Arnott on All Asset

Arnott on All Asset, April 2016

Rob Arnott, head of Research Affiliates, shares his firm’s market insights and allocation strategies for PIMCO All Asset strategies.

What are the catalysts that can trigger the start of a Third Pillar bull market, or has the "turn" already happened?

Robert Arnott: I’m asked this question at almost every client meeting! People want to know what they’re waiting for, or why they should stay the course. Firstly, the turn may have already happened. We’ve rebounded over 1000 basis points from the January lows. More on this shortly.

The punditry loves to speculate on what catalysts might drive the next market turn. As the late Yogi Berra famously remarked, “It’s tough to make predictions, especially about the future.” How can anyone know, with any proven accuracy, what market shocks are coming, or when? It’s a myth that anyone can confidently identify catalysts in advance. Even with the benefit of knowing how things turned out, it’s often difficult to identify catalysts after the fact.1

In a world dominated by short-term thinking, investors believe catalysts should be known ahead of time. The reality is that catalysts are, by definition, surprises. When valuations are extreme, turns become inevitable. A small shift in sentiment is often all it takes to initiate a swing of the pendulum from extreme fear to extreme euphoria. It’s simply a question of timing, which is most uncertain.

That said, we’ve pointed out some potential triggers. Firstly, a strong dollar leads to weak domestic earnings (already self-evident) and bolsters earnings prospects for our trading counterparties (happening in some markets). Secondly, the end of zero interest rates brings some small measure of sanity back to the economy; ironically, this isn’t good for stock or bond prices, but it’s very good for reigniting long-term macroeconomic growth. Finally, the political landscape – the prospect of quasi-socialism, bashing of Wall Street, protectionism, and so forth – may sow seeds for further erosion in long-term growth.

And, let’s not forget the impact of “gravity”! And time. 60/40 is expensive; Third Pillar markets are cheap. The yield spread for the “third pillar” markets relative to 60/40 is at levels last seen in 1998.2 What happened after? The Third Pillar beat 60/40 in 13 of the next 15 years. From 2013 to 2015, we saw a 3-year bear market in Third Pillar markets, which is rare: only one Third Pillar bear market (1995-1998) was longer and deeper than this one. Meanwhile, US stocks are in a 7-year bull market, which is even rarer: there’s been exactly one longer bull market in the last 200 years! So, the “gravity” of relative valuations, and the “time” of a tired bull market in 60/40 and a jarring Third Pillar bear market, may be all the “catalyst” we need.

Average annual total return

Too many investors focus on short-term thinking, but we have no clairvoyant ability in anticipating short-term events or timing market peaks and troughs. Instead, we prefer to focus on our competitive advantage. We assess which markets are cheap and which are rich; we gauge which long-term market prospects may be under-recognized by most investors; we respond in a deliberate, contrarian fashion; and we exhibit patience through the inevitable spans of adversity, knowing valuation ultimately prevails.

We’ve seen a rebound in the Third Pillar, up more than 7% in March alone. Our strategies have rebounded more than 1000 basis points from their January lows. Has the turn happened, or is this just a temporary blip? Time will tell.

Because we cannot know when markets turn, we “average out” of frothy markets before they peak, and “average in” to attractively priced markets before they hit bottom. As a result, we’ll always look a bit stupid – indeed, progressively more stupid, as we buy on the way down and sell on the way up – before the turn. The advantage is we wind up with peak exposure at a market low, and minimum exposure at a peak. While this is the painful part of contrarian investing, it is ultimately how we add value over the full cycle.

Q: The All Asset strategies have lagged 60/40 investing for three years. How do you expect to recover from this shortfall? What's the likelihood of achieving this outcome?

Arnott: After a punishing three years for contrarian and value investors, the early months of 2016 have been encouraging. Buoyed by a modest rebound in inflation expectations, in the appreciation of EM currencies, and in value vs. growth stocks, the All Asset and All Authority strategies returned 5.20 and 5.56%, respectively, March YTD. In this quarter, we’ve recouped about half of last year’s shortfall, while outperforming a U.S. 60/40 portfolio by over 300 bps.

Will these tailwinds persist? We cannot know. But, we do know Third Pillar markets are cheap. As of March 31, we believe a Third Pillar–based strategy would have a prospective blended average real return potential that is 5.5%, versus less than 1% for 60/40.3 That’s not unprecedented; the spread was a bit bigger after the “Asian Flu” in 1997–98, after emerging markets suffered a debt, default and currency crisis. What a fabulous time to load up on those markets! We’re confident in five years, Third Pillar–based strategies such as the All Asset and All Asset All Authority can potentially deliver impressive results, even if valuations and spreads don’t “mean-revert” toward historical norms. If they do mean-revert … wow.

Let’s delve into these return prospects. We’re getting paid to diversify. A spread of approximately 4.5% represents a higher return for the Third Pillar vs. 60/40 in steady markets; that’s a big cushion against adversity. It bears mention that this estimate ignores any impact from mean reversion. History powerfully supports mean reversion, though it’s reliably unreliable: the fact it’s gone against us over the last three years tells us nothing about when it’ll kick in. The further the rubber-band is stretched, the more powerful the pressure for mean reversion, and the lower the likelihood of continued adversity. We think mean reversion is far more likely over the coming 3 to 5 years than stasis.

How far is the rubber-band stretched today? The yield spread for Third Pillar assets relative to 60/40 widened from 0.9% three years ago, to 2.8% at the height of market volatility in February 2016 – its highest level over the last seven years and hovering near its top historical quartile since 1995. While past is never prologue, we shouldn’t ignore history’s lessons. Over the last 20 years, when starting yield spreads were stretched to 2.8% or more, spreads subsequently narrowed nearly 70% of the time over the next three years,, and in 98% of all five-year spans. The early stages of Third Pillar bull markets, like those in mainstream stocks and bonds, can be fast and impressive!

Likelihood of yield spread reversion

When yield spreads tumble, the excess returns can be substantial. If the yield spread compresses by just 1% (around halfway back to historical norms), that translates into about 1600 bps of outperformance.4 Suppose this happens over five-years; adding in the difference in the aforementioned baseline expected return, a Third Pillar strategy should outpace 60/40 by roughly 7.5% per year, compounded. History supports this prognosis: in the last 20 years, when the spread was as wide as it is today, the Third Pillar outperformed a 60/40 portfolio by about 8% per year over the following five years. That’s how far this rubber-band is stretched!

The expected five-year return difference has about 3.5% uncertainty.5 If this analysis is correct, then it would be a two-sigma event for a Third Pillar–based strategy to have any shortfall against 60/40 in five years.6 It would be no less unlikely  for a Third Pillar–based strategy to outperform 60/40 by 15% per annum. The range of outcomes is wide, but the tilt to the upside is remarkable. It’s the type of wager we’ve routinely chosen, which has served us well over the lifetime of our strategies.

We’re in the only business in the macroeconomy in which customers hate bargains. Whatever’s most expensive usually has two attributes: terrific past returns and lousy future returns. And yet, most investors chase past returns, knowing full-well past returns don’t predict future returns. Any bargain can have two attributes: lousy past returns and terrific future returns. Most investors flee bargains. We don’t. We buy more.



1 What was the proximate catalyst that broke the tech bubble? I have yet to hear a convincing answer – other than "gravity" – despite sixteen years to identify the catalyst.

2 The yield spread is calculated as the yield difference between an equally-weighted basket of Third Pillar asset classes and a 60% S&P 500 / 40% Barclays Aggregate portfolio. The Third Pillar Indexes and dates in which the yield data is available are as follows: Barclays Capital U.S. High Yield (January 1987), JPM GBI-EM Global Diversified Yield (December 2002), NAREIT Total Yield (January 1972), JPMorgan TIPS Index 10+ Year (May 1998), MSCI EM (May 1995), and Bloomberg Commodities (December 2004). The "implied" commodities yield is calculated as the sum of the total spot valuation change component of expected returns, and the yield of JPM TIPS 10+ Year Index.

3 The Third Pillar is a blend of the following Indexes: JPM GBI-EM Global Diversified Composite, Barclays Corporate High Yield, JPM Leveraged Loan Index, Barclays US Treasury Inflation Note 10+ Year, FTSE NAREIT All REITs, and FTSE Emerging Market RAFI, weighted using respective allocations to these asset classes in the All Asset strategy as of March 31, 2016. 60/40 is a blended portfolio of 60% S&P 500 Index / 40% Barclays U.S. Aggregate Index.

4 If the yield spread narrows as a consequence of rising yields on the 60/40 side, it requires roughly a 22% bear market, for a balanced portfolio, worse for the stocks alone. If it happens due to falling yields on the Third Pillar side, it requires revaluation upward by about 10%. Basically, this suggests a mid-point expectation of about 16%, or about 3% per year. Add this to the "carry spread" of 4 to 5%, and we're looking at an expected return difference of about 7-8% per annum.

5 The 3.5% uncertainty is calculated as the 7.5% per annum expected return differential divided by the square root of five years.

6 Given a standard deviation of 3.5%, a two-sigma negative event is represented by an expected return difference of 7%, essentially washing out the approximate +7.5% per annum return difference.
The Author

Robert Arnott

Founder and Chairman, Research Affiliates

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