Arnott: Investment Bargains Require Fear Factor

March 17, 2015

Rob Arnott is widely considered the "father of fundamental indexing." As chairman and CEO of Research Affiliates, he spearheaded efforts to improve on market-cap-weighted indexes through his Fundamental Index series. Beyond indexing, Arnott is a visionary thinker on the intersection of demographics, academic research and hands-on investing. A six-time winner of the Graham and Dodd Scrolls Award, Arnott has published more than 100 papers pushing forward the edges of financial thinking, and co-authored the book, "The Fundamental Index: A Better Way to Invest."

He sat down recently with to discuss why emerging market stocks and bonds are cheap relative to U.S. stocks. He also discusses the distortions caused by quantitative easing, and how eurozone stocks might fare in light of the ECB's new stimulus program. Finally, he defines smart beta and gives his thoughts on interest-rate-hedged ETFs. A famous quote of yours is "what's comfortable is rarely profitable." We all know what's comfortable right now—U.S., Japan and eurozone stocks—but which markets are "uncomfortable" at the moment?
Rob Arnott: I would question whether eurozone stocks are considered comfortable. People are worried about these markets with the negative-interest-rate environment. The Shiller P/E ratio in the eurozone is in the low teens, which is not expensive.

But what markets are uncomfortable? That list is vast. Would people be eager to buy Ukrainian bank stocks? Would people be eager to buy Greek or Cypriot stocks? The list goes on and on.

I look at emerging market stocks and bonds as, in general, cheap—for the very simple reason that people are afraid. You don't get bargains in the absence of fear. Those bargains are widespread in the emerging markets. Fundamental indexing in emerging markets currently carries a price/earnings ratio relative to last year's earnings of nine-times earnings. That's cheap for owning half of the world's GDP.

Does that mean they're going to soar in the coming year? Of course not. There could be further troubles. The question is, will the fear be greater or less a year from now? If the fear dissipates even slightly, those stocks are likely to soar. Same thing applies to the bonds where the spreads are huge. In September, you told us EM debt was more attractive than developed debt. Over the past year, the dollar has surged, especially against emerging market currencies. That FX impact has taken its toll on EM debt total returns. Does EM debt look more or less favorable today?
Arnott: I would say a little bit more attractive, both because the spreads have widened a little bit, and because the currencies have softened. I wouldn't say that EM currencies have weakened relative to the dollar more than developed currencies ex-U.S. The yen and euro have sagged relative to the dollar, if anything, more than emerging market currencies. So it's really a story of dollar strength more than emerging market currency weakness.

Of course, when there's dollar strength, the "now-casters" come out in droves forecasting further dollar strength. Nowcasting is an easy, popular activity, because you can get on the media and you instantly sound very intelligent by forecasting what's already happened. But it doesn't tell you anything.

The simple fact is the dollar is more expensive than it was. Our terms of trade are less compelling than they were. The knock-on effects are that the prospective earnings of our exporters are likely to be whacked. The prospective ripple effects in capital expenditures and across the earnings of other companies in the U.S. economy are likely to be affected.

Reciprocally, big export-oriented economies elsewhere are likely to see earnings surges. Emerging markets, the eurozone, Japan are likely to see positive earnings surprises. How much is the marketplace factoring those positive earnings surprises in to today's prices? Not so sure.

So there are ripple effects, second-order consequences that the market doesn't do a very good job of factoring in. You mentioned the eurozone a few times. In a previous interview, you said that Europe has a lot of potential, and alluded that the ECB needs to step up. It finally began its 1 trillion QE program. Will that do the trick?
Arnott: I don't think I said they needed to step up and do more. I may have said that they're expected to step up and do more. I'm not a fan of QE. The fact that they're stepping in and doing QE is a manipulation of the cost of money, and leads to misallocations of capital in the macroeconomy and distortions. It's ultimately, in the long run, unhealthy, even if, in the short run, it can lead to an appearance of stimulating the macroeconomy.

When you've got negative interest rates, it distorts the economy in so many ways. It's an overt tax on savers, the prudent, on investors. It's a direct transfer from investors and savers to the most profligate governments that are engaged in deficit spending. It's an enabling of bad behavior by central governments. It's an extremely dangerous path, and it's happening all over the developed world.

Is it good for the stock markets around the world? Yes! If you have essentially free money for those who don't need to borrow, then what are they going to do with that money? Are they going to fund long-term, high-risk projects that could be a fuel for long-term macroeconomic growth or are they going to pick low-hanging fruit by doing stock buybacks? They'll do the stock buybacks. Is it going to wind up leading to money being parked in the stock market, rather than funding entrepreneurial capitalism?

So it's good for equity valuations, but it's a distortion. Equities around the developed world are higher than they would be in the absence of QE. That's not healthy.


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