair value, is weighted too heavily. The majority of your holdings will be in overvalued companies; minority will be in undervalued companies. Rafi fixes that, not by knowing what the fair value is, but by randomizing the errors. A stock that's big in Rafi could be over or underpriced; years cancel instead of being systematically overweight the overvalued and underweight the undervalued. The second Achilles' heel of cap weighting is the way they add and delete stocks. Stocks are added because they've soared; they're dropped because they've tanked. And so, you're magnifying that effect of overweighting the overvalued by adding stocks when they're extravagantly expensive. We went back historically and found that stocks that were added were quite literally at four times the valuation multiples of the stocks that were dropped. What if you neutralize that? You can do that in a lot of ways. You can do that by not adding a stock until it has, let's take S&P 500, until it's been in the top 500 for three years back-to-back. Okay, by then it's no longer necessarily on a tear, and you'll have missed turnarounds; companies that soared and crashed don't drop the company until it's been out of the top 500 for three years back-to-back. It will no longer be in free fall, and you'll not have dropped companies that cratered and bounced back. So, you reduce the turnover; you reduce the sensitivity to price on your additions and deletions. And, oh, by the way, even though you're still cap-weighting, even though Tesla's still one of your five largest holdings, basis points per annum, it's a conventional cap-weighted index because you're not chasing the latest frothy fad and fleeing the latest unloved stock. So, we're coming out with a paper I hope FHJ will accept; should hear in a few days or weeks, in which we basically say, "Hey, indexers, get smart about how you add and delete stocks. You can make a better index and give your customers a better experience. And if they won't, we will. I like that."
Jon: “So, we're going to open it up to questions now. I think we're going to pass around a microphone. If you could state your name and a brief question, more questions than comments are preferred, but also understand that folks need some background as well. I think we have a question from Greg over here.”
Greg: Thanks, Jon. [Inaudible 56:03] So, there's a little bit of a debate going on right now about where the Fed's going and how high they're going to raise rates until they get to the peak and how long it's going to take. A question for you would be if you were the chairman of the FED, based on what you said earlier about inflation and how you've studied it in the past, what do you think you would do in terms of how high you raised the rate and how long you keep it there? And what tends to be more effective in fighting inflation? Is it going higher, or is it going up to a more moderate level and keeping it there for a longer period?”
Jon: “So, I think just to repeat the question, I think the question is if you're the chairman of the Fed,”
Rob: “What would I do?”
Jon: “What would you do?”
Rob: “I use to believe that during the good times, you run surpluses and get the debt reduced. He'd be shunned. So, a fellow named Ian McDougall was wandering the countryside in Scotland, and he says to a local, "How do I get from here to Inverness?" And the local says, "If I were you, I wouldn't start here. You don't start with a decade of free money; that was a catastrophic mistake and a catastrophically failed experiment. We're going to be paying the piper for that for two, three decades to come." They claim to be data-dependent, but the data that they focus on changes from one meeting to the next; it's whatever is the latest hot data point that they find interesting. The data point that they pay no attention to should be the central and most important data point that they look at is the long bond yield. The long bond yield is still set by the market; it's not set by the Fed, and the long bond yield tells all of us what a market-clearing price is for those who want to borrow at a risk-free rate, for those who are truly risk-free borrowers, or for those who want to defer consumption and get paid for it by deferring consumption by providing capital. And viewed from that perspective, the idiocy of negative real rates becomes self-evident. Why should they pay attention to that? Cam Harvey is an advisor to our firm; he was the first to notice that an inverted yield curve predicts a recession. He published it in his 1988 PhD dissertation, and I would argue that an inverted yield curve doesn't predict a recession; it creates one because what you're doing is saying to those who are willing to defer consumption, defer consumption for a long time, you're going to get paid less than deferring consumption for a short time. Or conversely, if you're a borrower, you want to borrow money long-term; we'll charge you less than if you want to borrow money short-term, which means shut down new initiatives that are remotely questionable. The result is that whenever the yield curve inverts, growth is stifled. To a person with a hammer, everything looks like a nail. The inflation is caused by elevated demand, diminished supply. The Fed can do nothing about supply. So, their view is, and they're very explicit about this, crush the demand until it equals the supply. All right, what does crushing the demand look like? A recession. Australia was called The Lucky Country because for 30 years, it had no recessions. What was the central bank policy during most of those 30 years? It was to have short-term rates pegged, whether deliberately or just by happenstance, at about one to two percent below the long rate. And they had no recessions, and they grew from being half the per capita GDP of the U.S to being about 80 percent of the per capita GDP of the U.S. Cool. So, I think if I were chairman of the Fed, I would set the Fed funds rate at one percent below the long yield, adjusted every meeting to keep it about one percent below the long rate, and go spend time with my family.”
Jon: “So, I just, I guess, follow up on that. Do you think, like, as off-landing as possible, that we could potentially have, you know, a soft landing if the Fed is, if the Fed is not determined to have a Fed-induced recession?”
Rob: “If the Fed is not determined to crush demand. Yeah, if it's not determined to crush demand, then yeah, we could have a soft landing. But they are determined to crush demand, so I think the likelihood of a soft landing is remote. I think we're in the early stages of a recession. If you look at GDP growth, we had two negative GDP prints in a row; that used to be defined as a recession. They changed the definition of a recession to say following GDP and rising unemployment. When you have two job openings for every job seeker, rising unemployment is difficult. But they're going to do it; they're going to make sure it happens. And with that determination, it creates a very high likelihood that we have a recession next year. It doesn't have to be a bad recession; it doesn't have to be a deep recession, but it's very highly likely that we have a recession. And businesses have to act accordingly.”
Jon: Well, it's fascinating, and it was like I think, in general, there are sort of three different causes of recessions. Over the past hundred years, the three most popular causes have been pandemics, financial asset bubbles (like the tech bubble or housing crisis of 2008), and, I think, the most popular one people tend to forget is actually fat-induced or Central Bank-induced recessions. These are, I guess, coming back in vogue now that we have inflation back. Well, it's very interesting to know what a potentially future Fed chair would do.”
Rob: “It's never going to happen.”
Jon: “Well, yeah. A lot of people said the same thing about President Trump.”
Rob: “[Inaudible 1:02:03]”
Jon: “Okay, not wise.”
Rob: “I like those policies, but I thought he was a lousy human.”
Jon: “This will be Rob's last interview from Miami. We've got a question here from Adam. Feel free to just shoot it.”
Adam: “So, we've just come to the end of a 30-year period of massive [Inaudible 1:03:26] globalization, outsourcing, technology impact that has basically come to an end. Globalization has ended, outsourcing has ended, or it's now at a static level. So going forward, and that's brought a seam at the same time in interest rates coming down systematically throughout that 30-year period. So, what do you think is a stable state or the equilibrium 10-year yield, and what is the corresponding equilibrium P/E multiple for the S&P 500 as a result? Because they should be related to one another, right? So, if being 17 and a half times over that period, should that contract to 15 and a half times on the forward basis?”
Jon: “Just to repeat the question for our friends online and the microphone here: the question is, or the comment, globalization seems to have ended. What is the long-term equilibrium 10-year yield and P/E ratio?”
Rob: “Let's start with real yields because the 10-year yield will be real yield plus 10-year expected inflation. Let's assume that the economics profession consensus settles in at two to two and a half percent inflation. I don't think a break-even inflation rate of 2.3 today makes any sense at all, but five years from now, hopefully, it does. I wish they would aim for price stability, meaning zero inflation, but that's an outlier view. It's very out of favor these days. So, if inflation is in the two to three percent range, and the real yield is in the one to one and a half percent range, then you're looking at, let's say, about a four percent yield, right about where it is now. So, that's a good end point. If you have two percent real yields on Treasury bonds, then a valuation multiple, I don't like using P/E, I like using Cape, the price relative to tenure smooth earnings because P/E based on trailing earnings is often extraordinarily high just because earnings are depressed or extraordinarily low because earnings are peak earnings. So, the 17 times that you're alluding to is 17 times peak earnings, and the Cape ratio right now is about 30. Historically, when you get real yields of around one to two percent, you find that the natural Cape ratio is pretty good; it's about 20 times. Well, that's a third off from today, and so I think yields, the FED will push rates higher. So, Treasury yields will rise from current levels, though not necessarily very much and not necessarily very long. But the eventual equilibrium level would be not dissimilar to today. Equity valuations would be lower, and real yields would be in the one and a half range. What that means is that we're not that far from equilibrium except on equity valuations, with the important caveat that between now and then, the FED is determined to create a recession.”
Adam: “So, get used to six percent mortgage rates.”
Rob: “Yeah, which makes sense on a long-term basis, blowing housing bubbles by creating an environment of two and a half percent mortgage rates really doesn't make good macroeconomic sense.”
Jon: “Getting used to six percent mortgage rates sounds horrifying to a young prospective homebuyer going forward, but I agree with you. But maybe we've been in this period of zero percent interest rates for so long that we've all become so accustomed to it.”
Rob: “Exactly, it was aberrantly low rates.”
Jon: “If you have any more questions, upfront, the gentleman upfront, and please speak loudly if you can.”
David: “So, my name is David Gonzalez. Thank you. From your comments, it would seem like a stagflation scenario is very likely in your view. Could you expand a little bit on that? And also, what are your thoughts on China for the next decade or so? [Inaudible 1:08:36]”
Rob: “Yeah, it sounds like about an hour.”
Jon: “The question, starts other thoughts on inflation and in on China. Okay, say, sorry, say, thoughts on potential static relations, so GDP contracting, economy contracting, and inflation at the same time, and what Rob thinks about China.”
Rob: “Firstly, our work on inflation suggests that there's a reasonably good chance that the burst of inflation we've had is only the start of an inflationary episode, not the end of it. There's a 20 percent chance that it recedes over the next two years, but there's also a 20 percent chance that it lasts a decade or more. I don't like those odds. That sounds like a formula for stagflation. If we wind up with a short, mild recession, and the FED backs off, and fed funds are back down to three, and the 10 years back at four, and equity valuations are a healthy multiple but not a lofty multiple, then we can enter a period of relative tranquility. But I would say stagflation is kind of the 30 percent bad news case, with FED ineptitude. It's not unlikely, and the Goldilocks scenario is a 20 or 30 percent benign case. In which case, you really want to be getting back invested outside the U.S., in particular, now, not wait. The China question, I feel for the people in China that you've got an autocrat at the top. He's unreconstructed Maoist. He believes in absolute control. His having Hu Jintao, his predecessor, marched off at the end of the party Congress suggests how far he's willing to take things. The zero-COVID policy, I'm sorry, everyone in China will be exposed to COVID. It's going to happen. Show of hands, how many people in this room think that they have had COVID or know that they have had COVID? Okay, that's about 80 percent. I'm guessing half of the rest of you did but didn't have any symptoms. My wife's had it twice, no symptoms either time. She was tested because of travel in both cases and found, "Oh, I have COVID." So, zero COVID policy is stupid from the get-go. It's going to spread. You want to protect the vulnerable and just recognize that everyone's going to get it. Let's not blow up the economy over this. In China, isn't it interesting how every time there's a massive protest, they find a COVID case somewhere nearby and lock them down? It's about control. It's not about COVID. It's about punishing enemies. It's not about COVID. So, I hope China has more enlightened leadership within the next decade. The current leadership is scary.”
Jon: “Any other questions from the audience? We've got one from Michael. Yep, we can hear you.”
Michael: “My question is about what do you advise investors who are making their investment decisions based on information provided by a neoclassical or Keynesian theoretical approach or valuation approach? But you're seeing administrations' fiscal and monetary policies that are continuing and ramping up. [Inaudible 1:13:00]”
Jon: “So, to repeat the question, I think the question is how does neoclassical and Keynesian thinking around economics and to some degree, that influence on investing, how does that work in an era of MMT (Modern Monetary Theory) seemingly inspired.”
Michael: “[Inaudible 1:12:38:] If you're using the wrong map, it might be a great map, but if it doesn't work, we should be ready to go. [Inaudible 1:13:45]
Jon: “So, I think the question is living in a paradigm where sort of economic policy has sort of shifted away from a neoclassical, long-term structural growth, pro-growth policy, or demand management Keynesian demand management, but where you're running deficits in bad times and surpluses in good times, you know, maybe like in the '90s in the Clinton era. What, how does shifting away from those traditional paradigms to one where we're just always running deficits and presumably always having very accommodative monetary policy? So, let's maybe change a little bit recently... How does that regime shift weigh on investing going forward?”
Rob: “I view geopolitical shocks, stupid policies, which is another form of shock, as a means by which mispricing is introduced into the markets. And those willing to concentrate against them will usually win, though it can take a while. So MMT, one of the premises of MMT is when you do start to see inflation, you'd better raise your taxes to rein in inflation. And that's an area where I would actually agree with the MMT crowd that if you are determined to keep spending and you've got inflation and you're not willing to cut spending, that you have to raise taxes. Or, as Milton Friedman famously said, the correct measure of the level of taxes is the level of spending. Because if it's not, what it does for the investor is create disruption and dislocations. So, you get stupid policy leading to zero interest rates for multiple years. Betting on rates normalizing upward eventually wins and did win. Betting on equity valuations faltering wins and did win. And so, geopolitical shocks likewise create opportunity. I would say be nimble, look for opportunities, and when you see a shock, ask the question, "Is this still going to matter in five years? Is COVID still going to matter in five years?" No, COVID will still be around; it's endemic, not pandemic. But while COVID's not done with us, we're done with COVID as a driver of policy.”
Jon: “We have a question from Rodolfo here. Would you mind saying your name?”
Rodolfo: “Yes, my name is Rodolfo Milani. Just have a question about energy stocks. There's no question that 12 to 18 months ago, many of these stocks were definitely in the value camp. Now, with many of them having doubled and tripled, I mean, they still may have low P/Es and they still may have decent dividends. I mean, is it Exxon or Chevron still a value stock to you after the kinds of moves that they've had?”
Jon: “So, the question is energy stocks, which not so long ago were thought of as value stocks. With the recent run-up that they've had, should they still be considered value stocks or maybe should they be thought more of as growth stocks?”
Rob: “I view them still in the value camp. Firstly, I'm a believer in global warming and climate change. I'm a believer that it's human-generated. I'm also a believer that it will change the world very gradually, that it will take a long time. I've been asked, "Why did you buy a house on the water in Miami Beach?" And my response is, "I'm eight feet above high-water mark or high tide mark. And with sea levels rising about one inch every five years, as is the current apparent pace, I may have to move in the next 150 years." It's going to take time, and those who want to deal with it with multi-trillion-dollar transfers and with multi-trillion-dollar spending programs, they're overlooking a very important reality. That is, fossil fuels are currently, for now, and for at least two or three generations to come, central to a well-functioning global economy. Eighty-three percent of energy used worldwide is from fossil fuels. The most optimistic projection I've seen is that that drops to 60 percent by mid-century. But the 60 is on a larger global economy. So, the actual extraction of fossil fuels in mid-century would be the same as it is today. At PIMCO's Secular Forum, they had a climate person speak, and it was more moderate than most. But I asked him the question, "If this is the trajectory for fossil fuel consumption without collapsing the global economy, how do you get to zero fossil fuel use by mid-century?" And he didn't have an answer. So, you don't without killing the world economy, killing billions of people, and creating a world war unlike any we've seen in the past. I view this as just and as we have no choice; we're going to continue using fossil fuels for decades to come. In that context, yes, these stocks are still value stocks. No, they don't have stranded assets. The assets will be used. I'm also a big believer in technology. We will find technological solutions to global warming in the coming century. Look at how the world is different today from 100 years ago; it is breathtaking. People 100 years ago could not imagine many elements of our current life—the notion of asking Siri a probing question and having this little handheld thing tell you the answer.”
Jon: “Let alone commercial air travel or air conditioning, too. I think are too.”
Rob: “Yeah, absolutely.”
Jon: “My favorites 100 years ago.”
Rob: “So, at the end of this century, I'm a believer, and this is based on zero knowledge of what technologies will be developed. I'm a believer that technology will answer the climate change problem, but it'll take generations, not decades.”
Jon: “One last question from the gentleman over here.”
Person: “[Inaudible 1:22:32] One thing that the Fed talks a lot about is long-term inflation expectations remaining anchored. At what point do you think inflation expectations become unanchored?”
Jon: “The question is, at what point do you think inflation expectations will become re-anchored or,”
Rob: “Unanchored?”
Jon: “Aren't they kind of unanchored right now?”
Rob: “No, they're very anchored.”
Jon: “Oh, sorry, long term. Okay, sorry.”
Rob: “Yeah, break-even inflation rates are still 2.3%.
Jon: “Yeah sorry, the question is at what point will inflation, well, long-term inflation expectations become unanchored?”
Rob: “I think, with very high odds, can't stay below three and well until this inflation cycle winds down.”
Jon: “Break-even inflation.”
Rob: “Break Even inflation.”
Jon: “The tenure?”
Rob: “That's the tenure.”
Jon: “Okay.”
Rob: “And if I'm right about that, I would say we've got 80-20 odds that a bet that inflation expectations become less anchored. I wouldn't say unanchored, less anchored in the coming year is highly likely.”
Jon: “Right, okay. Well, Rob, thank you so much for joining us. If you could please give Rob a round of applause. [Applause]”
