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.”


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.


Arnott Sees Opportunities in Emerging Markets

Rob Arnott of Research Affiliates and PIMCO says emerging markets continue to offer some of the better investing opportunities.

“Emerging markets, for the most part, don’t have large deficits; for the most part don’t have large debt burdens,” Arnott says in an interview with Index Universe’s Olly Ludwig. “Not because they wouldn’t be willing to have large debts, but because the markets won’t let them. The debt burden of the emerging economies is 10 percent of the world total. For the G5, it’s 70 percent. Both represent 40 percent of world GDP. So one has seven times the debt coverage ratio of the other. Which would you rather own?”

Arnott also defends his belief in fundamental indexing, a process in which holdings within indices are weighted based on macroeconomic factors — not market capitalization. “Viewed from the vantage point of the macroeconomy, the cap-weighted market is making huge active bets,” Arnott says. “During the Internet boom, Cisco was 4 percent of the market, when it was 0.2 percent of the economy, and that’s a huge active bet. And so viewed from that perspective, Fundamental Indexing is studiously seeking to mirror the look and composition of the economy and using it as an anchor to contra-trade against the market’s constantly changing views, expectations, speculations, fads, bubbles and crashes.” Indexing by cap weight, he says, “winds up loading up on growth companies, safe havens, weighting companies in proportion to their popularity”.




Arnott Likes EMs Over U.S. — For Stocks And Gov’t Bonds

Fundamental indexing guru Rob Arnott says U.S. stocks aren’t cheap, and thinks emerging market equities are offering much more value.

“U.S. stocks are actually pretty expensive today, and here’s why,” Arnott recently told Fortune. “Earnings regularly swing above or below trend by a wide margin. Wall Street is brilliant at taking peak earnings and predicting big future growth from those high levels. But history is replete with reversion to the long-term averages. When you have peak earnings, as companies do now, competition mounts and earnings falter. Earnings as a percentage of GDP are the highest since 1929, and wages as a percentage of GDP are the lowest since 1937. Mean reversion takes it the other way, where wages rise and profits fall. Using Robert Shiller’s cyclically adjusted price/earnings ratio, which uses 10-year average earnings rather than peak earnings, today’s P/E ratio is 22 or 23. That’s pretty high.”

Emerging market stocks, however, trade at a 20% to 30% discount to U.S. stocks, Arnott contends. “Everyone sees emerging markets as the growth engine for the world economy,” Arnott notes. “If so, why are they trading at a big discount to the parts of the world that are not the growth engine?”

Arnott also likes broad baskets of emerging market bonds, and higher-yielding U.S. corporate bonds. He thinks a good stock allocation right now is between 20% and 30% of one’s portfolio, with less than half of that in the U.S. And he says the U.S. allocation should focus on the value end of the spectrum.

Arnott on the Courage to Rebalance

While most investors feel crushed when major bear markets hit, Rob Arnott says that they are missing a key point that turns conventional thinking on its head.

In a piece for, Arnott says that most investors measure wealth in terms of their portfolio’s dollar value. But, he says, a better gauge is “the real spending that the portfolio can sustain over the entire life of the obligations served by the portfolio” — what he calls “sustainable spending”.

As an example, Arnott references the tech bubble. “Many people felt jubilation at the peak of the tech bubble, because they felt so wealthy. And they were — as long as they were inclined to liquidate their holdings and spend before the market lost its euphoria,” he writes. “If they were still investing (e.g., for some future retirement), those new purchases bought precious little yield! Reciprocally, people felt panic and dismay at the 2009 trough of the financial crisis, because they felt as if their assets had been wiped out. And they were — if they intended to liquidate and spend their assets immediately. But, for the buy-and-hold investor, their real income was higher than at the 2007 peak!”

Looking at the century’s worst ten bear markets, Arnott notes that real sustainable spending fell only slightly during the bears, “then recovered massively, on average by 35%, off of their lows just five years after the market trough. In almost every case, our real distributions also achieved new highs, relative to our pre-crisis spending, besting the dividends of the previous market peak by an average of 29%! … For those focused on the level of real spending, rather than the level of prices, the worst market downturns in U.S. history were mostly brief bouts of minor disappointment.”

Arnott says it takes a lot of courage to focus on real spending power rather than the dollar value of your portfolio. But exercising that courage can reap big rewards. By periodically moving out of assets that have performed well and into those that have been hit hard, an investor can increase real sustainable spending during downturns, he says, adding that this can be done within asset classes as well. He offers extensive data on how this strategy has worked over the long haul.