The Bubble You Can't Short | Rob Arnott on What You Can Do Instead

Key Concepts

• Bubble Definition: Implausible growth assumptions to justify current prices, with marginal buyers driven by narrative over discounted cash flow (DCF) models.
• Dot-com Bubble Lessons: Disruptors get disrupted; narratives shape prices; bubbles can burst without collapsing the entire market.
• AI Revolution: Expected to be more transformative than the internet, with broad societal benefits but potential for infrastructure builders to face challenges.
• Capex vs. R&D: R&D expenditure is positively correlated with subsequent stock success, while Capex tends to be negatively correlated.
• Fundamental Indexing (RAFI): Weights companies by business size rather than market capitalization, rebalancing to trim overvalued stocks and add undervalued ones.
• RAFI's Performance: Outperformed MSCI ACWI Index by approximately 2.5% annually over 20 years.
• Valuation Disparity: US stocks, particularly growth stocks, are expensive (Shiller PE of 40), while international and emerging markets offer significant value.
• RAFI Growth Index: Selects companies based on observed growth rates (sales, cash flow, R&D) and weights them by dollar magnitude of growth.
• RAFI Cap-Weighted Index (RAQQ): Aims to improve upon traditional cap-weighted indexes by using company size for additions/deletions, reducing "buy high, sell low" behavior.
• Emerging Markets Value: Presented as the most attractive major stock market investment for long-term investors, with high expected returns.
• Long-Short Strategies: Potential for significant alpha generation by leveraging the performance difference between RAQQ and the S&P 500.

Bubble Identification and Characteristics

The discussion begins by defining what constitutes a market bubble. The core definition has two parts:

1. Implausible Growth Assumptions: To justify the current price of an asset, one must make growth assumptions that are not impossible, but highly implausible.
2. Marginal Buyer Psychology: The marginal buyer is not focused on fundamental valuation metrics like discounted cash flow (DCF) models. Instead, they are driven by the prevailing narrative or story surrounding the asset.

A crucial cautionary note is emphasized: "Never short sell a bubble." Bubbles can persist and expand far beyond what investors might anticipate, making aggressive bets against them extremely risky.

Bubbles are also characterized as being asset-specific, not permeating entire markets. The example of Palantir is used to illustrate this: a market value exceeding half a trillion dollars with trailing twelve-month revenues of only $3 billion. The speaker argues that for Palantir's valuation to be justified, its revenues would need to grow from $3 billion to $100 billion or more within a decade, which is deemed implausible. The marginal buyer of Palantir is driven by its story, not a DCF analysis.

Lessons from the Dot-com Bubble

The conversation draws parallels between the current market and the dot-com bubble of the early 2000s, highlighting several key lessons:

• AI vs. Internet: While AI is considered a more significant technological revolution than the internet, the similarities in market dynamics are striking.
• Top Dot-com Companies: An analysis of the top six most valuable companies at the start of 2000 (Microsoft, GE, Cisco, Intel, Lucent, Nokia) reveals a stark reality: only one (Microsoft) has outperformed the S&P 500 over the subsequent 25 years. Five of these companies have delivered negative returns.
  • Microsoft: Took 18 years to beat the S&P 500.
  • GE: Declined significantly.
  • Cisco: Grew at an average of 8% annually, far below the 40% growth projected by its CEO.
  • Intel: Has been disrupted multiple times by competitors like AMD, ASML, TSMC, and Nvidia.
  • Lucent: No longer exists.
  • Nokia: While still existing, its market position has drastically diminished.
• Disruptors Get Disrupted: A fundamental lesson is that even companies that disrupt existing industries are themselves vulnerable to disruption.
• Narratives Shape Prices: The market narrative can inflate prices beyond fundamental justification. Investors should be wary of narratives and look for where they might be "off-target." In the dot-com era, the narrative was correct that the internet would change everything, but it underestimated the time it would take. It was also wrong about the durability of many companies' competitive advantages.
• Bubble Bursts and Market Impact: The dot-com bubble burst in March 2000. While the NASDAQ experienced an 80% drop, the median stock in the Russell 3000 was up 20%, and small-cap value stocks were up 53%. This illustrates that bubble bursts do not necessarily drag down the entire market uniformly. The bull market for average stocks continued for two years after the tech-heavy indexes collapsed.

Practical Investor Takeaways and RAFI Indexing

Given the concentration of portfolios in large-cap tech stocks, practical advice for investors is offered:

• Diversification: Investors should consider diversification beyond the dominant tech darlings, including other asset classes and sectors.
• Fundamental Indexing (RAFI): Research Affiliates (RA) pioneered the Fundamental Index (RAFI) approach.
  • Methodology: RAFI selects the 500 largest businesses in the US (not by market cap, but by business size) and weights them by their economic footprint. This naturally downweights growth stocks and the "Magnificent Seven," which constitute a disproportionately large share of the S&P 500 (34% vs. 18% in RAFI).
  • Rebalancing Alpha: RAFI employs a rebalancing strategy that trims stocks whose prices have soared without fundamental validation and adds to stocks that have tanked without fundamental justification. This contrarian approach aims to turn market volatility into alpha.
  • Performance: Globally, RAFI has outperformed the MSCI ACWI Index by approximately 2.5% per year over the last 20 years, with a low tracking error. It has beaten ACWI in 15 out of 20 years.
• Value Investing: Value is currently considered very cheap historically. RAFI offers a strong value tilt.
• Broader Diversification: Investors should look beyond mainstream US stocks to liquid alternatives and international markets.
  • US Valuation: The US market has a Shiller PE ratio of 40, which is in the top 1% of historical valuations, comparable to the dot-com peak.
  • Value Valuation: US value stocks are in the bottom 2-3% of historical valuations.
  • International Markets: Non-US stocks trade at roughly half the valuation multiples of US stocks. Emerging markets are priced at a Shiller PE of about 12 (70% cheaper than the S&P 500). Emerging markets RAFI trades at a single-digit Shiller PE.
• Long-Term Outlook: While short-term performance is uncertain, the speaker expresses strong conviction that emerging markets, RAFI, and emerging markets value will significantly outperform the S&P 500 and US growth stocks over a 10-year horizon. The current pricing of US growth stocks is "priced for perfection," assuming no future disruption.

AI Capex Spend and Historical Context

The discussion shifts to the massive capital expenditure (Capex) in Artificial Intelligence (AI):

• Capex vs. R&D: Historically, R&D expenditure is positively correlated with subsequent stock success, while Capex is negatively correlated. Capex can be seductive but dangerous, as it doesn't guarantee profitability.
• Creative Destruction: A healthy capitalist system involves creative destruction. Companies that spend carelessly on Capex risk being displaced by more efficient competitors.
• Nvidia's Customers: While Nvidia has happy customers willing to pay high prices for its chips, these customers are currently struggling to transform that Capex into revenues and profits. The Capex spend by AI companies is significantly larger than the revenues generated by that spend. This situation is compared to the dot-com bubble.
• AI as a Revolution: AI is acknowledged as a profound technological revolution, potentially the biggest in the last half-century or even in technological history. However, like previous revolutions (steam engine, railroad, telegraph), the primary beneficiaries are often the end-users, not necessarily the infrastructure builders.
• Broad Beneficiaries of AI: The speaker believes everyone will benefit from AI, even those not directly involved with technology. Examples include autonomous vehicles and retailers using AI to enhance customer reach.
• Disruption of Business Models: AI is already disrupting established business models. OpenAI's ChatGPT has challenged Google's core advertising-based search engine model. The rapid emergence of competing AI tools (e.g., DeepSeek) highlights the dynamic and unpredictable nature of the AI landscape.
• OpenAI's Financial Projections: The speaker questions OpenAI's commitment to $1.4 trillion in spending and investment alongside its customers, given its current revenue run rate. This is seen as another example of implausible growth assumptions characteristic of a bubble.
• Historical Technological Revolutions: The speaker draws parallels to past revolutions like the railroad and telegraph, where infrastructure investment led to societal progress but not always profitability for the builders.
• Personal Use of AI: The speaker shares personal experiences using AI for research (demographics) and content creation (generating images for research papers), noting the significant efficiency gains and the potential disruption to professions like graphic design.
• Job Market Impact: Technological revolutions historically lead to job losses in some sectors but also create millions of new jobs. The speaker dismisses the Luddite fear of job losses, citing historical examples like the mechanization of looms and the advent of computers.
• Productivity Growth: Technological revolutions are essential for sustained productivity growth. Without them, economies can stagnate.

Index Construction and RAFI's Innovations

The conversation delves into RAFI's work on index construction, aiming to create better investment vehicles:

• RAFI's Trifecta: RAFI has developed three key innovations:
  1. RAFI Fundamental Index: A superior approach to value investing, outperforming value indexes significantly over 20 years.
  2. RAQQ (Research Affiliates Cap-Weighted Index): Aims to improve upon traditional cap-weighted indexes by using company size for additions and deletions, reducing the "buy high, sell low" behavior inherent in committee-selected indexes like the S&P 500. RAQQ has outperformed the S&P 500 by 81 basis points annually with high correlation and overlap.
  3. Fundamental Growth Index: A new approach to growth investing.
• Rethinking Growth vs. Value: The traditional binary classification of stocks as "growth" or "value" is challenged. A stock being expensive doesn't automatically make it a growth stock; it means it must grow to justify its price.
• Fundamental Growth Methodology:
  • Selection: Companies are selected based on their observed growth rates (3-5 year growth in sales, cash flow, and R&D spending). The top 25% fastest-growing companies are chosen.
  • Weighting: Companies are weighted by the dollar magnitude of their growth, not their market capitalization. This gives more weight to larger companies experiencing significant absolute growth.
  • Performance: This approach has historically delivered approximately 4% per annum incremental return compared to the Russell 1000 Growth index. It also demonstrated resilience during the dot-com bubble, with "growth at a reasonable price" (GARP) companies outperforming frothy ones in the aftermath.
• Excluding "Expensive and Slow-Growing" Companies: Research indicates that owning expensive companies with sluggish growth is a poor investment strategy. Over 55 years of data, "cheap and fast-growing" stocks performed best, while "expensive and slow-growing" stocks significantly underperformed the market. RAFI's growth index aims to exclude these underperforming companies.
• Reinventing Cap Weighting (RAQQ):
  • Problem with S&P 500: The S&P 500 is not strictly the 500 largest market cap stocks and is subject to committee decisions. Traditional cap-weighted indexes exhibit "flip-flops" – stocks are added after they have soared and removed after they have tanked, leading to a "buy high, sell low" dynamic.
  • RAQQ's Solution: RAQQ uses company size for additions and deletions. This means stocks are added when they become among the 500 largest businesses, not just after a price surge. This approach reduces the damage from "flip-flops," leading to better performance. RAQQ has historically outperformed the S&P 500 by 69 basis points per year over 35 years.
• International Markets:
  • Underutilized and Underappreciated: International markets, particularly emerging markets value, are seen as undervalued and underappreciated.
  • Long-Term Outlook: The speaker believes emerging markets value offers the highest expected return (10% annualized) over the next 10 years, compared to US large-cap growth (1.5%).
  • Valuation Spread: The valuation spread between growth and value stocks is widest in the US, making international markets more attractive.
  • Narrative of American Exceptionalism: The narrative of US exceptionalism is priced into US stocks, making them expensive. International markets, especially Europe and Japan, have lower expectations, making them potential bargains if they merely meet bleak forecasts.

Conclusion and Future Research

The discussion concludes with a summary of key takeaways and a look at future research:

• Averaging Out: Just as averaging into cheap assets is important, "averaging out" of expensive assets by trimming holdings is equally powerful and often overlooked.
• Future Research: RAFI is exploring new areas, including a "fundamental growth" product and the feasibility of long-short strategies.
  • Leveraged Long-Short: A strategy involving heavily leveraging a long position in RAQQ against a short position in the S&P 500 has shown significant alpha generation in personal portfolios. The firm is investigating the regulatory and feasibility aspects of offering this as a product.
• Long-Term Perspective: The emphasis remains on long-term investing and identifying assets with the highest probability of outperformance over extended periods.

The conversation underscores the importance of rigorous data analysis, historical perspective, and a contrarian mindset in navigating market dynamics, particularly in the context of potential bubbles and transformative technological shifts like AI.