A Conversation With Robert Arnott

A so-called perma-bear is sprouting the beginnings of horns. Robert Arnott is founder and chairman of Research Affiliates, a Pasadena, Calif., investment firm. A former editor of Financial Analysts Journal, Arnott is perhaps best known as the author of more than 100 research papers challenging fairly widespread beliefs. In a 2000 paper he demonstrated that managed mutual funds underperformed the market by more than previously thought once taxes are considered. In 2002 he showed that reinvested dividends, not share price gains, have produced the bulk of stock returns throughout history -- and he warned that puny dividend yields foretold a stretch of disappointing stock returns.

In a 2003 study he proved, to my surprise, that companies that pay out the bulk of their profits as dividends go on to produce faster profit growth than companies that retain and invest profits on shareholders' behalf. In 2005 Arnott introduced the idea of weighting stock indexes by company fundamentals like profits and dividends instead of by the market value of their shares. Through Research Affiliates, he put that idea to profitable use by creating and licensing the Research Affiliates Fundamental Index, or RAFI.

I recently spoke with Arnott about the stock market's decline and where to find bargains.

SmartMoney.com: You were cautious on stocks several years ago because of their low dividend yields and lofty valuations. Now the market is down sharply and carries a yield of around 3%. Does that do anything for you?

Robert Arnott: Actually, it does. Maybe six or nine months ago someone in the press labeled me a perma-bear. This is one perma-bear that sees some interesting things to buy. The nature of this crash has been so sweeping. In September, 15 of the 16 asset classes we track were down. That hasn't happened over the past 30 years. In October it has gotten worse. Most people look at this and feel devastated. The more sensible approach is to look at it as a buying opportunity.

SM: For stocks?

RA: Value stocks have been savaged to the point where the spread between growth and value is wide once again. The deepest part of value is financial services. It's currently 14% of the market value of the S&P 500 index. It's about 25% of the economy by book value, earnings, revenues, dividends -- objective measures of financial scale. Five years from now financials will still be the largest nongovernment part of the U.S. economy and will be priced accordingly. The problem is we have no idea which ones are going to be the survivors. But what people overlook is that with each failure the survivors have more pricing power and more profit potential than they had before. You end up with an oligopoly of jumbo financial institutions. That's actually a very good situation for the survivors.

SM: So you'd feel good about someone buying a financial index fund right now?

RA: Absolutely. Or an exchange-traded fund.

SM: What about growth stocks?

RA: The growth side of the market has shrugged this off to an extent that's inappropriate. Yes, growth stocks have been hit. But we're in a recession and it's likely to be a fairly serious one. We're unlikely to go into a recession without demand for capital goods and technology going down. We're unlikely to get through an election cycle without the health-care sector being bashed as it always is. To my way of thinking we have a bifurcation of the market. Value looks attractive. Growth does not. If we see another leg down in the market, growth stocks will lead the decline. It's extremely unusual for value stocks to fall further in a bear market, but it's without precedent for value stocks to fall further in the late stages of a bear market.

SM: What about outside of stocks?

RA: That's where I see some real opportunity. It's a little early yet, but high-yield corporate bonds have gone from 2 to 3 percentage points of yield premium over Treasurys to 10 points or more. That makes no sense. High yield is likely to be a buy when the marketplace broadly acknowledges that we're in a recession and it's not going to be a light one. I don't think we're there yet. People who buy into high yield now won't regret it three years from now, but there may be a better buying opportunity six months hence.

SM: What else looks good?

RA: Emerging markets debt -- especially denominated in the local currency -- represents a wonderful opportunity. You get a pick-up in yield because it's emerging markets and that scares people. You get a pick-up in yield because it's denominated in the local currency and no one wants to hold, for example, the Brazilian real. And you get the possibility of currency appreciation because the currencies in most of these markets are cheap.

SM: What about the risk of default?

RA: Most of these countries have fiscal surpluses -- their budgets are in the black. We have a fiscal deficit in the year ahead approaching a trillion dollars. Most of these countries have no hidden expenses on their books. We have half a trillion dollars of off-balance-sheet spending in Social Security, Medicare and Medicaid, Iraq and Afghanistan are off balance sheet. Emerging markets also have ratios of gross domestic product to debt that the U.S. could only dream of. So by objective measures emerging markets debt is more creditworthy than U.S. Treasurys. That's something people have overlooked.

SM: Can you envision a scenario going forward where the pristine credit rating of U.S. Treasurys comes into jeopardy?

RA: No, I can't, because the U.S. Treasury has access to a printing press. U.S. Treasurys will never default. Period. Full stop. They may tacitly default by inflating their way out of the real value of the debt. In other words, you may be paid back in diminishing script.

SM: After the Great Depression it took 25 years for the stock market to come back. After 1974 it took 16 years. Is this the sort of decline that could take the market a decade to hit a new high?

RA: I've been on record saying it could be 20 years for the market to hit a new high in inflation-adjusted terms after the 2000 peak. I believe we're in a secular bear market. Secular markets tend to span 15 to 20 years, typically three to four market cycles in which the bull markets are unexceptional and the bear markets are daunting. At the end of secular markets stocks are cheap by historical measures. Right now for the first time in a very long time price/earnings ratios are below their historic norm based on 10-year smoothed earnings, but only modestly. About 5% or 10%. Stocks are mildly and selectively attractive.

SM: What got us in this economic mess?

RA: Most people blame a housing bubble. I blame a lending bubble. Banks were lending to people who objectively had no resources to pay back the loan. That's stupid. The Fed was charging 1% and banks wanted to borrow at 1% because that was below inflation. The Fed was not only giving money away, they were paying people to borrow. If you're a bank and have access to the Fed window, you want to borrow at 1%. To do that you then have to turn around and push it out to borrowers. If they're largely satiated you push it out to borrowers of lower and lower creditworthiness. Lending becomes genuinely irrational.

SM: How long will it take for housing to rebound?

RA: Housing prices cannot rise while inventories are rising. Inventories can't fall while foreclosures are rising. Foreclosures are projected to crest middle of next year. If that happens, inventories will wind down early the following year and prices can recover late in 2010. Housing is a lagging indicator, so if housing isn't going to recover until late 2010, the economy is likely to be comfortably in recovery by then.