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By Russel Kinnel | 01-25-2011 04:39 PM

Arnott: Market Hyped Up on Stimulus

Research Affiliate's Rob Arnott sees much more downside than upside in the market today.

Russel Kinnel: Good afternoon, I am Russel Kinnel, Director of Fund Research for Morningstar and I am joined today by Rob Arnott, who is the originator of the fundamental indexing concept and Manager of PIMCO All Asset and PIMCO All Asset/All Authority. Thanks for joining us Rob.

Rob Arnott: It's a pleasure.

Kinnel: So, it's the beginning of the year, people are always eager to talk asset allocation. So we'd love to hear what's your take, because your funds have tremendous latitude as part of the newer fund allocation style that has a much bigger tool box. So, what areas are looking attractive to you today?

Arnott: Well, Warren Buffett early in his career told his friends that the way to succeed in investing is to be greedy when others are terrified and terrified when others are greedy. Now, when was the last time people where really terrified? Two years ago. When was the best time for a 'risk on' trade? Two years ago, before the catch phrase 'risk on' became part of the public jargon.

Now you have a market that's being propped up by stimulus. I liken it to a kid with ADHD presented with a massive bowl of M&M's. The kid wolfs down the M&M's, gets a sugar rush. If the M&M's ever run out, they get a sugar crash. And we have a market that's being propped up by what might be called the Bubble Instigator In Chief, Ben Bernanke.

So what we have is a sentiment at work in the marketplace in which most investors today are much more worried about missing the last of the bull market than about downside risk. Times like that I think investors fall prey to the temptation to chase down nickels in front of a steam roller. So this is a time not to have risk on in my view. There is much more downside risk than upside opportunity from current levels. So our investment posture and my worldview is a very cautious one at the moment.

Kinnel: So, I am gathering, U.S. stocks and U.S. bonds, are you wary of both right now?

Arnott: A little wary of both, more on the stock side than the bond side. The economy is like the emperor with no clothes. It's an economic recovery relatively anemic that's built on a foundation of stimulus, and stimulus dwarfs the size of the recovery. If you add up fiscal stimulus, bailouts, quantitative easing and QE2, the aggregate size of the fiscal and monetary stimulus is on the order of $4 trillion. And the aggregate size of the run up in the national debt in the last 2.5 years is same ball park. And $4 trillion of stimulus has brought us $0.5 trillion of increased economic scale, increased GDP.

That's not a very attractive trade-off. That's a pretty bad investment if it's borrowed money that funds it. So I think stocks today are priced to reflect, one, a consensus that the economic recovery is gaining organic traction in the private sector -- that what Keynes called the animal spirits of the private sector are being reignited; two, that that economic recovery is going to gain traction and is going to accelerate; three, that there is no end in sight to quantitative easing, of which I am skeptical that QE2 can be followed by anything. So the market is pricing in expectations of not just a neutral outlook but a very robust outlook where the downside is much greater than the upside.

You can bifurcate bonds into treasury bonds and everything else. I think treasury bonds ultimately reflect inflation expectations on the long end, and those inflation expectations have been ratcheting up. So, long-term, I'd be cautious on long treasuries, a little less cautious on credit. We are getting some credit spreads that are not bad. So I think that the opportunity set out there is not bad.

The places that I love are things like PIMCO has an unconstrained bond fund that's the only one that I know that can go net short duration on a tactical basis -- that's very cool if you are worried about inflation kicking up the interest rates at the long end. And fundamental long/short -- long the fundamental index, short the cap-weighted index. If you have a defensive view on the market, what could be more interesting than something that loads up on out-of-favor value stocks -- where you could reasonably expect a good risk premium because they are seen as risky -- and shorts the most popular trendy beloved growth stocks, where why on earth should you get a risk premium for investing in something that everyone thinks is a safe heaven? So, those long/short strategies, and there is a couple of them available in the marketplace, I think are awfully interesting at a time when we want layers of alpha and don't want beta.

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