Another highly successful money manager is suggesting investors avoid “bread and butter” U.S. stocks
Some of the brightest minds in investing see a paradigm shift for U.S. stocks out on the horizon.
In a recent Digest, we featured analysis from billionaire hedge fund manager, Ray Dalio. He described a paradigm shift in the stock markets this way:
In paradigm shifts, most people get caught overextended doing something overly popular and get really hurt. On the other hand, if you’re astute enough to understand these shifts, you can navigate them well or at least protect yourself against them …
Today, let’s look to another high-profile money manager for his thoughts on market direction, and where to be invested now.
There’s lots to cover, so let’s jump in.
***The state of the markets according to Rob Arnott
A few days ago, Barron’s published an interview with Rob Arnott, founder of Research Affiliates. He’s a pioneer of factor-based indexes (a “factor” is a quantifiable characteristic of a stock, such as profitability or book value). In total, there’s $184 billion worth of investment products that track the indexes from Research Affiliates.
One of the early questions posed to Rob involves expected returns going forward for stocks and bonds. The interviewer asks, “what’s the biggest surprise for most people?”
From Rob:
That what has performed best in the past isn’t likely to perform well in the future, and what has disappointed in the past is where the opportunities lie.
Now, as a quick aside, if this sounds a bit familiar to you, it’s because Ray Dalio, who we referenced a moment ago, made a related point which we featured in a recent Digest. Dalio said:
The worst thing one can do, especially late in a paradigm, is to build one’s portfolio based on what would have worked well over the prior 10 years, yet that’s typical.
So, we have both Dalio and Arnott cautioning against the assumption that “just because it has been working well means it will continue to work well.”
On that note, what’s worked well in the past?
Well, obviously U.S. stocks and bonds have been working wonderfully. But as Arnott notes, the expectation that this will continue is likely going to disappoint.
Bonds over the past 30 years have given us a 7% annualized return. Does anyone think you’re going to get 7% in the future just because you got 7% in the past? Of course not. If the yield is 2% to 3%, you’re going to get 2% to 3%.
As to future U.S. stock returns, Arnott points toward faulty thinking from investors …
(Investors) think that because they’ve earned double-digit returns in the past decade, and 9% returns [on average] over the past 100 years, those 9% or 10% returns are a perfectly reasonable expectation. That’s not true.
Part of the lofty returns of the past was rising valuation multiples. The market was getting more expensive. If anything, rising valuations tend to mean-revert. They presage lower future returns, not higher.
Over the past century, the average [dividend] yield was 4.5%. Right now, it’s not even 2%. To get a 10% return with a 2% yield, you’re going to need 8% from growth. And that has only happened off deep recessionary lows, never off an economic peak.
***So, what is a U.S.-focused stock investor supposed to do?
Well, shift your gaze away from the broad market and focus it on specific trends that are likely to experience major growth as their related technologies and products change our world.
In other words, it’s time to put down the shotgun that’s worked fine over the last 10 years and pick up a sniper rifle.
Here’s how we described this in a recent Digest:
… expectations are that we can’t bank on big gains from the broad market (the S&P) in the coming paradigm. So, for long positions, making sure you have exposure to specific sectors and trends that will outperform is key.
Here, I’m envisioning portfolio-exposure to trends highlighted by Matt McCall and Louis Navallier, such as 5G, cybersecurity, AI, autonomous vehicles, the Internet of Things, and marijuana, among others. If the broad market is going to be languishing, having a portion of your stock portfolio earning above-average returns from these trends will be critical.
That said, let’s return to Rob Arnott, because his answer points toward where using a shotgun would still be appropriate …
Beyond U.S. borders.
***The “contrarian” perspective on global stocks
Returning to the Barron’s interview, after Arnott throws cold water on forward-looking U.S. stock returns, the interviewer asks “what’s an investor to do?”
Arnott’s answer?
Emerging markets.
People think emerging markets are a terrible place to invest. The narrative of more bad news to come, which will lead to disappointment long before it will lead to profit, is what creates bargains.
It’s human nature [to expect] that whatever has caused us pain and losses is something we want less of. Well, what has caused pain and losses? Emerging markets. They’ve been terrible for the past 10 years. They’re as cheap as they were at the end of the global financial crisis, even cheaper, relative to earnings, relative to dividends, relative to book value. That’s a pretty remarkable fact.
So, what might these emerging market stocks return over the coming years? Back to Arnott:
… when it comes to emerging markets collectively, we’re seeing pricing that suggests a 7% real return over and above inflation. That’s not even counting that value stocks in emerging markets are trading at about a 30% to 40% discount to those already-cheap multiples for emerging markets. The normal discount for value is about 20%.
Our own Eric Fry, editor of The Speculator, has been noting the opportunity in emerging markets. It was back in June that we featured some of Eric’s analysis in the Digest. He was discussing the opportunity in the emerging market country of Brazil.
He referenced Brazil’s low stock market valuation, noting that despite big 1-year gains, the Brazilian index was still 40% below the all-time high it reached in 2011.
But Eric has been watching Brazil well before June. In fact, it was back in January that he recommended subscribers jump on an opportunity in the Brazilian company PagSeguro, which is a fast-growing digital payments processor. Since Eric’s recommendation (a call option), those calls have climbed 661%. He still holds a portion of the trade open for additional gains.
Meanwhile, another emerging market has been all over Matt McCall’s radar — China.
Despite the enormous size of its economy, China is still considered an emerging market. And even though the headlines trumpet trade war woes and slowing Chinese growth, Matt McCall sees huge growth from select sectors in the country.
Earlier this summer, Matt was in China doing “boots-on-the-ground” research. The opportunities are so abundant that Matt now has a “China” basket in his Investment Opportunities portfolio, and a “Chinese Biotech” basket in his Early Stage Investor portfolio.
Matt is so bullish on Chinese biotechs that he’s even called them “an investment that may have the biggest upside potential I have ever seen.”
***But one thing that’s critical to keep in mind in all of this is “timing”
By the accounts of many analysts, we’re in the final stages of our great bull market here in the U.S. One sign these analysts point toward is the recent inverted yield curve. Historically, this inversion signals a recession roughly 12-18 months later.
But according to The Wall Street Journal, the average gain for the S&P 500 in the 12 months following an inversion is 13.48%.
So, we might be looking at big, fast gains for the broad market in the U.S. Should we expect equally-fast gains from emerging markets?
Not necessarily.
In many cases, it takes longer for these “value” markets to gain sustained, upward momentum. Think of a huge oil tanker out on the sea trying to reverse directions. Can it turn on a dime? No, it turns in a wide, sweeping arc that takes time.
What this means is that if you allocate to emerging markets, you might find yourself watching the broad U.S. stock market climb over the next 12 months or so while emerging markets don’t do much. That could create a “fear of missing out.”
Let’s return to Rob Arnott for how he sees this:
Let’s say the stock market’s up 20%. And you’re invested in emerging markets, and they go nowhere. How distressed will you be at that opportunity cost?
If you’re like most investors, you pay close attention to what happens to U.S. stocks and bonds, and not much attention to anything else. If that’s so, then chances are pretty good that you won’t have a lot of tolerance for maverick risk, or performance dissimilar to the markets that you’re focused on.
This ties us back to timing.
Yes, valuations suggest that emerging markets (and niche trend-investments here in the U.S.) will outperform over the coming years … but it might take time for those gains to come.
Meanwhile, valuations suggest that the broad U.S. market is going to underwhelm over the coming years … but if we hyper-focus on the next 12 to 18 months specifically, it could post some solid numbers.
It’s a bit of tough trade-off, wouldn’t you say?
Here’s how Arnott is handling this:
I personally have essentially nothing exposed to U.S. stocks at these valuation levels. But again, maverick risk isn’t a big issue for me. If I’m out of step with the markets for a year or two, that’s OK.
Of course, for you and me, this isn’t an “either/or” decision. Through wise asset allocation, we can position our portfolios to have exposure to both emerging markets and the U.S. The important thing is simply an awareness of what’s likely to come in each market, so that we can align our investments with our personal goals and time-frames.
Does your portfolio have exposure to key trends here in the U.S.? Does it have exposure to foreign emerging markets that offer much lower valuations?
If you’re a longer-term investor, these markets are the ones most likely to drive big returns over the coming years. Take some time to look into them today.
Have a good evening,
Jeff Remsburg
