Arnott Talks Indexing, And Why Wall Street Hates Math

In an interview with Bloomberg View’s Barry Ritholtz, Research Affiliates’ Rob Arnott recently talked about the fundamental indexing approach that he pioneered.
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Arnott Sees Value in EMs

Emerging markets have been scaring a lot of investors lately — and that makes them just the sort of play that top strategist Rob Arnott likes. Continue reading

Arnott Still Sees Low Returns Ahead

While stocks have been climbing higher, fundamental indexing guru Rob Arnott of Research Affiliates hasn’t changed his outlook for the coming decade — and it’s not an optimistic one.

In a recent column for MarketWatch, Mark Hulbert looks at a forecasting model Arnott uses that has been highly accurate over the past century-plus. The model forecasts stock market returns by adding together just two factors: dividend yield and real growth in earnings and dividends. “Even if we generously assume that this latter growth rate will be just as high as in the past, despite the anemic economy, we only get a projected nominal return of between 5% and 6% annualized over the next decade [using the model] — about half stocks’ long-term average,” Hulbert writes.

According to the model, for stocks to post “anything close to [their] long-term average return, earnings and dividends will have to grow at more than double their historical average,” Hulbert says.

But Arnott actually thinks growth will be lower in the future than in the past, because of “demographic headwinds.” He thinks that could reduce GDP by 2% annually. Hulbert writes.

Arnott: Time To Take Risk Off Table

Top fund manager Rob Arnott says that it’s becoming “embarrassing” to admit you’re a bear lately, and that means it’s time to be cautious. “If you look at advisor sentiment surveys, you find that right now there are fewer bears than have been seen in these surveys except at extreme major market tops, such as in early 2000,” he tells Yahoo! Finance’s Breakout. “When it gets to be downright embarrassing to be a bear, doesn’t that make for a wonderful time to take some risk off the table?” Arnott says “we’re definitely in a slowdown relative to last year … and quite possibly already in recession.” But, he adds, there’s always something interesting to invest in. Right now, he likes emerging market debt and emerging market stocks.

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Arnott: “3-D Hurricane” Still Bound For U.S.

Though the market and economy have been looking up recently, Rob Arnott says he still expects a “3-D Hurricane” to cause problems in coming years.

The three Ds — debt, deficit, and demographics — should cause investors to lower their expectations, Arnott said during the keynote session of the ETF Virtual Summit, Advisor One reports. “We’re experiencing the early gusts of this 3-D hurricane,” he said. “Japan is getting it now, and Europe is closer than we are. Forward-looking, bonds and stocks will yield 2%. GDP growth will be closer to 1%. None of this is dangerous; it’s still growth. What is dangerous is an expectation of having more, and receiving less.”

Arnott said that in 2011, U.S. debt reached 100% of gross domestic product. But when Social Security, Medicare, and Medicaid liabilities are included, the figure is actually more like 600%. “If you owe six times your personal income, logic dictates that it is not sustainable,” he said.

Arnott also said that inflation is more of a problem than policymakers are letting on. If inflation were calculated the way it was back in 1980, he says it would be about 10% right now. “Who really believes their personal inflation rate was under 2% last year? They’re masking the real problem, and it gives a false sense of security,” he said.

Investors, Arnott says, should realize “what must happen will happen, and what cannot happen will not happen. You should evaluate how you get from point A to point B in that frame of mind, meaning taking the path of least resistance.”

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Where Arnott Sees Value

Rob Arnott of Research Affiliates and PIMCO is finding value in emerging market stocks and high-yield bonds.

Arnott tells Brett Arends of The Wall Street Journal that emerging-market stocks have lagged those in the U.S. over the past five years, and are now considerably more attractive than U.S. stocks. And, while high-yield bond yields have fallen to record lows recently, they are still attractive, Arnott says. On average, high-yield bonds yield about 5.3 percentage points more than comparable Treasury bonds, Arends reports, which is in line with the median difference since 1996 of 5.5 points.

Arends looks at a variety of interesting valuations metrics in the article, including Tobin’s Q, which currently indicates the market is 50% overvalued.

Top Forecasting Model Offers Bad News

Wondering how the stock market will do over the next 10 years? MarketWatch’s Mark Hulbert says one pretty reliable forecasting model has a disappointing answer.

Hulbert says that the model — a variant of the “dividend yield model” — is indicating stocks will return just 5.6% annualized over the next decade, and that’s before inflation. “The model, at least the variant I will focus on for this column, is breathtakingly simple,” he says. “It says that the market’s long-term return will be a function of just two things: the current dividend yield and real growth in earnings and dividends.”

Over the past century, real growth in earnings and dividends has averaged about 1.4%, Hulbert says. When you add in dividend yield and expected inflation, you get the 5.6% nominal return, he says, citing data from Research Affiliates’ Rob Arnott. After inflation, that makes for a projected return of just 3.4% annualized.

Hulbert says that while this forecasting model hasn’t been perfect, its track record is “overwhelmingly” statistically significant. He also looks at the issue of profit margins, and why they may be set to shrink, making that 5.6% figure optimistic.