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- Rob Arnott, the chairman and founder of Research Affiliates, advises major Wall Street firms including Pimco.
- He recently co-authored a note outlining where the biggest bubbles exist in financial markets today and how to avoid them.
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It's often said that market bubbles are obvious in hindsight.
However, one of the most sought-after minds on Wall Street is challenging that notion and pinpointing where they've developed today. Rob Arnott, the founder of Research Affiliates, has also gone the extra step of laying out how to avoid bubbles in real-time.
This is a topic that's always been of benefit to investors, dating from the tulip mania of the 17th century to the housing bubble of the 21st. It's as relevant as ever today as stocks continue to smash new records in their longest bull run ever.
Not only do investors want to know about bubbles, but they want to learn about them from Arnott, whose roster of clients includes $1.8 trillion Pimco. He is also widely credited for pioneering smart beta as an investing strategy. His first exposition on bubbles, written in April 2018, still holds the record for his most-downloaded paper ever.
He recently followed up with tips on how to spot and avoid bubbles, with recommendations on how to profit from what he calls anti-bubbles. Below is his four-part manual.
1. Reduce exposure to bubble assets.
What specifically are these bubble assets, you ask? Arnott has a few answers, starting with the suspects du jour: bitcoin and cryptocurrencies at large.
He says bitcoin fits two of his criteria for defining a bubble: It is unlikely to ever hold a positive risk premium relative to bonds and cash, and plenty of its investors believe a popular narrative that could send its price higher and generate profits when they decide to sell.
"Consistent with our definition of a bubble, cryptocurrencies hold little chance of offering a positive risk premium relative to bonds or cash based on a reasonable expectation of future cash flows, which are by definition zero," Arnott said.
And then there's Tesla, Arnott's second concrete example of a present-day bubble. He says that the company has a slim chance of delivering on the cash flow it needs to justify its valuation or pay its debt.
He also argues that the company has lost its magic. Big announcements by Tesla CEO Elon Musk, from the Model Y reveal in March to the semi-truck unveiling in 2017, no longer supercharge its stock price. And, the market's outlook on Tesla has turned south this year, with several Wall Street analysts at firms including Goldman Sachs and Wedbush Securities downgrading their ratings.
2. Avoid market cap-weighted funds.
The issue with such funds is self-explanatory: they rely on stocks with the priciest valuations to drive returns. They create a positive feedback loop wherein the most expensive stocks have the greatest concentration and continue to attract the most investor dollars because they're the biggest.
For example, Facebook, Amazon, Apple, Microsoft, Netflix and Alphabet were responsible for 40% of returns of the Russell 1,000 index during the first nine months of 2018, before the market started to decline.
"The return from these stocks is well above normal levels, although not as dramatic as the return earned by technology stocks during the dot-com bubble in 1999," Arnott said.
3. Find 'anti-bubble assets.'
These refer to assets that meet the opposite definition of a bubble: they are likely undervalued.
They're hard to find in individual stocks because any company's stock can cheapen all the way to zero and never recover. But it's a lot less plausible for an entire sector to completely dissolve.
For instance, even though all the big banks were at risk of perishing during the 2008 financial crisis, it was unlikely that the entire financial-services sector would vanish. Arnott believed the sector was an anti-bubble candidate at the time.
These days, he points to emerging-market state-owned enterprises. Many investors don't have any money in them even though they're generating substantial profits and trading at valuations that will likely catch up to their future cash flows, he said.
4. Invest in value-based smart beta strategies.
Arnott finally recommends the investing strategy he pioneered - with a focus on strategies outside a relatively frothy US stock market.
"While emerging markets as a whole trade at much more attractive valuations than the US markets, value strategies within the emerging markets space are poised to deliver an additional 2% to 4% performance advantage over their cap-weighted counterparts," he said.