Investors may be thrilled that U.S. stocks have rallied, pushing the S&P 500 (.SPX) to a 4.4% total return for the year, including dividends, as of the close on Wednesday. But the good times probably won’t last, according to Rob Arnott, founder of the investment research firm Research Affiliates and co-manager of funds such as Pimco All Asset All Authority (PAUAX).
A value-oriented contrarian, Arnott has long warned that U.S. stocks look pricey. And he’s especially concerned now that a handful of big tech stocks are carrying the market on their shoulders.
“U.S. stocks have gotten frothy and expensive,” Arnott told Barron’s in an interview. “The FAANG stocks, in particular, are priced for perfection. If they don’t reinforce the notion that they’ll be 10 times as large a decade from now, then they’re overpriced and will perform badly.”
The FAANGs refer to Facebook (FB), Amazon.com (AMZN), Apple (AAPL), Netflix (NFLX), and Google’s parent Alphabet (GOOGL). Along with a few other big-tech stocks, including Microsoft (MSFT) and Chinese internet firms Alibaba Group Holding (BABA) and Baidu (BIDU), they have become a huge source of market concentration and power: Their total equity value tops $4.2 trillion, and they have been fueling the market’s gains.
“The seven or eight largest companies on the planet are all tech darlings,” says Arnott. “Is that a diversified roster of top tier companies? Hardly.”
Arnott points out that U.S. stocks trade at 30 times earnings, based on the cyclically adjusted price/earnings ratio (CAPE) from the last 10 years, a valuation measure developed by Nobel-winning economist Robert Shiller. The CAPE ratio only topped 30 once in history, just before the dot-com collapse, he says.
Emerging markets, by contrast, look like a screaming buy. They trade at a CAPE ratio of 13. Investors worry that declining currencies and commodity prices will keep emerging markets depressed, and that the trade war between the U.S. and China will continue to be a drag on growth.
But Arnott views those fears as overblown. “Will the trade war materially change the trajectory of half the world’s gross domestic product over the next 10 years?” he asks. “The answer is no.
You cannot have a bargain in the absence of bad news that could get worse before it gets better. If you can accept that, then you have an opportunity to get some very good deals.”
Granted, investors in Pimco All Asset All Authority (PAUAX) haven’t seen great returns. The fund is down about 7% this year, and its 10-year annualized return of 5% trails 90% of mutual funds in the moderate-target-risk category, according to Morningstar.
Arnott points out that most funds in the category are typically anchored to a 60/40 mix of stocks and bonds. All Authority aims to be different, holding what he calls “third-pillar” assets that can protect investors in a bear market and should do well in an inflationary environment: commodities, Treasury-inflation protected securities, and real-estate investment trusts. He also likes “stealth inflation fighters” such as emerging-market stocks and bonds, and high-yield U.S. junk bonds.
Moreover, the fund is typically short the U.S. stock market, betting it will go down. “We actually have to love U.S. stocks in order to go above 0% in net U.S. stock exposure in All Authority,” he wrote in an email to Barron’s. Not surprisingly, he added, our returns “are in line with our home-base third pillar markets.”
Those markets had an average return of 0.8% over the last five years. “That’s why our return lagged US stock-centric approaches—not because we’ve had an increasingly cautious view on U.S. equities,” he said.
Still, it has been a painful slog for investors who have stuck with the fund while U.S. stocks have climbed, rising at a 14% annualized gain over the last decade, based on returns for the SPDR S&P 500 exchange-traded fund (SPY).
“All Authority’s home base–away from mainstream stocks and bonds–will reliably lead to underperformance in a bull market,” Arnott tells Barron’s. “That’s what diversification does in a bull market.” At the end of what is now the longest bull market in history, he adds, “this is not a time to worry about the drag imposed by diversifying asset classes. “
Indeed, Arnott sees a good chance that markets will start moving in his favor: He pegs the odds of a bear market breaking out in the U.S. in the near term at 40%. Investors might do well in a fund without much correlation to U.S. stocks in that scenario, though as he acknowledges, they may have to wait for their patience to be rewarded.
“Do I have high confidence that the asset classes we focus on will beat U.S. stocks next year? No,” he says. “But I have high confidence they’ll win over a 10-year horizon.”
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