Is It Time for U.S. Investors to Look Abroad?

Jeff Ptak: Hi, I’m Jeff Ptak, chief ratings officer for Morningstar Research Services. I’m pleased to be joined today by Rob Arnott. Rob is founder and chairman of Research Affiliates and is speaking at this year’s Morningstar Investment Conference. Rob, thanks for joining us and welcome.

Rob Arnott: It's a privilege. Thank you.

Ptak: Well, thanks again. I think we should start at a logical place, which is talking about market valuations, in some sense the elephant in the room. Your firm projects there is only a one in 100 chance that U.S. large-cap stocks will generate a 5% real return over the next decade. In fact, I think you're forecasting that U.S. large-cap stocks will lose money over the next 10 years. Maybe we can talk about why you think that is, and for investors in U.S. large-cap stocks, whether there's any place for them to hide at this point.

Arnott: Sure. Absolutely. Well, first, this is drawn from our Asset Allocation Interactive website, which anyone of your attendees and clients who wants to Google Asset Allocation Interactive, it’ll take you straight to the website, where we forecast the returns of 130 different asset classes. Now, the return for U.S. stocks is among the most bleak on a 10-year basis. How did we get to that? There are basically three constituent parts to return in anything you invest in. One is the yield of the investment. Two, the growth in income; for stocks, they tend to grow with the macro economy or at least with inflation. Three, any change in valuation levels that leads to a valuation change, for bonds that would be a yield change, for stocks that would be a change in the P/E ratio, for instance. And those three components are actually very easy to estimate. They’re very useful for predicting 10-year returns. They’re almost useless for predicting one-year returns. So they should be viewed as a basis for gauging long-term returns.

U.S. stocks have a yield of 1.5%. Historically, they produce a growth rate that is about 1.0% to 1.5% above the rate of inflation. Well, that gets you to a 2.5% to 3.0% real return--a far cry from what most investors want to expect from stocks. Then there is the valuation component. We're currently at a price relative to 10-year smoothed earnings, a Shiller P/E ratio of 38. Historic norm is 18. Now we don't assume a mean reversion to 18. We know that maybe it's a new normal, maybe this is the new normal for valuations. Or maybe it does mean a revert, as it has in the past. Let's split the difference. Let's instead of going from 38 to 18, let's go from 38 to 28. Well, that's going to cost you about 5% to 6% per year compounded, bringing your real return slightly negative. OK, well, that's where we come out with an expectation that the real return will be negative, and that the nominal return will be modest.

Ptak: Essentially what the yield and cash flow growth giveth, the multiple taketh away, so to speak.

Arnott: Correct.

Ptak: Given that, what do you think investors who are accustomed to pouring a significant chunk of the equity sleeve of a portfolio into U.S. large-cap stocks? What do you think they should be considering as alternatives?

Arnott: One of the things I love about today's markets is the broad dispersion between markets that are very expensive and markets that aren't. U.S. value stocks are trading roughly in line with historic norms for valuation, meaning that they're at a deep, deep discount relative to the market. In fact, the spread between growth and value is still, even after a rebound for value, wider than it was at the peak of the tech bubble if you use price to book value or price to sales as a measure for value. So, value looks priced to give us about a 4% real return above inflation, still kind of anemic. Emerging markets are priced to give you about 5%, and emerging-markets value--value stocks within emerging markets, avoiding the highfliers in the emerging markets--are priced to give you about a 9.5% real return, well, add in inflation and that's probably a 12% return per annum for 10 years. Now, is that going to happen in the next 12 months? Who knows? But if it doesn't, I would just top up the emerging markets, equity, value, allocation, and perhaps even over-rebalance into a larger allocation. Extraordinary opportunities in that market.

Ptak: So, dispersion value, EM, EM value in particular--tilting toward those areas is one of the ways to offset some of the weakness you expect that we'll see in U.S. large-cap stocks.

Arnott: Correct.

Ptak: I wanted to go back to something else that you mentioned, which is some of the assumptions that you're making about maybe a Shiller P/E or sort of a normalized market multiple, and it sounds like you've made some adjustments upward in what you would have formerly assumed. You're going to be participating in a keynote panel session with Cathie Wood of Ark Invest, as you know she's had a great deal of success investing in hyper-growth names. These are stocks that I think to you and many other value investors would look very, very pricey. But I suppose the counter argument is that the market evolves and adjusts its expectations and its willingness to support a high multiple. And so as a value investor, what are the ways in which you or others need to adjust your assumptions? You mentioned one such adjustment you make and sort of a normalized multiple that you expect over a 10-year horizon. Are there other adjustments that you've had to make as a value investor?

Arnott: Not a lot. Our focus is on buying deep value when value is cheap and having only a modest value tilt when value is fully priced. Now Cathie has had a tremendous run, her performance has been superb. So did some managers in the late 1990s during that tech bubble. And the key question that she and her clients should address is, what's your sell discipline? What would prompt you to sell? We all heard the story about new paradigms back in 1999. The new paradigm was replaced with the old paradigm that you'd better eventually deliver earnings and dividends or else you don't justify those high valuations. Cisco has had 12% per annum growth since 2000, 12% growth in sales and profits, and it's down from the year 2000. It's trading cheaper than it was in the year 2000. So, the market in the year 2000 was expecting growth faster than this for longer than this. Isn't that interesting?

Ptak: My closing question: I wanted to ask you about the traditional 60-40 portfolio U.S. stocks and bonds, 60% of the former 40% of the latter. You have a pretty grim forecast, not unexpected given the fact that we're looking at elevated valuations and paltry yields. That presents a particular quandary to retirees who are basically facing both of those headwinds. If you were their advisor, what would you suggest that they consider apart from some of the other ideas that you offered earlier--value, EM, EM value? What are some other sort of tactics that a retiree should be considering in an environment like the one that we're presented with now?

Arnott: Well, I've been called a permabear. I'm not a bear on things that are cheap. If you wanted to invest in a diversified balanced portfolio, what if you took that 40% in bonds--let's make it even more conservative, let's make it half and put that half of the portfolio evenly into U.S. high-yield bonds and emerging-markets bonds. OK, those are bonds, they have a good yield, they have a much better yield than U.S. Treasuries. The default rates for emerging-markets bonds are lower than for U.S. high yield, and yet the spread is just as large, the incremental yield is just as large. Now, let's take the half that you put in stocks and put half of it into EAFE international stocks, and half of that into emerging-markets stocks, both on the value side. If you go to Asset Allocation Interactive, you can create portfolios and ask the question, what's the likely return on this? And the expected real return on that blend turns out to be 5.5% above the rate of inflation, which is about a 7.5% or 8.0% annual return. That's terrific. What it requires is investors to simply jettison their home-country bias and ask the question, where can I invest that is priced attractively?

Ptak: Rob great insights, as usual. Thank you so much for having this conversation, for participating in this year's Morningstar Investment Conference. It's been fun talking to you.

Arnott: It’s a privilege. Thank you very much.