Con­suelo Mack Wealth­Track — Octo­ber 14, 2011

CONSUELO MACK: This week on Wealth­Track, Finan­cial Thought Leader Robert Arnott pre­dicted hur­ri­cane force winds of deficits, debt, and demo­graph­ics would hit the economies of Europe and the U.S. Now that they’ve arrived, what can investors do to pro­tect them­selves? Research Affil­i­ates Great Investor Rob Arnott is next on Con­suelo Mack WealthTrack.

Hello and wel­come to this edi­tion of Wealth­Track. I’m Con­suelo Mack. Things are not what they seem. They are worse! That is the view of this week’s Great Investor guest. For more than two years now, Research Affil­i­ates’ Robert Arnott has been sound­ing the alarm bells about what he calls the “3-D hurricanes-” deficits, debt and demo­graph­ics– major head­winds fac­ing Amer­ica and the rest of the devel­oped world. He says the storms have arrived.

Arnott, a summa cum laude grad­u­ate in eco­nom­ics, applied math­e­mat­ics and com­puter sci­ences from the Uni­ver­sity of Cal­i­for­nia, Santa Bar­bara, is one of those rare indi­vid­u­als who can reduce com­plex finan­cial the­o­ries and analy­sis to under­stand­able and prac­ti­cal invest­ment advice. For instance, he recently wrote an essay called “Sim­ple Tru­isms” to guide long term investors. We will have a link on our web­site for you. In it, he out­lined six eco­nomic truths to invest by. Here are two of them:

“Tru­ism: GDP growth is pro­duced mostly by young adults in their 20s and 30s.” Arnott says think emerg­ing mar­kets; whereas an aging pop­u­la­tion means slower growth, think the U.S. and Europe.

“Tru­ism: earn­ings and div­i­dends can­not be expected to grow faster than GDP indef­i­nitely…” again think of the slow­ing economies of the devel­oped world. Arnott’s point: can prof­its be far behind?

We are delighted that Arnott’s firm Research Affil­i­ates is a spon­sor of Wealth­Track, but Rob is here on his own mer­its as a finan­cial inno­va­tor and thought leader. Rob has pio­neered sev­eral port­fo­lio strate­gies that have gone main­stream includ­ing tac­ti­cal asset allo­ca­tion. He cre­ated one of the first global asset allo­ca­tion funds using alter­na­tive mar­kets with PIMCO. He runs their All Asset and All Asset All Author­ity funds. At his firm Research Affil­i­ates, he cre­ated fun­da­men­tal index­ing, replac­ing the tra­di­tional mar­ket cap weight­ings of stocks in indexes with their eco­nomic weight­ing mea­sured by fun­da­men­tals such as sales, div­i­dends, and cash flow. Over­all, across mul­ti­ple asset classes his RAFI Fun­da­men­tal Indexes have out­per­formed mar­ket cap ones by sub­stan­tial mar­gins over the last five years.

I began the inter­view by ask­ing Arnott about his warn­ing on Wealth­Track over a year ago, about a pos­si­ble dou­ble dip in the U.S. economy.

ROB ARNOTT: I think we’re prob­a­bly already in it. I think the econ­omy prob­a­bly crested in June. The prob­lem is really sim­ple. We have a lot of GDP that’s phony GDP.

CONSUELO MACK: So explain what’s phony about our GDP.

ROB ARNOTT: GDP con­sists of con­sumer spend­ing, gov­ern­ment spend­ing, cap­i­tal spend­ing, and net exports. It’s mea­sur­ing spend­ing not pros­per­ity. So it’s mea­sur­ing some­thing that is not as impor­tant as aggre­gate pros­per­ity. Now, take a fam­ily. Sup­pose a fam­ily mea­sures their GFP, Gross Fam­ily Prod­uct, and they mea­sure it based on mea­sur­ing their spend­ing. They make 50 grand. They go out and buy a flash car and bor­row 100 grand to do it.

CONSUELO MACK: Those were the old days, right?

ROB ARNOTT: Yeah. But they feel much wealth­ier. They aren’t. They have a flash car. They have a ton of new debt. They have debt ser­vice to face and if two years later they have to sell the car, then they don’t have the car, they still have the debt to ser­vice. A nation is very much like a large fam­ily and what we have is a coun­try where our deficit is 10% of GDP. That means 10% of our GDP is debt finance con­sump­tion; it’s not prosperity.

CONSUELO MACK: So there­fore, what do you think is the real GDP? And I don’t mean sub­tract­ing infla­tion. So what do you think the econ­omy, the pace that the econ­omy is run­ning if you took away, as you said, the debt type finance spend­ing that we’re see­ing both in the gov­ern­ment and in the con­sumer level?

ROB ARNOTT: Right. Much less so in the con­sumer level. Con­sumers have been delever­ag­ing. But if 10% of our GDP is debt financed con­sump­tion, you can sub­tract that and that gives you the under­ly­ing struc­tural GDP. Struc­tural GDP is down 11%, maybe 12 from where it was in 2007 per capita and net of infla­tion and it’s bot­tom bounc­ing. It’s barely above where it was at the trough in 2009. You can also sub­tract all gov­ern­ment spend­ing and that shows you the pri­vate sec­tor GDP. Pri­vate sec­tor GDP is also down 11 to 12% from ’07 and it’s also bot­tom bounc­ing near 2009 levels.

CONSUELO MACK: I want to talk about the U.S. stock mar­ket because so many Amer­i­cans are invested in their home mar­ket as is the case all around the world. At one point you’ve said, “Don’t buy U.S. stocks because they’re priced as if we will get through this mess unscathed.” So are you still say­ing, don’t buy U.S. stocks?

ROB ARNOTT: I’m soft­en­ing that a bit. The mar­ket has, in fact, tanked to some extent. The mar­ket is reflect­ing some fears that maybe, maybe some of these chal­lenges are real. And so am I still cau­tious on equi­ties? Yes.

CONSUELO MACK: And it’s specif­i­cally U.S. equities?

ROB ARNOTT: Specif­i­cally U.S. equi­ties. Am I cau­tious on all U.S. equi­ties? Not so much. The value side of the mar­ket has been sav­aged again and is cheap again. The growth side of the mar­ket remains very expen­sive. I was asked recently what my favorite long/short bet would be, and being some­body who doesn’t mind being a lit­tle proac­tive, I said, “Short Apple, buy B of A.”

CONSUELO MACK: That is provoca­tive. And seriously?

ROB ARNOTT: Oh, absolutely.

CONSUELO MACK: Not in jest? This is a seri­ous recommendation?

ROB ARNOTT: No, absolutely. Is B of A a beau­ti­fully run com­pany hum­ming on from height to new height? No. Is Apple a shabby com­pany about to fall off a cliff? No, but Apple is cur­rently priced at the num­ber one mar­ket cap­i­tal­iza­tion on the planet.

CONSUELO MACK: Right. Big­ger than Exxon Mobile.

ROB ARNOTT: So the mar­ket is basi­cally say­ing this com­pany will pro­duce the biggest profit dis­tri­b­u­tions to its share­hold­ers in the decades ahead of any com­pany on the planet. Could that hap­pen? Yes. Is it likely? I don’t think so.

CONSUELO MACK: “Always some­thing to invest in.” That’s what you’ve said many times on Wealth­Track and else­where. So when you are look­ing for some­thing to invest in what are your expec­ta­tions? What do you look for, espe­cially in this new nor­mal environment?

ROB ARNOTT: Sure. What I look for would be yields above his­toric norms for an asset class.

CONSUELO MACK: For an asset class. So for instance, for stocks that would be?

ROB ARNOTT: If yields are above three, they get to be a lot more inter­est­ing than when yields are two. I like to look for invest­ments where the head­winds aren’t going to be dras­tic. What about emerg­ing economies? Most of them don’t have a prob­lem with a deficit. If they have a deficit, it’s mod­est. Most of them don’t have lofty debt bur­dens, there are excep­tions, but most don’t. Most of them don’t have a demo­graphic head­wind. Quite the con­trary. Sweet spot for GDP growth is young adults age 20 to 40. Is that because folks who are past 40, not you, but me. Peo­ple above 40, are we not con­tribut­ing to GDP? That’s not it. It’s that our con­tri­bu­tion to GDP isn’t grow­ing as fast as it used to. So if you go from teens to twen­ties, you’re look­ing at being a con­sumer of GDP to a con­trib­u­tor. A huge jump. Twen­ties to thir­ties. A huge jump. Thir­ties to for­ties, a smaller jump. For­ties to fifties, smaller jump or for many peo­ple a slight down tip. Fifties to six­ties, usu­ally a down tip. So the con­tri­bu­tion to GDP growth is in the young adults.
What’s hap­pen­ing to our young adult pop­u­la­tion? It’s shrink­ing as a share of the pop­u­la­tion. What’s hap­pen­ing in the emerg­ing economies? It’s soar­ing. You have a lot of emerg­ing economies where birthrates used to be huge, median age was 18. Half the pop­u­la­tion, teens are younger and a mod­est cadre of young adults and a tiny cadre of old adults. Now with falling birthrates, you have a flood of peo­ple com­ing into that young adult sweet spot. So the emerg­ing economies of the world seem to me to be poised to truly emerge in a very sig­nif­i­cant way in the years ahead.

CONSUELO MACK: And so for a long term investor that demo­graphic trend is some­thing that you think is very impor­tant, because that’s going to be a big deter­miner of GDP growth. What about Africa? I mean, so Africa has a really young pop­u­la­tion. So is that not there yet?

ROB ARNOTT: That’s not help­ful. That’s not help­ful. You need the 20 to 40 crowd.

CONSUELO MACK: The twen­ties. So that’s going to hap­pen in another ten years maybe in Africa?

ROB ARNOTT: Yeah, it’s early for Africa. It’s prime­time for most of the emerg­ing economies of the world. So emerg­ing mar­ket stocks aren’t cheap, but they have to be part of somebody’s toolkit if they want to think seri­ously about invest­ing in the com­ing decades, if we are in a bear mar­ket for stocks.

CONSUELO MACK: And you think we are in a bear mar­ket for stocks?

ROB ARNOTT: I think we prob­a­bly are in a U.S. and Euro­pean bear mar­ket. Well, Europe, obvi­ously, but I think we are in a bear mar­ket for stocks. I think the next leg is more likely down than up. That will cre­ate some pock­ets of bar­gains in the U.S., but it will also pull down emerg­ing mar­ket stocks, cre­at­ing some real bar­gains. Well, that’s inter­est­ing. Emerg­ing mar­kets bonds. The G5 is 40% of world GDP. Emerg­ing mar­kets are 40% of world GDP. The G5 has 70% of world debt. Emerg­ing economies have 10% of world debt. So the emerg­ing economies have seven times the debt cov­er­age ratio of the G5 and yet rel­a­tive yields, the emerg­ing economies have 3.5% higher yield. Why on earth is that? It’s because investors think back to times when the emerg­ing mar­kets debt was big rel­a­tive to the G5 and the defaults that ensued and they think, oh, I don’t want to be part of that. But who is to say that the G5 is immune from defaults?

CONSUELO MACK: Now we know.

ROB ARNOTT: Either explicit defaults or back­door defaults through debas­ing the cur­rency through reignit­ing the infla­tion engine. So when I look at that I think, okay, lower debt bur­den, bet­ter debt cov­er­age ratio, higher yield. That’s a more inter­est­ing mar­ket. And if in the com­ing decade the spread dis­ap­pears, you’re going to have a pre­mium yield and cap­i­tal gains on top of that. Well, that’s inter­est­ing. So I look around the world and I see pock­ets that are mildly to mod­er­ately inter­est­ing. Com­modi­ties have come off quite a bit. They’re now get­ting kind of inter­est­ing. I don’t mean gold.

CONSUELO MACK: And we’ll talk about gold. We always talk about “we”, when I say on Wealth­Track, because gold is almost in a sep­a­rate class of its own.

ROB ARNOTT: Right, right.

CONSUELO MACK: And your view of gold is?

ROB ARNOTT: Gold has three con­stituen­cies. There are those who like gold as an infla­tion hedge. There are those who like it as a hedge against geopo­lit­i­cal shocks. There are those who like it as a hedge against gov­ern­ment expro­pri­a­tion of wealth. So all three con­stituen­cies are ner­vous. So all three con­stituen­cies are over­pay­ing for their pro­tec­tion. Now, I’m not opposed to those who want to own gold. If it helps you sleep bet­ter at night great, go for it. If it’s prof­itable that will be in a con­text of the rest of your port­fo­lio not doing so well. So this is an invest­ment where you buy it, A, to sleep bet­ter at night, and, B, hop­ing that it’s unprofitable.

CONSUELO MACK: This is your good friend, Peter Bern­stein, of course, called gold an insur­ance pol­icy against extreme out­comes which is one of the three categories.

ROB ARNOTT: Which is exactly right.

CONSUELO MACK: That you men­tioned. And when you think of the last 11 years, the bull mar­ket in gold, it cer­tainly has been a ter­rific investment.

ROB ARNOTT: It’s been awesome.

CONSUELO MACK: Con­sid­er­ing that other assets that we mostly invest in, at least stocks, have not done well at all.

ROB ARNOTT: Or as the gold bugs are fond of point­ing out, the rec­i­p­ro­cal of that is gold has held its value. The dol­lar, the stock mar­ket, the bond mar­ket has not. Fiat cur­ren­cies, cur­ren­cies that are not backed by any­thing tan­gi­ble, that are just pieces of paper that are backed by trust. Trust that they have value.

CONSUELO MACK: Just about all paper cur­ren­cies right now.

ROB ARNOTT: Right. Fiat cur­ren­cies have never, ever suc­ceeded on a long-term basis. Now, we’ve had a great run. We’ve had a con­trac­tual fiat cur­rency since the gold win­dow was closed in ’71. We’ve had a de facto fiat cur­rency since gold own­er­ship was denied in 1933 by FDR. So we’ve had 40 years or 80 years depend­ing on how you count it. But the gold bugs will point out that the dollar’s pur­chas­ing power mea­sured in ounces of gold has gone down 98% since ’71, 99% since ’33. So we’ve lost all but one to two per­cent of the pur­chas­ing power of the dol­lar dur­ing this fiat cur­rency era.

CONSUELO MACK: That’s a pretty com­pelling argu­ment for gold.

ROB ARNOTT: That’s sober­ing.

CONSUELO MACK: It is.

ROB ARNOTT: Now of course, gold is very near all time peaks and has out­per­formed most com­modi­ties. So to my way of think­ing, an investor think­ing about infla­tion pro­tec­tion would be bet­ter served by a bas­ket of currencies.

CONSUELO MACK: A bas­ket of currencies?

ROB ARNOTT: Excuse me, commodities.

CONSUELO MACK: Com­modi­ties.

ROB ARNOTT: Bas­ket of com­modi­ties. And there are a lot of funds that do track com­mod­ity indexes. And that’s one way to deal with that par­tic­u­lar risk.

CONSUELO MACK: Look­ing around the world specif­i­cally as far as if you’re look­ing at coun­tries, for instance. And if you want to be in a cur­rency that you think is going to hold up, I mean, are there any coun­tries that you think are par­tic­u­larly appeal­ing at this point for you as a global investor?

ROB ARNOTT: I think the emerg­ing economies are likely to do very well.

CONSUELO MACK: As a class?

ROB ARNOTT: Right. And I pre­fer not to drill down to indi­vid­ual countries.

CONSUELO MACK: Right.

ROB ARNOTT: Because I want the diver­si­fi­ca­tion of a bas­ket. And so when I look around the world, my incli­na­tion is to say I want to invest in assets that can shrug off the impact of infla­tion. There are a lot of those. It’s not just the TIPS and the com­modi­ties, but they’re cer­tainly part of the toolkit. There are emerg­ing mar­ket stocks and bonds. There are high yield.

CONSUELO MACK: So high yield dol­lar denom­i­nated bonds?

ROB ARNOTT: Sur­pris­ingly, yes.

CONSUELO MACK: Really? Alright.

ROB ARNOTT: Yeah. High yield bonds are a stealth infla­tion hedge.

CONSUELO MACK: Explain.

ROB ARNOTT: The way it works is very sim­ple. If you get infla­tion, the debt cov­er­age ratios improve because the real value of the debt is falling. So if the busi­ness is grow­ing with infla­tion and the real value of the debt is falling, debt cov­er­age ratios improve, which means that the spreads can col­lapse, which means that you have a rich start­ing yield and cap­i­tal gains. For that rea­son, if you go back his­tor­i­cally and mea­sure the cor­re­la­tion of high yield bonds with infla­tion, you find that the cor­re­la­tion is higher than the cor­re­la­tion with TIPS.

CONSUELO MACK: Oh, fas­ci­nat­ing.

ROB ARNOTT: So it’s a stealth infla­tion hedge. In the even of mod­er­ate infla­tion, five to ten per­cent infla­tion, it can work beau­ti­fully. In the event of hyper­in­fla­tion it doesn’t, of course.

CONSUELO MACK: And talk to us about TIPS. It’s been One Invest­ment rec­om­men­da­tion of yours in the past. You are being dubbed an infla­tion hawk and is that a fair—

ROB ARNOTT: That’s a fair statement.

CONSUELO MACK: Char­ac­ter­i­za­tion? Alright. So TIPS?

ROB ARNOTT: TIPS. Expen­sive, low­est yields that they’ve ever had. You get a neg­a­tive yield out to ten years. You get a one per­cent yield if you go all the way out to 30 years. That’s not very impres­sive. But it’s an insur­ance pol­icy against renewed infla­tion and in that con­text it’s not dif­fi­cult to imag­ine sce­nar­ios in which it could actu­ally go to lower yields. Let’s sup­pose we have ten per­cent infla­tion three years hence. If that hap­pens what is the T bond yield going to be? It won’t be ten, but it’s going to be a lot higher than 3.25. What’s the TIPS yield going to be if the trea­sury yield is eight or nine and infla­tion is ten? It could be minus one, minus two at the long end. So I’m not sug­gest­ing that as a likely sce­nario. I am sug­gest­ing that if we get renewed infla­tion that’s sig­nif­i­cant, dou­ble digit, then the TIPS will be a go-to asset and the buy­ers won’t care if the TIPS carry a two han­dle for their yield or a one han­dle or a zero han­dle. They’re going to want it because of the con­trac­tual link with CPI.

CONSUELO MACK: Right. But your infla­tion expec­ta­tions are not dou­ble digit?

ROB ARNOTT: Actu­ally, I would give us 50–50 odds or a bit bet­ter than 50–50 odds that we’ll see dou­ble digit some­time in the next ten years. I think the temp­ta­tion to debase the cur­rency and reduce the real value of the debt will be polit­i­cally overwhelming.

CONSUELO MACK: Rob, One Invest­ment for a long term diver­si­fied port­fo­lio. What is your choice today?

ROB ARNOTT: My choice today would be fun­da­men­tal index for emerg­ing mar­kets stocks, if you’re a buy and hold investor plan­ning to hold it at least five years; if you’re a shorter term investor, look for buy­ing oppor­tu­ni­ties and aver­age in over the next two or three years. The rea­son I say that is that fun­da­men­tal index has a value tilt. It pushes you more heav­ily into the out of favor deep value com­pa­nies. With emerg­ing mar­kets what we find is that emerg­ing mar­ket stocks, cap weighted, have pro­duced slightly bet­ter returns over the last 15 years than the devel­oped economies. Okay. You could have had a higher return with emerg­ing mar­kets cash.

CONSUELO MACK: Cash being?

ROB ARNOTT: Emerg­ing mar­kets short matu­rity gov­ern­ment debt.

CONSUELO MACK: Really?

ROB ARNOTT: And so emerg­ing mar­kets cash invest­ments for the last 15 years had a higher return than emerg­ing mar­ket stocks. Well, what’s going on there? It’s that cap weight­ing pulls the return down by con­cen­trat­ing you in the two or three com­pa­nies in each coun­try that are most well polit­i­cally con­nected, most beloved, most well known glob­ally, and most extrav­a­gantly expensive.

CONSUELO MACK: And the biggest mar­ket cap.

ROB ARNOTT: The fun­da­men­tal index weights you into com­pa­nies accord­ing to the size of the busi­ness and so it takes out of favor value com­pa­nies and weights them with a nice, solid weight. If they’re out of favor and come back into favor they do awfully well. So I look on deep value emerg­ing mar­kets as the best oppor­tu­nity for a long term investor, but I do view it as an aver­ag­ing in oppor­tu­nity from today.

CONSUELO MACK: So you per­son­ally, are you invest­ing in stocks right now?

ROB ARNOTT: Indi­rectly in mod­est ways. I have 100% of my per­sonal pen­sion in PIMCO’s All Asset All Author­ity Fund. So when that fund is investing–

CONSUELO MACK: Your fund.

ROB ARNOTT: Yeah.

CONSUELO MACK: Right.

ROB ARNOTT: When that fund is invest­ing in emerg­ing mar­kets stocks, I’m invest­ing in emerg­ing mar­ket stocks. And broadly today, we’re look­ing at a toolkit where most things are expen­sive. Yields are too low across the board on a whole sweep of asset classes so it’s a great time to hun­ker down and have a defen­sive pos­ture, have broad diver­si­fi­ca­tion to tamp down our risk, use that broader toolkit to pick out indi­vid­ual cat­e­gories that might be priced off for supe­rior returns, and to play the game that Buf­fett described in his twen­ties. He said, “The way to suc­ceed in invest­ing is pretty sim­ple. Be greedy when oth­ers are ter­ri­fied, be ter­ri­fied when oth­ers are greedy.” When were peo­ple last ter­ri­fied? Two and a half years ago. Where are they now? They’re edgy.

CONSUELO MACK: They’re get­ting there.

ROB ARNOTT: They’re ner­vous. They’re not ter­ri­fied. Where were they six months ago? Don’t want to miss that last leg of the bull mar­ket. And so that’s a per­fect envi­ron­ment for tak­ing risk off the table. Two and a half years ago was a won­der­ful envi­ron­ment for ramp­ing up risk aggres­sively. Today we’re in between those two, closer to the peak than the trough. So I look on today’s mar­kets as a great time to start tak­ing a lit­tle bit of risk here and there, but mostly remain very defensive.

CONSUELO MACK: Rob Arnott, Research Affil­i­ates, finan­cial thought leader. It is always such a treat to have you on Wealth­Track. Thank you so much for doing this.

ROB ARNOTT: Thank you very, very much.

CONSUELO MACK: At the con­clu­sion of every Wealth­Track, we give you one sug­ges­tion to help you build and pro­tect your wealth over the long term. This week’s Action Point: Con­sider the PIMCO All Asset All Author­ity Fund, run by this week’s guest, Rob Arnott. As Morn­ingstar puts it the “PIMCO All Asset All Author­ity Fund eats mar­ket declines for break­fast.” By invest­ing in a num­ber of PIMCO funds, across mul­ti­ple asset classes in all parts of the world, plus hav­ing the abil­ity to go short, Arnott has man­aged to beat the mar­kets and pro­tect share­hold­ers against mar­ket declines since the fund’s incep­tion in late 2003. Two other pluses– it’s nearly 7% yield and Arnott has invested 100% of his pen­sion money in the fund. That’s a reas­sur­ing com­mit­ment.
Next week on Wealth­Track, we are going to have a rare dou­ble inter­view with bond pow­er­house PIMCO’s two invest­ment gurus, Bill Gross and Mohamed El-Erian, together from PIMCO head­quar­ters in New­port Beach, Cal­i­for­nia. For those of you who want to see our Wealth­Track inter­views ahead of the pack, includ­ing an extended inter­view with Bill and Mohamed next week, we have a new oppor­tu­nity for you. Sub­scribers can now see our pro­gram 48 hours in advance on our web­site along with timely inter­views exclu­sive to Wealth­Track web sub­scribers. To sign up– go to our web­site, wealthtrack.com. Thanks for watch­ing and make the week ahead a prof­itable and a pro­duc­tive one.

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