#26 - Rob Arnott: Quant Investing, Asset Class Outlook

35:01Now, a three to one ratio sounds like a big spread. It's not. It's only been tighter once before in history, and that was in the 70s. The spread widened. The norm is four and a half to one and widened and widened and got to a nine to one ratio. What does that mean? It means that valuations fell by two thirds relative to growth stock valuations from one third to one ninth. That was even cheaper than at the peak of the dot-com bubble, which is really quite astonishing. I never thought I'd see a bubble of that magnitude again in my life. But one ninth is expensive, is off the charts. The market was saying these companies, these tech companies are beautifully positioned for a pandemic and a post-pandemic world, and these bricks and mortar companies are toast.

35:55There's going to be rolling bankruptcies across all of mainstream America. Watch out. And as with most narratives, there was truth in that, but it was already embedded in the price. Price already reflects the fact that these are better companies. And these are more troubled companies. So how bad were value stocks hit relative to growth stocks? They underperformed in those 13 years by 57%. Well, if they underperformed by 57 % and get cheaper by 67%, what does that mean? It means if the relative valuation had stayed the same if value was no less out of favor in 2020 than in 2007, value stocks would have outperformed by about 2 % a year.

36:48So my takeaway from that is value isn't dead. It's just fallen wildly out of favor, which it does from time to time. Today, we're back to the nine to one ratio. The AI My narrative has taken over the entire marketplace as the theme of the century. And as with most narratives, this narrative has a lot of truth in it. These companies are going to revolutionize the way you and I do business, the way we communicate with our clients, the way we do our research. It's the same as the dot-com revolution was very real. But when you go back to 2000, look at the 10 most valuable tech stocks in the world in the year 2000.

37:38How many of them had beat the S &P by 2015? Zero. By 2020, one. Microsoft, by about 1.5%, 2 % per annum. Today, two. Microsoft and Oracle. If you look at those 10 most valuable tech stocks back in 2000, my favorite poster child is not pets.com, which was a stupid idea. My favorite is Qualcomm, which was a brilliant idea. Qualcomm, the narrative at the time was this company produces the plumbing for the internet. It is absolutely needed. It has a big moat. It's very hard to build the infrastructure to compete with them. Its profit margins are big and getting bigger. Does this sound familiar?

38:34And it has growth as far as the eye can see. It came into the year 2000 with a PE ratio of 284. Now, that narrative was this company is going to see stupendous growth. How's it done as a business? Profits last year were 60 times the profits in 2000. 60-fold growth. So it must have performed well. Nope. If you bought the S &P in 2000, you're twice as wealthy as if you bought Qualcomm. Qualcomm's gone up nicely, but half as much as the S &P. That's what happens when things get frothy. So I look at today's markets, and I think history doesn't repeat, it rhymes. That quote has merit. We're looking at a situation today that looks very, very similar to the peak of the dot-com bubble.

39:34valuations aren't as stretched and the profitability is deeper and more real than in the dot-com bubble. But, you know, as of last Friday, NVIDIA was at 36 times sales. Now, Scott McNally from Sun Microsystems famously was interviewed by Congress for a variety of topics back in the early to mid-90s. And he famously said, when asked about privacy, he said, there is no privacy. Get over it. The other quote was he was asked about the valuation of his company. and he said we're priced at over 10 times sales. I don't know how anyone can justify a price like that. And here's a company at 36 times sales.

40:34So we did a little simple back of the envelope. NVIDIA has a moat. It utterly dominates the super chip market. It's a beautiful company with beautiful product. The product works. So the question is, they've got over 50 % profit margin, net of all cost of production of the product, net of all R &D, net of all taxes. Wow, that's a stupendous profit margin. So what could possibly go wrong? On a one or two year horizon, nothing. There is no serious risk to NVIDIA over the next couple of years. But does anyone think AMD, Intel, and Taiwan Semi are going to sit on their hands and say, you can sell$40 ,000 chips with a 55 % profit margin?

41:32That's okay with us. It's hard to break into that business. you have a moat and we're not going to try. No, of course they're not. So competition is a natural part of the economy and part of what makes the economy move and grow and change for the benefit of everyone. But you're going to see competition. Disruptors get disrupted. Back in the year 2000, Palm was a spinoff. Palm made the Palm Pilot, the ubiquitous Palm Pilot. Everyone had one in the late 90s. And 3Com owned Palm and decided to spin it off as its own company. The spinoff was instantly worth more than 3Com before the spinoff. Very cool.

42:23It was within days worth more than General Motors. Two years later, BlackBerry came along and Palm was irrelevant. Five years after that, the iPhone came along and BlackBerry fairly quickly became irrelevant. I was giving a talk a few weeks ago and asked the audience, how many of you still have a Palm Pilot? Of course, no hands went up. How many of you still have a BlackBerry? Out of about 300 people, three hands went up. So disruptors get disrupted. NVIDIA is a disruptor, a massive disruptor, a massively successful disruptor that has great product, visionary management, and emote. Fantastic. But let's suppose that pricing pressures bring the price down by half over the next 10 years.

43:19That seems in the tech arena to be probably an unduly optimistic view. Let's assume that market share for NVIDIA goes from 90 plus percent to 40 or 50 percent. Let's assume that volume of production of super chips rises 25 percent a year for the next decade. It's a stupendous growth. Put those three assumptions together and what do you get? you get a profit for NVIDIA in 2034 that's smaller than in 2024. So I'm not saying that we're at peak profit for NVIDIA. I'm saying that we could well be at peak profit this year and next for NVIDIA. And it would be very dangerous to assume that 36 times sales will be justified.

44:15Now, in fairness, the 36 times sales is backward looking. It's the last 12 months. As everyone knows, the sales are right now running about twice what they were a year ago. So double the sales, you chop the price to sales ratio in half, that's still 18 times. It's wild. So I look at this and I think, as always, growth companies are, for the most part, much better companies with better products, better finger on the pulse of their marketplace, better management, better strategy for competing. value stocks tend to be the opposite weak product weak management weak strategy and that narrative is correct the parts of the narrative that fail are the narrative that these leaders will still be the leaders in 10 years these losers will still be losers in 10 years, and that change is going to happen fast.

45:22So the stupendous growth of Qualcomm or of NVIDIA will persist for years to come because change is coming and coming very fast. The internet changed everything. But is the world of 2024 different from the world of 2000? Oh my God, yes. Was the world of 2002 radically different from the world of 2000? Well, geopolitically, yes, we had 9-11. But in terms of the economics, the functioning of the economy, the depth of penetration of the internet in day-to-day life changed gradually. And the embrace of AI will happen gradually. It's not that the change is going to be slow, it's that the adoption is going to be gradual.

46:18We have a quarterly all-hands meeting. And first quarter of last year, I spoke with our team and I said, you're hearing a lot about AI. And it's very real. It is revolutionary what's happening. But you're also hearing that it will cost millions of people their jobs. Let's not forget, it'll also create millions of jobs for those who know how to use it. Now, you might be worried because you're reading about all these white collar jobs that are going to disappear. I can guarantee you not a single person in this room will lose your job to AI. You might lose your job to somebody who knows how to use AI better than you do, so start studying.

47:02And I think that's the way to think about any technological change. There was two key points in what you just talked about that I think are particularly insightful. One is valuation is reliably mean reverting. And you always have to look at it through that lens and kind of where are you in that cycle? You don't know when it's going to turn, but it's going to be mean reverting. That's just how capitalism works. And the number two is, and I've heard you say this before, if you bet on the narrative, you basically haven't bet on anything. Because the narrative is already in the price for the most part because that's the conventional view.

47:39That's exactly right. Narratives shape pricing. Prices move based on changes in the narratives. And if a narrative is these winners are going to be big winners for a long time to come, These losers are going to face headwinds for a long time to come. If that narrative is true, it doesn't do a bit of good for you, just as you said. For that narrative to be useful, for these stocks to outperform, they have to do better than lofty expectations. For these stocks to underperform, they have to do worse than bleak expectations. Can that happen on a short-term basis? Absolutely. on a long-term basis, meme reversion exerts its influence powerfully and reliably.

48:27It can also be self-fulfilling and also self-reinforcing. Because as you have a strong narrative and with the tailwind there, more people get interested, they invest, price goes up, it supports the narrative until it gets extrapolated to a point where it's unrealistic, stick, even for companies that are growing rapidly. And I think it's also related to the fact that you have humans. Now, I guess you have some computers, but it's mostly humans that set the price. And humans are hardwired to be emotional. And they're oftentimes driven by fear and greed. So that probably hasn't changed in hundreds of years.

49:07Yeah. And it's rooted in human nature and we're shaped by evolution. A bargain typically got there by inflicting pain and losses. A frothy overpriced stock typically got there by producing profits and great joy. And pain and losses, we don't want more of that. So if something's hurt us, the last thing we want to do is buy more. If something's helped us, the last thing we want to do is take our profits. I like to say that our ancestors on the African belt didn't thrive by running towards a line. But when it comes to investing, running towards what's out of favor, what feels dangerous,

50:05is a reliable path to long-term success. success. Here's that problem. On a short-term basis, the likelihood of your picking the trough is slim to none. So you buy something that's out of favor, that's inflicted pain and losses, and you're going to look and feel like an idiot until the turn happens. But the only way to have maximum exposure when the turn happens is to be willing to buy more if the narrative that prompted you to think it was a bargain is still true. So you ask yourself the question, is the thesis on which I liked this asset at this price still intact at the lower price? If so, top it up.

50:54And this is all also related to your previous point about the rebalancing, buying low, selling high. That's basically what rebalancing is. And the challenges of doing that in a paper, it's obvious. And the challenges relative to doing it in practice where human emotion comes into play. One of the things I've loved to do over the years is find ways to institutionalize rebalancing buy low, sell high into our investment processes. We do this in our asset allocation work. We do this in fundamental index. With fundamental index, you're weighting the stocks in the portfolio based on how big their business is.

51:41So whatever the size of the business, that's how much you put into it. Growth stocks are priced at premium multiples. So tacitly, we say, love the company, but the narrative is already in the price. So I'm not going to be hurt to reweight it down. Value companies trading at deep discounts, yeah, the company's got head wings. I get it. That's why it's cheap. Because it's in the price, it's not going to hurt us to top it up. And if you do that, you wind up with a portfolio that has a stark value tilt, a big value tilt, just as big a value tilt on average as the cap weighted value indexes. But unlike the cap-weighted value indexes, it has a rebalancing alpha.

52:29If a stock rises and its fundamentals don't, you're going to say, oh, thanks for the higher price, I'm going to trim it. If it tanks and the fundamentals don't, you're going to say, thanks for the deep discount, I'm topping it up. The market thinks prospects have gotten better. Don't worry about the higher price. It's going to show up in the fundamentals catching up because that growth is coming. And that narrative might be correct, but it's in the price. So the rebalancing alpha of RAFI, of the fundamental index, is its secret weapon. It's not the value tilt. The value tilt is powerful, but value is an unreliable alpha engine.

53:10Rebalancing is a more reliable alpha engine. Here's a fun factoid. RAFI has been around since 2004. It's been live since the end of 2004 in the U.S., international and small, 2005, emerging markets, 2006. So it goes way back. Put those together in a global frame. The FTSE, RAFI, All World 3000 includes U.S., international, large and small and emerging markets. That index has been around since 05. Now, how's it done since then? If you look at it on a standalone basis, it's performed very well for value. It's beat the market inception to date, even though value has gotten savaged. But where it really shines is relative to value itself.

54:11There's multiple flavors of Rafi. There's FTSE Rafi, Russell Rafi. There's multiple flavors of cap weight. There's MSCI Acqui and FTSE All World. Okay. Let's take a blend of these two Rafis and these two cap weight value indexes. Okay. So I'm not cherry picking for the best relationship. I'm just looking at Rafi versus cap weight. The value add over the last 17 years has been 4 ,700 basis points. That's 2.3 per annum compounded. The tracking error has been 1.5%. So you have an information ratio of 1.5. The worst drawdown ever was 1.9%. The longest drawdown ever was seven months. And so you have this relentless alpha engine and the T statistic is six, I haven't seen simulated back tests with a T statistic of six.

55:17And here's a live strategy measured against a live cap weighted value index with a T statistic of six. So the critics of Rafi who said, this is just a clever repackaging of value investing. Well, let's take that at face value. It does have a deep value tilt. But if it's just repackaging a value, then the relevant benchmark is value. And here we are comparing it with value and you've got a T statistic of six. It's astounding. For what it's worth, I have a swap. Long Rafi short cap weight value in my personal portfolio and it's doing very nicely. And then just to put those numbers in English for everybody to understand, basically outperforming by over 2 % a year for 17 years and doing it relatively consistently.

56:11That's exactly right. There's no drawdowns that weren't recovered to a new all time high in relative performance. It always happens in less than 18 months, at least over this 17-year span. So the point of this is not... By Rafi, although if your viewers choose to do so it's fine with me. The point of this is to say a rebalancing alpha is enormously powerful as long as you do it systematically. But it systematically goes against human nature because you're buying what's out of favor, what's newly unloved, what's newly disappointing, and you're selling what's newly beloved, what people are piling into.

56:56And it just goes against human nature. So related to that, would you just talk about the difference between the performance of a value stock versus a value company? And I guess you could do the same thing with a growth stock versus a growth company. One could be doing really well versus the other not doing so well. Yeah, this is something that's been discussed and well known all the way back to Ben Graham's time. Basically, well, Ben Graham famously said that he thought of the stock market as, in the short run, a voting machine, popularity voting machine, and in the long run, a weighing machine.

57:38Is this worth what it's priced at? And another way to put this in finance theory terms is it's an error in price model where the price is the market's best guess at fair value. The fair value is constantly moving as news comes in. The price is constantly moving and the price is hunting for that value, that fair value. So the price equals the fair value, which we can't see plus or minus an error. Now, why does that matter? That error is mean reverting. The market's constantly hunting for errors in price that need fixing. That is the engine for a long horizon mean reversion. Yeah, that's pretty fascinating.

58:30And I guess if you, I know ResearchAvillia spends a lot of time creating long-term expected returns across asset classes. You have tools that do that. And I think the key there is that in many ways, it's easier to predict long-term returns across markets than it is short-term returns, which can sound very counterintuitive to most people because in the real world, short-term is easier to predict than long-term. Would you describe that? Absolutely. Absolutely. Is NVIDIA going to be a brilliant stock for the balance of this year and next year? Or is it going to mean revert downward or what? I have no clue.

59:17And by the way, just as an aside, I strongly recommend against shorting things that look like bubbles because bubbles can go a lot further than you ever could imagine. So be careful. do not short bubbles. But long-term returns are actually surprisingly easy to predict because they have very few moving parts. You've got your income, the yield. You've got growth in income. For fixed income, it's zero. For junk bonds, it's negative because there are some defaults. For stocks, it's positive with an inflation kicker and a real growth kicker. but you've got income and growth in income. And then you have changes in valuation multiples.

1:00:03So I like to use the Shiller PE ratio. Shiller PE ratio for the US stock market is now 34. You pay 34 times the 10-year average earnings for the S &P 500. If there's mean reversion in earnings, and if there's mean reversion in valuation multiples, those can both work against you in these markets at this time. So past is not prologue. The trailing 15-year returns for the stock market have been stupendous, but that doesn't mean the next 15 years is going to be stupendous. Long-term returns consist of yield, growth, and changes in valuation multiples, which tend to be mean revered. So what does that mean for US stocks?

1:00:53The yield is less than 1.5%. You put$100 in the stock market, you're going to get income of less than 1.5 % for S &P or Russell or broadly diversified portfolio. That's a pretty crummy income stream. Growth. Wall Street says, don't worry about the 1.5%. You're getting 10 % from growth. You're investing in growth. pardon me, but going back over the last 50 years, 100 years, 150 years, 200 years, we find that earnings and dividends tend to grow about 1.5%, at best about 2 % above inflation. So expected inflation on a 10-year basis is currently 2.3%. Let's call it 2.5 % just to round it, add in one and a half for real growth, and you've got 4 % growth, not 10 % growth.

1:01:494 % growth and one and a half yield gives you five and a half as a return expectation. That's not brilliant. Well, what allowed the returns in the last 15 years to be so spectacular? Revaluation. The valuation multiple 15 years ago, keep in mind, 15 years ago was just coming out of the global financial crisis. So 15 years ago, price relative to 10-year average earnings bottomed out at 12 times. By mid-year 2009, it was about 14 times. Now it's 34 times. So valuation multiples have well over doubled. That's a dangerous part of return to extrapolate. So the inspiration for our work on capital market return expectations was Jeremy Grantham's work at GMO.

1:02:47He does long-term return expectations and has been doing it for decades using yield plus growth plus mean reversion in valuations. And I think his approach makes an important mistake by assuming you're going to fully mean revert back to historic norms over the next seven years. So the normal Shiller PE ratio, price relative to 10-year smooth earnings, over the last century has been about 18 times. So going from 34 to 18 times, that's almost dropping in half. You're going to have a negative return expectation. I view that as the tail wagging the dog. What if we're at a new normal and 10 years from now, we're still at 34?

1:03:34Well, then you get your 5.5%. What if you mean revert back to 18? Then you're at a negative return. Well, let's split the difference. What if you just go to 25, 26, still expensive 10 years from now, not full mean reversion, but a little bit of mean reversion. Now you're down at about a 3 % return. So our forecast for US stocks is a 3 % return. People are horrified by that. You can get five and a half from T-bills. So why on earth would you put money in stocks a 3 % return? Folks who are watching this, I would invite you to look at our website. Just go to researchaffiliates.com. and on the upper right of the home page, there's Asset Allocation Interactive.

1:04:25You just click it or you can Google Asset Allocation Interactive and the first thing that's not an ad is a link that'll take you straight there. We provide forward-looking return expectations for 130 different asset classes and the price for this service is classic internet pricing. It's free. 3 % return for stocks. We're projecting 4 % for T-bills because if inflation is 2.5%, 5.5 % won't stick. It'll come back down. Why invest anywhere? Those returns are terrible. You look at IFA, the MSCI International Index, it's priced to give you 9%. percent. Emerging markets, 9.5%. Value within the US, international and emerging markets, price to give you 3 % to 4 % more.

1:05:18Well, 3 % more than 3 % is 6%. That's still pretty crummy. 3 % more than 9.5 % is 12.5%. That's pretty good. That'll double your wealth every six years. So I look at the world of today and I see a lot of interesting places to invest. I've been called a perma bear because I don't like buying things that are fully priced or expensive. I'm not a perma bear when something's cheap. And right now there's a lot of things that are cheap. So one of the things that we talked about is kind of the golden rules of investing is buy low, sell high. We understand that theory works well in practice. It's hard to do.

1:06:00It's painful to do. One of my favorite Soros quotes is that investing shrewdly and wisely is fundamentally a painful exercise because you're going to do what doesn't come naturally. You're going to do what's out of favor and uncomfortable. You're going to feel like you took stupid pills until the turn happens. And sometimes the turn doesn't happen. So this is why you diversify because you could be wrong. That's right. Yeah. So rule number one, buy low, sell high. Rule number two, you just said is diversification. And the simplest way to articulate that is don't put all your eggs in one basket, which is you're taught.

1:06:49That's one of the first things you're taught in investing. And in my experience, the conventional allocation, the typical portfolio is not very well diversified. I'm curious if you agree and if you could expand on that. I emphatically agree. You look at most 401k platforms and let's say they have 30 different investment options. I mean, some have scores of investment options. Some have only a half dozen, but let's say you've got 20 options. 16 of them are going to be various flavors of stocks. A couple of them will be various flavors of income bonds. and you might have a couple of options that are a little out of mainstream, like a REIT fund or a TIPS, inflation-linked bond fund.

1:07:41One factoid that's really interesting is if you have 20 options available to you, the average allocation is going to be about 5 % to each across all of your employees, which means that if 80 % of the available choices are stocks, they're going to be on average 80-20. 80-20, if it's stocks and mainstream bonds, is not a diversified portfolio. It's a stock portfolio, typically overwhelmingly domestic stocks, with a little dose of bonds that don't provide diversification, they just tamp down the risk. shockingly a 60-40 portfolio, the classic balanced 60-40 portfolio has a 98 % correlation with the stock market.

1:08:32Stocks provide risk and a risk premium. Bonds provide risk reduction, not a risk premium. And so the ability to find diversification is almost absent from most 401k platforms. So I think Harry Markowitz was a dear friend of mine. He often said his most important contribution to the world of finance was the recognition that diversification matters. Diversification doesn't mean six different stock funds. Diversification means a little bit in various buckets that don't move together, that move at different times, that reward you at different times. And one of my former colleagues is fond of saying diversification is a regret-maximizing strategy.

1:09:29In a roaring growth-dominated bull market, you regret every penny you have in diversifiers. When that comes to a screeching halt, you regret every penny you don't have in diversifiers. So after the 1990s, we had the decade of the 2000s when the stock market return was negative in real terms. Bond market return was decent and diversifiers had very healthy, strong real returns. Decade of the 2010s and early part of this decade look an awful lot like the 1990s. I see a lot of parallels between right now and the year 2000. That doesn't mean that I think this market is coming to a screeching stop right now, but it does mean that we're in frothy, dangerous territory.

1:10:19You talked about the last couple of decades, and we were speaking briefly before we started recording about how memory can be very short in the investment world. People are thinking about the stock market goes straight up. It's had that 15-year bull market. 15 years is a long time. In market terms, it's not a long time. It's almost like one, you can think of it as one data point. And you just mentioned the decade before that, the stock market lost money. Would you help investors gain some perspective on long-term market cycles so they have a better sense of how markets can go through long periods of underperformance?

1:10:59The markets move in what are commonly thought of as bull and bear markets, with bull market reaching a new high and then the bear market taking the wind out of the sails and then a new high and so forth. You also have secular bear markets that 1966 to 1982, the market was lower in the summer of 1982 than it was in the spring of 1966. Lower even though we'd had a decade and a half of severe inflation. meaning that in real terms, the market was down by about two-thirds. You lose two-thirds of your money in the space of 16 years. That's a secular bear market. 2000 to 2009, you had a horrible bear market, a beautiful bull market, a horrible market crash.

1:12:00Net-net from 2000 to 2009, you lost a lot of money, especially adjusted for inflation, which was modest then, but not negligible. Net of inflation, you were down by well over half in the space of a 10-year span, and you're supposed to make money over 10-year spans. Come on. What's the whole point of long-term investing if you can't make money in a decade? Well, there are decades where you can't. My unease is that I think for US stock investors, we might be looking at that kind of decade in the coming decade because valuations are very high. Optimism is very high. And there's lots of markets that are priced cheaper that you could move money into that are priced to give you a much better return.

1:12:57value, non-US stocks, emerging market stocks, maybe REITs, although I'd want to average in carefully. MLPs are, a lot of them are in the resource sector, which is very out of favor. And MLPs were very popular a while back, not anymore. So they're priced to give you pretty darn interesting rates of return. So I see lots of places to invest that look really very interesting. But most people have most of their money in mainstream US stocks that are frothy and mainstream US bonds that have a respectable yield finally again, but not a great yield. Yeah. And this goes back to where we started, diversification.

1:13:49And it's interesting when you look backwards, 10 years, maybe even 15 years, the more you were diversified, the worse you did. The less you were diversified and the more US stocks you owned, the better you did. So that has maybe taught us the wrong lesson. And when you zoom out and look at longer term market history and gain that perspective, you see the benefits of diversification through time. And I think when you look forward, to me, it's a very simple question. Is this a world looking forward that you want to be more diversified or less diversified? And I think if you ask that simple question, most people would say, it's probably a good idea to be more diversified.

1:14:27There's just a lot of risks on the horizon. Yet most people are less diversified than they were 10 years ago. Very, very, very true. Yeah. I talked earlier about short-term high-frequency trading versus long-term investing. I think quantitative techniques in general, AI more specifically, work magnificently in short horizon trading. And you don't need theory if you've got billions of samples of data. When it comes to long horizon investing, the data is not going to help you because there's not enough data. So just drawing on simple facts like what's the yield, what's the historical growth rate, if there's mean reversion, what would that do to our returns gives you a window into long-term returns that's actually shockingly clear and shockingly accurate.

1:15:28If you go back historically and just use that very simple yield plus long-term historical growth in income plus halfway mean reversion spread over the next 10 years, you find that that leads to forecasts of long-term returns that on average are within about 2 % per annum. That's pretty good. AI is not going to help you there. And so I find long-term investing to be the antithesis of crowded space. very few people pay attention to long-term prospects when they're surrounded by buzz about this company or that. The CNBC and MSNBC approach to making a sport of investing, to treating investing as a day-to-day opportunity to make a bet, make a bet, is actually pretty dangerous.

1:16:34You talked about the potential similarities to the 2000s. Are you finding any analogies in terms of how today looks versus the 1970s, the last time inflation hit high levels? And would you remind everyone how stocks and bonds did during that period? Yeah, no kidding. The 70s were awful for stocks and bonds. We came into the 70s with stock market in 71. shocking to hear this, breached 1 ,000 for the Dow industrial average for the first time. 1 ,000, it's now rather ahead of that level. This was a decade in which you had serious inflation. March of 1980, inflation crested at 14.7%. 1971, inflation was rising, but was at the alarming level of about 3%.

1:17:37All right. What happened? The Dow crossed 1 ,000 for the first time ever in 1971. one. That's a shockingly low number today. But it bottomed in 1982, 11 years later, I believe the number was 700. So you were down by a third on an 11-year basis at a time when inflation was running double digits a lot of the time. So a lot of money was lost. Bonds had a horrible time. Interestingly, there was something called the yield book back in the early 70s, which was big bond houses like Solomon Brothers had a book that allowed you to convert yield to price. And the book stopped at 6%. So a friend of mine, Marty Leibowitz, became one of the youngest partners in the history of Solomon Brothers by dint of using a calculator to create a yield book that went beyond 6%.

1:18:50and yields reached 12 % in late 74, early 75, reached 15 % in 1982 with T-bills cresting at 20 % in 1980. If yields are going from T-bills going from three to 20 in a dozen years, that's not going to keep pace with inflation. If bonds follow suit, you're having capital losses on the bonds because higher yields mean lower prices. So it was the worst decade in history for the bond market. And it was one of the worst decades in history for the stock market. only parts of the 1930s were worse. So you have periods of time, stagflation is a terrible thing. And current policy seems to be reckless on the spending side.

1:19:54Before the call, or early in the call, I mentioned that our work on spending suggested that spending leads to slower growth. If you have soaring spending, you're going to have sluggish growth. If you have soaring spending and there's no place to put it and it makes its way into the economy, into people's pockets for spending, inflation is just a matter of supply and demand. More money in your pocket means more demand. Disincentives for creating goods and services creates reduced supply, supply chain disruptions from over-regulation. lead to reduced supply. Higher demand, lower supply means inflation.

1:20:36It's that simple. And people overlook the fact that it's that simple. In the 70s, we had soaring inflation that didn't get under control until Volcker took drastic measures and imposed extreme pain, imposing a double dip severe recession on the country. He got away with it because the country had experienced inflation for a decade and was just sick of it. I don't think our country is sick of it enough yet to demand harsh medicine, nor is this Fed showing any signs of wanting to impose harsh medicine. So I look on the current situation as having downside risk that's comparable to the 70s. Now, a lot of what we've been talking about is bad news or dangerous news.

1:21:31I'm an optimist long-term. Bottom line is we're in the best of times. Politicians get votes and media gets eyeballs by promoting fear and anger and talking about how awful things are. Things are actually pretty damn good. And that's part of the reason that the markets are so expensive. They're expensive because you can look way down the road and accept a relatively low excess return, a relatively low risk premium, a relatively low discount rate. You can't do that in a world of horrific tumult, short life expectancy, and high risk. So in some ways, we're in the best of times. Yeah. And then relating all that to the portfolio side, you can drastically reduce the risk of suffering pain through an environment like the 70s or the 2000s by just being better diversified and known things that do well in those environments.

1:22:29Is that right? Absolutely right. So if we look forward to growth and inflation, and in particular, what's discounted, when you look at that, where do you see the asymmetry and the mispricing? I see the asymmetry between growth and value. As with the summer of 2020, the bricks and mortar side of the market is being written off as dead. You mentioned earlier the difference between growth and value companies and growth and value stocks. the simple fact is a stock is not a company stock is an investment in a company which can be expensive if the growth prospects of the company are perceived as brilliant or cheap if the growth prospects are perceived as lousy that embedded narrative is the expectation the reality is different from that and And you can have a growth stock that is disappointing as a company, and you can have a value stock that exceeds expectations as a company.

1:23:42The narrative in the summer of 2020 was that the bricks and mortar businesses were going to see rolling bankruptcies, the likes of which we've never seen. It didn't happen. It didn't happen partly because of massive stimulus, which did cherry pick winners and losers, but was also a flood of money that helped companies survive. And also the vaccine coming along just a year into the pandemic meant that we could go back to business as usual quicker than we would have otherwise. So the value companies did fine. Right now, we're again in a narrative where the growth companies are creating artificial intelligence that will radically reshape our future.

1:24:33And these companies are amazing and will be massively successful. They are amazing. And they might be massively successful. They are massively successful today. They may have headwinds in the future. I don't know. But the value companies are also doing fine. Most of them are doing just fine, which means that the pricing that says these bricks and mortar companies are in deep trouble doesn't make sense. They're too cheap. So I look at the disconnect between value companies and value stocks. Value stocks are cheap. They can see stupendous growth in price, even if the companies don't see stupendous growth in the underlying business because they're priced to reflect an expectation of really bleak outlook, which isn't fair.

1:25:27I mean, those companies, a lot of those companies are doing fine. And how do you think about just the consensus view on economic growth for the economy as a whole and also inflation? What's priced in for inflation and where do you see the asymmetry in those two metrics? Okay, there's four warning signs that are flashing amber. How is it that this economy is booming in the face of those headwinds? very, very simple answer, a wealth effect from a bull market and consumer spending. During the pandemic, consumers were spending like there's no tomorrow because a lot of them thought there would be no tomorrow, so might as well spend it.

1:26:09And those patterns die hard. Once you've gotten accustomed to overspending, it's hard to cut back. So overspending means credit card debt starting to soar, cash reserves depleted, that's happening. And with consumer spending being elevated and a wealth effect from the stock market, those are holding the economy up. Now, the question is, will the four measures that I just described improve back to historic norms before this runs out of steam? If it does run out of steam, then you get a slowdown at least and a recession not improbable. Jamie Dimon about two weeks ago was quoted saying a hard landing is not off the table.

1:27:01It could easily happen. We would agree with that. We would agree that a hard landing is not off the table. It's not the high odds central expectation, but the notion of a booming economy with persisting well into the future, with inflation continuing to moderate on the downside, is the consensus of the market today. And both of those risks are asymmetric. Inflation risk is asymmetric to the upside. Economic growth risk is asymmetric to the downside. and we're spending like there's no tomorrow, which leaves little dry powder for trying to stimulate our way out of a recession if we have one. Not that stimulus works very well anyway.

1:27:51It only works on a very short-term basis. So we're looking at an array of risks, which in a perfect storm would lead to a return to stagflation of the 1970s. I'm not saying that as my central expectation. I am saying it is a risk that is not priced in by the market. So having a little part of your portfolio that would do well in that circumstance is a very good idea. You don't invest all your money in that. You diversify. AI is going to have massive long-term economic implications and it's going to change the footprint. Do you see asymmetry in its outlook? Do you think it's equally likely that it underperforms the lofty expectations that currently exist or outperforms?

1:28:43AI is going to outperform lofty expectations, but on a much longer horizon than the market currently thinks. AI is not new. I was doing neural networks in the 1980s. They didn't work very well. That's where I first realized that if you have thousands of samples of data, AI is useless. But AI has been around for decades. AI has been used in significant ways for decades. The military uses it for fast response. High-frequency trading companies use it to figure out which way the next tick move is going to be. These are great applications for AI. What is new is user-friendly AI. You can type a question into chat GPT, or if you're a graphic artist, you can You ask Dolly to paint you a picture of thus and such and just describe it and have it done.

1:29:56And it's shockingly good, but it's also not ready for primetime. When ChatGPT first came out, I asked ChatGPT to write me a children's bedtime story with knights and unicorns. And it came out with a 500-word story that was so sweet, so nice, and so fun that any Chaz book author would have been thrilled to put their name on it. I then asked it to write my bio, and it said that I had an MBA from the University of Chicago and started my career at Goldman Sachs, all of which is news to me. But that's often referred to as AI hallucinations. AI gets basic facts totally wrong. So it's not ready for prime time, but it will be very soon.

1:30:44And uptake by people using it will take longer. It's just like Facebook and Google weren't even around, but they were new a few years into that decade. And they weren't widely used until a few years after they became readily available. Same thing holds true for user-friendly AI. It's going to be big. it's going to change the world over the next 20, 30 years more and in more ways than we can possibly anticipate today. But it'll take time. And so that's where the market's got it wrong, I think. The market is projecting that the near-term growth will be stupendous and the headwinds non-existent, and also assumes that the winners of today will be the winners of 5, 10, 15, 20 years from now.

1:31:41Like I said, the 10 most valuable tech stocks in the world in the year 2000, zero had beat the market 15 years later. That's a shocker. It is. Rob, I appreciate you sharing your insights with us today. And I enjoyed the conversation. I hope you did as well. Alex, this was great fun. Thank you very much. And thanks for the great roster of questions. Thanks for listening. We hope you enjoyed this episode. Please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast. If you have questions, feel free to email us at info at insightfulinvestor.org. And if you enjoyed the discussion, please subscribe to this podcast to ensure you don't miss future episodes.

1:32:30And don't forget to forward today's conversation to others you think would enjoy listening. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of Evoke Advisors, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations, nor reference past or potential profits. And listeners are reminded that securities trading, commodity trading, and alternative investments are complex, and carry a risk of substantial losses.

1:33:10As such, they are not suitable for all investors.

1:33:17Listeners should be aware that guests featured on The Insightful Investor may have current or past associations with Evoke advisors or the host, including as an investment manager of a private fund opportunity by Evoke, or access through an affiliated Evoke fund, or as a client. Participation as a guest on the podcast should not be perceived as an endorsement or testimonial with respect to Evoke Advisors, the podcast host, or their services. Similarly, the inclusion of a guest on the podcast does not imply that Evoke Advisors or the host endorses the guest or any company with which they may be affiliated or employed.

1:33:56Evoke has neither paid nor received compensation from guests for their participation. Thank you.