Those crystal-ball gazers still plying their craft in the vicinity of Wall Street are bound to be feeling more bullish these days when they crowd into their favourite watering holes, redolent once again with the smell of money.
The surviving investment banking giants are posting dazzling profits, trading revenues are soaring, new corporate bond issues are flying out the door at a record clip and the plethora of surprises so far this earnings season have mostly been of the positive kind. As one financial type visiting lower Manhattan last week noted: “Everything on Wall Street, or almost, seems to be back, and more so.”
Some of the news flowing from the real economy seems promising too. Amid further gloom on the labour front, U.S. housing shows signs of stabilizing. And the U.S. Conference Board's closely watched index of leading economic indicators, regarded as a useful gauge of how the economy will fare over the next couple of quarters, has climbed to its highest level in two years.
Phew! Glad that crisis is over. Now back to the races. But the crisis isn't over.— Rob Arnott
It was all enough to prompt such an estimable strategist as Ed Yardeni to conclude that despite the challenges, “I think we are in a bull market.”
Mr. Yardeni went on to say “I believe that the economic expansion is likely to be increasingly self-sustaining.”
So why isn't famed money manager Rob Arnott, who was uncharacteristically bullish when we chatted about market prospects earlier this year, joining the growing line at the punch bowl?
“At the beginning of the year, I thought the market was priced for Armageddon,” which made badly mauled sectors hugely attractive, Mr. Arnott said the other day from his perch in southern California, about as far from Wall Street (where he once toiled as an equity strategist) as he could get.
Now the markets are largely priced as if they're suffering from collective amnesia: “Phew! Glad that crisis is over. Now back to the races. But the crisis isn't over. We're enjoying the eye of the storm. It still has a lot of winds and a lot of waves coming.”
One of Mr. Arnott's guiding investing tenets is to make sure you get paid for the risks you're taking. And right now, he insists, that just isn't the case for much of the market.
“My view is pretty starkly different from what it was nine months ago,” said the chairman of Research Affiliates, which manages more than $20-billion (U.S.) of other people's money.
What we're seeing is value priced as if Armageddon isn't right next door; but it might be three or four doors away. And the growth side is priced as if the troubles are over and it's back to the races.— Rob Arnott
“I thought we were setting the stage for capital markets to give pretty respectable returns for the next three to five years, even as the economy was likely to struggle. Instead, we got at least three of those years shoehorned into [eight] months. We've had some wonderful returns. And those who were willing to take risk have been amply rewarded. But now you're getting paid less for the risks than you should.”
Mr. Arnott is well known in investing circles as an architect of fundamental indexing, which assigns weightings to stocks based on a combination of measures of economic success – sales, profits, book value and dividends. It ignores market capitalizations, the basis of traditional indexes.
His approach naturally colours his investing strategy in a deep value hue, while cap-weighted indexes typically ride the growth stock train to ever higher allocations. Right now, growth is trumping value in the U.S. market by an historically wide margin.
For example, the price-to-book value of stocks in the Russell 2000 value index is currently less than half the level of the Russell growth stocks. Normally, they trade at a 30-per-cent discount.
“What we're seeing is value priced as if Armageddon isn't right next door; but it might be three or four doors away. And the growth side is priced as if the troubles are over and it's back to the races. That doesn't make sense.” If the growth story is right, then value stocks are cheap. And if the value bets are on the money, growth stocks are ridiculously expensive.
It's not hard to guess where Mr. Arnott stands in this seemingly endless tussle between growth and value. The last time we spoke, he was extolling the virtues of such deeply battered U.S. sectors as financials, consumer discretionary and industrial stocks.
“I still am. The investments that make sense in this environment are deep-value stocks, which are priced for a fairly tough economic slog, and inflation-linked bonds, because they're priced to reflect fairly low inflation expectations at a time when governments around the world are setting a trillion-dollar bonfire every few months.”
He also favours low-volatility assets – cash and short-term credit. And above all, he reminds me again: “Now is the time to be reining in risk.”
