Picking Up Nickels in Front of a Steam Roller

by The Curmudgeon


Rob Arnott is one of the most respected names in global investing.  Founder & Chairman of Research Affiliates, Rob’s firm manages and licenses over $150 billion, including the PIMCO All Asset & All Authority Fund where he has 100% of his retirement account invested.  Mr. Arnott also sub advises mutual funds and ETFs for Schwab, Powershares and Nomura Securities.  


In a July 15, 2013 PIMCO webcast for investment advisors, Rob shared his view on various financial markets, said where the PIMCO All Asset & All Authority fund was invested and why.  This article summarizes his key points, especially related to U.S. equities.  We'll also review what Stephanie Pomboy of MacroMavens told Barron's this past weekend.


Rob Arnott on the Current Market Environment

On the July 15th call, Rob described the current state of the U.S. stock market as "a very late stage rally coming off already high valuations."  He said he has an "aversion to U.S. stocks" and has rebalanced his PIMCO All Asset & All Authority fund (PAUDX or PAUIX) out of risk assets and into what he referred to as "cheap assets," like emerging market equities and bonds. (The Curmudgeon notes that "cheap assets" have a decided tendency to get cheaper when they are in a strong downtrend).

The PAUDX/PAUIX portfolio is currently 37% in "Risk Off" assets, 22% in Low Beta assets, 16% in bonds and 21% SHORT U.S. equities (via PIMCO StocksPLUS AR Short Strategy Inst'l shares). That U.S. stock short position is the fund's largest single holding!


On the webcast, Mr. Arnott twice said that buying U.S. stocks now is like "picking up nickels in front of a steam roller."  It's simply not worth the risk at this late stage of the Fed fueled bull market, which he said was not at all healthy in terms of real economic growth.  PAUDX/PAUIX fund is keeping its "powder dry" by investing in "market neutral alternative strategies" at this time.  The fund "looks to acquire inflation protection assets at cheaper prices, if they sell off due to talk of deleveraging and the coming deflation."


Are stocks expensive? In the graph below, U.S. equities, as measured by the S&P 500, are shown to have a Shiller P/E1 of 23.2 (the latest Shiller P/E-as of July 15, 2016 -  is actually 24.6 ).  The 23.2 number represents a 43% premium to its long term average of 16 (the current 24.6 Shiller P/E is 53.75% premium!).  That's also way above the current S&P 500 P/E of 18.43 and the very controversial "forward P/E" of 15. 


When the Shiller P/E is in the 20 to 25 range (it's now at the very upper end), U.S. stocks have had an annualized 4% nominal 5 year return and a 1% annual 10 year return.  That's a fact, not a prediction!


The downward arrows in the figure below point to the asset classes that have been most effected (distorted?) by the Fed's QE and Zero Interest Rate Policy (ZIRP).  Rob noted that short term securities (e.g. 3 month T bills have a negative 2% forward real return - their nominal interest rate is effectively 0 and there's a 2% annual inflation built into the price of TIPS.   Note also that U.S. equities (S&P 500) are forecast to have only a 0.2% real yield2, but have a 5 year annual volatility of 18.3% - not a very good risk/reward ratio, especially at already expensive valuations as per the Shiller P/E Ratio described above.


Barron's: Mission Impossible Ahead- the Fed's job is to end the party, but how can it do so without crashing the building? 

"The credit market has provided the funding for all the shareholder goodies that have been holding stocks aloft,” Stephanie Pomboy of MacroMavens told Barron's Kopin Tan on July 13, 2013.  


Between January and the start of the tapering talk in late May, the stock market added $2.8 trillion in market value. But the size of the U.S. economy expanded just $500 billion, according to Pomboy. Credit issuance during this stretch totaled almost exactly $2.3 trillion (this is large companies issuing debt). As rates jumped recently, the pace of monthly credit issuance shriveled to $58 billion from $260 billion. "If growth - actual and borrowed - dictates where stocks are headed, then the quartering of issuance in the last six weeks portends ugly signs ahead," Pomboy added.

Closing Comment:

Indeed, second quarter GDP forecasts have come down significantly and now look to be at or below 1%. The U.S. stock market is expecting a significant pickup in growth in the third quarter of 2.5%, and the fourth quarter of 3.0%. With continued government spending cutbacks (sequester), higher crude oil and gas prices along with the real estate market likely to slow (due to higher interest rates), it is extremely difficult for the CURMUDGEON to see any acceleration in GDP or corporate earnings growth.

But the market really doesn't care about any of that now.   Only QE and ZIRP matter! We shudder to think what will happen when "the jig is up?"


Till next time.....................



1.   The Shiller P/E (popularized by Prof. Robert Shiller and known more formally as CAPE ratio or P/E-10) is the current price of the Standard & Poor’s 500-stock index divided by the past decade’s average inflation-adjusted earnings of the constituents of the index.

2.  The 0.2% real yield on the S&P 500 assumes NO PRICE CHANGE in the coming year.  It's not a total return forecast, but rather the nominal yield minus the expected annual inflation rate.


The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.