Rob Arnott on Bubbles

I am the boss here. You know that that's a big compliment in Jersey here, so I hope you like that one down in North Carolina. I don't know if they take Tony Soprano as as big as a compliment as with you in Jersey, but I'm gonna take it and run with it. Alright. Good a big week on the show. So the breakneck rally in the stock market, even amid the economic uncertainty surrounding the coronavirus, has many

market observers wondering if a bubble is forming. Our guest is the absolute perfect person to discuss this, and for years has analyzed the nature of bubbles across financial markets, and as always, will close out the episode with our tradition the craziest thing I saw in markets this week, And remember, if you saw anything crazy, give us a call on the Bloomberg Podcast hotline at six four six three to four three four nine zero, or tweet to us at Podcasts and maybe we'll read your tweet or

play your voicemail on the show. And Sarah, as you said, very very excited to welcome back this week's guest. But before I introduce him, I do want to point out one thing to listeners. You know how the big thing on Wall Street now, the big trend is to look at all the alternative data, the Apple Maps mobility data open table, that sort of thing. I want to warn people. I think there's a problem with the Apple mobility data and sorry, you know what that is. I'm waiting for

this explanation. Let's hear it. The upticking that data is all because of Sarah. I think, truly I did. I'd use Apple Maps a very fair amount over the past week or so planning out how I was going to get up here. Um I will say, though, service is very rocky, so the Apple Mobility data probably hasn't been able to send through a decent amounts of time. I'm hiding out. It's pretty cool hiding out Florida. Now I'm hiding out in the woods. You look like you're in

a giant sauna right now. We're we're you can't see this at home, but we're all on a zoom calls. How we do our podcasts in the age of COVID and Sarah. Sarah fled New York because the virus got really bad to her family home in Florida. It got bad in Florida. Now she's fled to North Carolina. So if you're listening from North Carolina, I mean, I'm no doctor, but I'm gonna say, maybe shelter in place because this

virus is following side. I've really timed COVID nineteen very well with my travels across the country, and I have been driving everywhere too and keeping to myself. Um, but yes, fingers crossed, that doesn't happen obviously, I would hate for that to happen in North Carolina. There's an alternative explanation. Maybe she's bringing it wherever she had never had it. I promise I've been tested nothing this this is one more reason why I'm glad we're doing this, uh these

podcasts remotely these days. But that other voice you here, that's our guest this week. Very very excited to have him back on the show. His name is Rob or Not. He's the co founder of Research Affiliates. Rob, welcome back to the show. Thank you so much. It's a pleasure. And Rob, where are you? You're in California? I presume right. I live mostly in Miami Beach, but I flee Miami Beach during the summer months and returned to Newport Beach,

where I used to live. So I'm I'm hunkered down here at home until end of September, roughly Florida, California. Rob can't escape it either. Yeah, well, Rob, as Sarah pointed out in the in the introduction, You've thought a lot of really fascinating research over the years on bubbles, and boy, I think that one of the craziest things I've seen this year is this notion of the valuation expansion that we've seen in a market that already seemed

very frothy before the recession hit. You know, of course, we had the the big correction, the bear market that was very quickly almost completely reversed. How shocking is it to you to see this valuation expansion we're seeing right now, and you know, based on on your studies of past bubbles, is there any way to sort of expect how far it goes or or when the sort of the music stops playing and we all have to come back to earth sort of mean reverting valuations, if ever, I'll take

the last part of your question. First. Short answer is no, there's no way of knowing when it's when the bubbles going to peter her out. We just know that it will. Um. We also know that people buying bubble assets will make money until they don't. And if they're buying on the presumption that hey, it's soaring, I want to get on

this and uh right at the next leg up. Um, if they don't have a cell discipline, if they don't have a view of what will it take for me to say, okay, enough already, I'm going to get out, Um, then they are doomed to ride the roller coaster over the top and down. And uh so, without a cell discipline, buying bubble assets is insanely stupid. Bubbles. Jeremy Grantham went on record saying this is the third bubble of his lifetime. I view bubbles on a more uh scaled approach. There's

always bubbles. There's a little micro bubbles at work in the market all the time, bits of irrationality all the time. What we think of as a bubble is really when a market as a whole goes to irrational levels, or when a segment of the market as a whole goes to irrational levels. One of the things that I've done that I think is relatively important is to come up with a workable definition of the term bubble. People bandy around the term, and all it means is, well, it's frothy. Okay,

froth is a characteristic of bubbles and vice versa. But that doesn't define it in a way you can use it in real time. Uh. My definition that you can use in real time is if you wanted to value an asset using discounted cash flow or some other accepted valuation method, you would have to use implausible assumptions to justify the current multiple second part of the definition, and no less important. The marginal buyer, the person who's buying

it today's prices, doesn't care about valuation models. At all. If those two definitions are in place, you've got a bubble and you can identify it when it's happening. Now, the right answer is not to short short all of the bubble assets, because bubbles can continue farther than you can imagine. The The old adage the market can be irrational longer than you can remain solvent is absolutely true,

and there's there's myriad examples of that. I love the title of one of the papers that Research Affiliates put out back in April, and it's yes, it's a bubble, so what And you mentioned micro bubbles and at the time, one of those micro bubbles that you mentioned was Tesla, And of course look at where we are now with Tesla. But we hear the word bubble being thrown out almost constantly these days, whether or not it relates to tech

or the fame names or Tesla for example. Well, we had a recent guest on the podcast we talked about the concept of a melt up and said that hold on a second. Sure, it's scary because eventually will end and roll over, but you can enjoy it while it's happening well from your perspective, because it's so difficult to time these things. What advice can you give on how to possibly approach what maybe a bubble? Well, you can enjoy it as long as it keeps going, for sure.

The question is do you have a cell discipline? So whoever said enjoy it while it's running, the question to them would be a very simple one. Okay, So what will it take for you to sell? Tesla is currently valued larger than the entire US auto industry x Tesla. It's valued at more than twice the value of Toyota, which has remained profitable through the COVID crisis, remained profitable through the global financial crisis, and produces thirty times as many cars as Tesla. Now, Tesla is not just an

auto company. It's also a technology company and a patents company, and an energy company and so forth. But what they purport to make money on at the moment is cars, and what they hope aspirationally to make money on is

some of these other things too. The bottom line is to justify a valuation larger than Test than Toyota plus the entire US auto industry the combination of all of that, you'd have to paint a scenario in which Tesla's revenues are comparable to all of those companies combined in let's say ten years. Is that possible. Yes, That's why I

use the word plausible. Is it plausible? No? It would have to see thirty or forty growth per annum for the next ten years in order to have that uh thirty full fortyfold fiftyfold growth in business in just ten years. In fact, in its last ten years, it hasn't grown fiftyfold. Sir, I think Ellen needs to restock those short shorts he was selling to justify this valuation. Summer is not gonna last forever. I would note that I have never shortened Tesla.

I've thought it was overpriced since it was a lot cheaper than than current levels. At level, I was thinking it's a short, but I've never shorted it for the very simple reason that bubbles can continue longer than you can possibly imagine, and can go further than you can

possibly imagine. They don't last forever. When I use the word plausible, it's important because you do have bubble stocks that that simple definition would identify as a bubble, and correctly identify as a bubble that subsequently proved to have results that that exceed plausible and that actually justify those prices. The vivid example that comes to mind from the earlier

tech bubble of two thousand is Amazon. Amazon and ninety nine was priced at levels that it would have had to achieve implausible growth to justify the prices at that time. Well over the next ten years, it underperformed the market in a big way over the next ten years. It's in that second decade that they finally hit their stride and achieved the kind of growth that would have justified the price. That's a long time to wait, so bubbles

usually burst. There's just enough exceptions to the rule that do achieve implausible growth, and then some that it draws suckers in to say, Okay, this time is different. I wonder if there is an element of people trying to put a book value on on Elon Musk's brain, you know, and look looking, and it's the Amazon example is a great example. You know that valuation for an online bookseller was one thing, but of course we saw, you know,

Amazon turn into something much more than that. I wonder if people are thinking, Nielon will will turn this into something bigger than just a car company, you know, a

battery company that you know whatever. I don't know, but it's hard to get into the brains of people that are buying uh Tesla at ten thousand times trailing earnings or or twelve times annual run rate revenues to make money at ten times revenues, if you assume maybe the company will have a twenty or thirty percent profit margin down the road, how how big would those revenues have

to grow to justify ten times revenues. Well, you'd have to have the revenues grow to thirty to fifty times current levels to justify ten times revenues today, and thirty to fifty times growth, My goodness, that is an extravagant expectation. I would also say that Amazon has entered what I would call bubble territory um. When it announced its first quarter earnings at the end of April, it was priced at the end of that day at a hundred eleven

times trailing. When you're earnings now, I use trailing earnings, not expected earnings, because expected earnings haven't happened yet and they often don't. But in any event, they were selling at a hundred eleven times the trailing earnings. My chief

investment officer Chris Brightman did a very simple analysis. He said, what if Amazon grows tenfold in the next ten years, grows tenfold and at that stage is bigger than the entire US retailing community in terms of its sales, bigger than all of US retailing in the space of ten years, what would it be worth And he came up with an answer of seventy times earnings. It would be worth a massive premium to the market. Seventy times earnings is a big premium. It's not a hundred times, and it's

not today's hundred sixty times. Right. It's a good point about trailing earnings, especially in this environment when boy, who's even given a forecast anymore, it's it's almost impossible to know. But rap I think what a lot of from the map, from sort of the macro angle, um, I think what a lot of people are struggling with when they try to do valuation models is the notion that real yields

are negative right now. In other words, you know, treasury yields, the safest assets are paying a yield uh that's less than the inflation rate. Even out I think all the way to thirty years, I'd have to double check that. But the whole curve pretty much is negative on a real basis. How much does that gum up your attempt to to find a fair valuation. You know, our colleague of mine who writes a colum at Bloomberg, Cameron Christ, keeps joking that, you know, people think this justifies sort

of an infinity valuation on tech stocks. But there is some truth to the fact that when the you know, when the ascount rate is solo, when real yields are negative, we should be able to sort of expect some valuation expansion. But how do you wrap your head around an equity valuation from a macro level when when real yields are negative. Well, firstly, low real yields do justify higher evaluation, So let's stipulate that and move that out of the way. The question

is how much higher? Now one of the nuances, there's a Gordon equation, which is uh dividends over a discount rate being a valuation metric for companies, which means that if the if the discount rate is zero, that the evaluation is infinity. Okay, Well, that is tacitly the argument that negative rates justify any evaluation. You choose. My pushback on that is, we had negligible real rates in the mid fifties and stocks were trading at ten twelve times earnings,

so it didn't work. Then we have negative rate real rates in Japan and Europe. They're trading at half to two thirds are multiples, so it's not working there. So if it doesn't work in other locations or at other times, then why not? And I think the reason is very very simple. Your your growth rate is also linked to real interest rates. Real interest rates being low can mean money is cheap and the discount rate is way down. Uh, And it can mean that growth expectations are anemic, and

you have to take that into account. If growth expectations dropped just as much as the interest rates, they cancel and the low rates don't help your valuations at all. So what does research affiliates do in that environment? I spoke with Chris Brightman back in April, so just a couple of months ago, early on in a month, and he explained to me how you are moving from a more defensive posture to more so riskon moving into small

tap us stocks, moving further more so into value. Obviously that's worked out well as that was early April, but it does feel like a good amount has changed since that point in time. Is that still where you stand. We've been moving back towards a defensive posture recently, and um, we're reluctant to go fully to a defensive posture until this next stimulus bill gets negotiated and passed and starts to work its way into the economy. In the last two weeks, the rumored size of the stimulus has risen

from one trillion to two trillion. Uh. That's a big delta. And we know, we know from the past that stimulus doesn't just drop into consumer pockets and drop into their spending and stimulate the economy. What it does is stimulate asset bubbles, and so to the extent that it drops into people's pockets and people aren't working, so there's less goods and services to buy, then you're either going to get asset inflation or consumer price inflation, or a bit

of both. We didn't get the consumer price inflation after the global financial crisis because the money may remainstalled on the Fed's balance sheet and in rebuilding the balance sheets of banks, and didn't get out into the macro economy. To be spent to create the demand. Now, if it gets out in the economy to create the demand and there's no supply, there's elements of truth in both Keynesianism

and supply side economics. If there's no supply, you're going to create inflation, and so there in lies the challenge. Do I think some of the stimulus will make its way into the capital markets? Of course yes, And so does that push the market higher very possibly yes, um, or at least it props it up at levels that don't make economic sense. Um. I never thought after the tech bubble that I would ever see dispersion and valuation between growth and value stocks as wide as we saw then.

It was insane, and we're there again. The spread between growth and value stocks using price to book value, which is a very flawed measure, reached a point of nine to one ratio, growth being nine times as expensive as value during the tech bubble. That's an astonishing ratio. Well, it's now eleven to one, eleven to one. Using price to sales, it reached a point of sixteen or seventeen to one. It's now nineteen to one between growth and value.

Some valuation metrics you mentioned Elon Musk and the negligible book value of Tesla. Some valuation metrics like price to book are actually pretty deeply flawed. We have a paper coming out shortly the demonstrates that intangibles are a huge missing component of book value and that if you incorporate intangible as you get a better valuation metric. And that I think is exciting work because it actually makes the FAMA French price to book based value factor about thirty

more powerful. That's cool, That's that's pretty interesting, you know. Rob. That brings us to another really interesting report that you guys have out recently about the sort of the notion of when that turn to value uh might happen? Uh. And you point out that value tends to underperform in a in a downturn in a market like like we

saw this year, and then outperformed during the recovery. The question I always have with this is, you know, when you look at sort of what the cohort of value stocks is right now, Um, you know a lot of banks, a lot of energy companies, um, that would clearly benefit from higher interest rates, higher energy prices, that sort of thing.

So how much of of the phenomenon is actually the factor, and how much does it depend on sort of what sectors are in that factor at any given time, or does it just so happen that cyclical stocks like that tend to be in the value factor a lot more often, especially at these sort of inflection points in the economy like this. That's a lot of questions rolled into one. Firstly, the notion that value loses during bearer markets. Actually, what our research showed is that it's a coin toss um.

People buy value thinking it's going to help cushion the downside. Uh, it sometimes does, and it sometimes doesn't. If you buy furcate bear markets into those that are driven by the bursting of a bubble, value when is big big the end of the tech bubble, value stocks actually were up about thirty percent in the first two years of that bear market up, all right, that's interesting. When the nifty fifty burst in seventy three and four, value outperformed handily.

When you have a macroeconomic shock where the economy itself is getting hit hard, value tends to perform as badly as the market or worse. Global financial crisis, it performed worse, not drastically worse, but worse enough. To get people's attention because they thought it was going to protect them on the downside, which it doesn't. Where value really shines is in the first two years after a bear market peters out, and it makes very little difference whether the bear market

was fundamentals related or bubble related. The recovery um of value tends to beat the market as a whole by ten to twenty percentage points over the next two years, and taken together, the bear market and the recovery value on average winds by about ten percent in cases where it's it's economic dislocation and uh forty or fifty percent in times when it's bursting in bubble. What do we have now? We have kind of both, right, yeah, kind of economic driven bearer market, and the bubble has not

yet burst. So if we have a second leg to the bearer market, my prediction would be that it will be a bubble bursting portion of the bearer market. I have no idea when is the right time to pivot into value. I have a very strong view that value over the next five years will beat growth handily by a wide margin. But if you want to pick the entry point, I have no clue. I would say average in over the course of the next year or two. Do not do not cut your value exposure just because

it's hurt. You have laid now. The other part of your question is what about those sectors that comprise value, aren't they Let me rephrase your question and put words in your mouth. This time is different, People say this time is different lots of times and usually always things are different. Things are always a little different. Rarely are they different enough to matter this particular economic meltdown. Things

are different enough that they do matter. And the question is by how much there are going to be a ton of bankruptcies. Those bankruptcies will be overwhelmingly on the value side of the spectrum. So to the extent you can invest in value and avoid value traps that are headed to zero, that is wonderful. It's a tough thing to do, but that is a wonderful aspirational goal. Then the question is how much of the value segment would have to go bust to justify that current eleven to

one spread. That spread is absolutely enormous. Growth stocks eleven times as expensive as value using price to book and different ratios using earnings or sales eleven to one spread. What's the normal spread, it's about five to one. So what would it take for the eleven to one spread to go to five to one without value doubling or relative to growth. Well, the easy way to do that is for half of the value stocks to go bust.

So I would say, if you look at the current situation, and if you come away with a view that half of the publicly traded value stocks in the market are likely to go bust in the coming year, then I would say, don't pivot into value. My personal view is ten or of them are going bust. I don't know which ones, although I think deck coverage ratios and things like that can help avoid some of the falling knives.

But uh, in any event, um, if you have the view that this cycle is different, but not so radically different as to kill half of the value stocks, then it's a phenomenal time to buy value. I believe Rob gets some special award for actually answering all parts to Mike's question. I think I think he got every one of them. It's like when you know, well, you when you watch the you know, the Federal Reserve press conference,

you know you've got your one shots. You're you're throwing like five questions I thought, I've I've seen my friend Jeff Kern's ask questions that those things, and I keep expecting like that music they play at the Oscars, you know, halfway through his questions exactly. But never mind, never mind, I've been in our comment on that one. Rob, I don't know no emergency rate cut. I think that leads us to uh, that time of the week, Sarah, I believe it does stand clear of the craziest things we

saw in markets this week. So Rob, this is our week, our weekly gimmick, the craziest thing we saw in markets this week. I'm gonna let Sarah go first, because I feel like in North Carolina there's got to be something crazy going on that we don't know about. Uh, not too much. I really have been confined to where I'm staying right now. I haven't been able to get out and about and explore. Unfortunately, hopefully soon, UM, so I might disappoint you. Not as crazy as it is, I

think interesting. Um to the point that we are in right now, I was able to see so far, eleven SMP five hundred technology companies have reported earnings, and every single one of them have beat in earnings expectations. Now, of course there are plenty of other metrics that people are watching and that go into this um, but since the earning season began, check is actually the worst performing

sector along with communication services. So you you bring in some of the other fang names as well, and it just shows you the point that we are at right now with some of these mega cap very popular tech names where they can beat on earnings, but it doesn't matter because they already are trading at very high valuations and expectations are them or just just sky high? Yeah, that's that's pretty good. That's tells you a lot about

sort of the climate right now. Not only do you have to beat I guess you have to you know, uh, cure cancer and land on the moon and who knows what else, but every single one of these tech companies is going to do that, right right, they'll all go to the moon. Maybe Tesla. So I'm gonna I'm gonna break your rules a little bit. I'm gonna go back

a week. Um. The craziest thing I've seen, uh this month was a week ago Monday, when Tesla rose uh two hundred fifty points and then fell three hundred points basically a fifteen percent up down move based on precisely zero news about Tesla. Now you can think about that and come up with possible rationals. Um Uh. If they have a trailing twelve month profitability net profitability, S and P will finally have to add them to the index. The index funds like to say, we don't move stock prices.

Oh my god, is that a lie? Uh. It doesn't move on the day they add the stocks because it moves in the weeks ahead as arbit treasures and hedge funds load up on the company in order to fulfill the one day immediate demand. But Tesla would come in at about a one percent weight. There's about six trillion index to the S and P. Uh. That means that when it's added to the S and P, there will be a sixty billion dollar buy ticket for Tesla stock

in a single day. People looking ahead to that will say, okay, I wanted to front run that, put that on my books, and then flip it over to the index funds when it gets added. We saw it on Twitter that went up in the space of ten days. Uh, and the index funds were able to say we didn't move Twitter's price. It closed more or less unchanged, same thing will happen

this go around. Um, but that swing up three hundred, up to fifty and down three hundred in a single day based on no news was to me the wackiest thing I've seen this month. That was a good one. Yeah, it's amazing. I think it's because they ran out of those short shorts. It is why everything is because they ran out of those short shorts. The reason that they posted twelve month profitability, Mike was because of those short shorts as well. I really don't want to see Elon

Muskin short shorts. Maybe that'll be what finally brings the stock downhill. He'll tweet out I think Tesla stock is too expensive, and then will also include a picture of him in Tesla short shorts. Well, it's it's interesting to think of what, you know, how much is gonna have to get sold of all the other stocks in the index funds to make to make some room for Tesla. I guess they. I guess they buy it ahead of time. And just that's a nuance that a lot of people overlook.

You're gonna have to see to buy sixty billion in Tesla that day, you're gonna have to uh sell about three billion of uh Apple and a like amount of Microsoft that same day in order to make that trade, and people aren't paying attention to that. Right, You're not making room for a little guy, You're make You're making room for a very large stack. When it gets at it, it will be the biggest addition to the SMP ever ever.

Right as far as a waiting, I guess. And of course the share price hasn't budged in the least based on that speculation, just trading sideways lately. Right, alright, that's

pretty good. Well in the spirit of bubbles, you know, Sarah, a lot of our Twitter friends complain that we don't cover bitcoin and crypto enough, So I'm gonna delve into that world a little bit through the back door, so to speak, um and talk about sort of what I think is the most important uh real world use case for bitcoin, and that is committing crimes, you know, and another another shadiness general shadin. I know, I know, I'm I'm bound to get some more similar tweets at me

about this, but all in good fun. I'm just joking sort of. But anyway, there's a great story in this week's Business Week about this company, Norse Chidro. It's a it's a big aluminum manufacturer based in Norway, and they got hit with one of these ransomware attacks where you know, a hacker basically freezes is up your computer systems and demands bitcoin and payment, and then they send you the decode to unlock your computers again. And you know, companies

have a variety of strategies for dealing with this. Norse Chidros was was really interesting. They're like, no way, we're unplugging all of our computers. They took the entire company offline, and then the story is all about how they tried to operate in sort of an analog world without being connected to the Internet, and they had to do all sorts of things, uh, including um, they went to Staples and bought a bunch of printers and paper and ink

car cartridges. They said, they cleaned out the local staples basically, and they had these old PCs somewhere in storage that don't connect to the Internet. So they broke them out and they started printing out orders. Now the salesman, you know, because they couldn't communicate on the Internet, had not much to do, so they they made the salesman go to the factory floor and start running these instructions on paper back and forth between the guys on the floor, the

workers on the floor. But my favorite part, Sarah, is well, one other thing they in order to meet payroll, they basically just copied all of the previous week's paychecks from their third party supplier and set them all out again. And they tried to weed out the people who had

retired and gotten fired and that sort of thing. But to communicate with suppliers, they broke out the old fax machine, which I think is amazing because, Sarah, if this happened to Bloomberg, I think I might be running the I might be one of the only guys old enough who still knew how to work a fax machine. I would be I'd be like, I'd be facts in your stories.

That is my When I started in my newspaper career in the early nineties, I used to go to the fax machine every day and I'd have to check for oh bits, you know, obituaries and police reports, and tucked in among all of that would be news from from this new, young, upstart news company called Bloomberg News, and I and they would just facts. It's too newspapers. Uh. That's how we started, was was faxing out the stories and hoping that newspapers would say, it's pretty good. We're

gonna we're gonna take this service. You know, we're gonna start running this stuff. Um so I'm I'm an old hand with a fax machine. Rob. I imagine you worked a fax machine or two in your day. Oh I have, I have. I still get some every now and then if you facts to us. There's some facts number we're all associated with, and it'll show up in my email. Uh, sort of a scan of the facts, and it's always like, you know, some sort of Caribbean vacation or I don't know.

You get you get the weirdest stuff, fascinating story. But I still think Rob gets the win with Tesla. You you almost can't lose with Tesla these days. Yeah, yeah, especially the short shorts head on the back. But where are going to have to leave it there? Rob or not? Thank you so much for coming on the podcast this week. This was great fun. Thank you so much. What goes up? We'll be back next week. Until then, you can find us on the Bloomberg Terminal website and app or wherever

you get your podcasts. We love it if you took the time to rate and read the show on Apple Podcasts so more listeners can find us. And you can find us on Twitter, follow me at Sara Pantzack. Mike is a reaganonymous and you can also follow Bloomberg Podcasts at podcasts And a very special thank you to Charlie Pellett of Bloomberg Radio and the voice of the New York City Subway System. What Goes Up is produced by Jordan Gospore. The head of Bloomberg podcast is francesco Leavie.

Thanks for listening, See you next time.