WEBVTT - Arnott on Bubbles and Valuation Gaps 0:00:13.480 --> 0:00:17.560 Hello, and welcome to What Goes Up, a weekly markets podcast. 0:00:17.680 --> 0:00:19.880 My name is Mike Reagan. I'm a senior editor at 0:00:19.880 --> 0:00:23.720 Bloomberg and Humble Donna higher Across Asset Report at Bloomberg, 0:00:24.280 --> 0:00:27.600 and this week on the show, Well, crypto is raging again. 0:00:27.800 --> 0:00:31.200 Stocks are near record highs thanks to just a handful 0:00:31.240 --> 0:00:35.040 of companies really, and Tesla's market cap has surged past 0:00:35.080 --> 0:00:38.040 the one trillion dollar mark. It really makes you think, 0:00:38.240 --> 0:00:40.839 do you have to worry about being in a bubble again? What? 0:00:41.000 --> 0:00:42.960 We'll get into it with one of the best known 0:00:43.080 --> 0:00:47.199 experts in fundamental investing. But first, Phil Donna, I have 0:00:47.400 --> 0:00:50.920 to ask you about your adventure in n f T 0:00:51.159 --> 0:00:53.440 Land this week. I know, they actually allowed you to 0:00:53.520 --> 0:00:55.800 turn your computer off for once. I think it's the 0:00:55.840 --> 0:00:59.000 first time your computer has been off in about eighteen 0:00:59.000 --> 0:01:01.520 months or so, a year and a half, a year 0:01:01.520 --> 0:01:04.560 and a half and you you you literally stopped typing 0:01:04.560 --> 0:01:06.680 and they let you go to the n f T 0:01:07.560 --> 0:01:13.040 Non Fungible Token Conference in New York. What was that like? Yeah, 0:01:13.200 --> 0:01:16.560 it was my first conference where I actually was with 0:01:16.680 --> 0:01:19.560 other people, because I've been to a bunch of you know, 0:01:19.720 --> 0:01:22.959 virtual conferences over the last couple of months, but um, 0:01:23.000 --> 0:01:26.119 it was it was strange to be around people. First 0:01:26.120 --> 0:01:29.200 of all, the second of all, the big the main 0:01:29.280 --> 0:01:35.000 event really was the after parties after the conference, and 0:01:35.040 --> 0:01:37.360 I hadn't realized that going in. So they were like 0:01:37.640 --> 0:01:41.160 twenty or thirty or some crazy amount of parties and 0:01:41.200 --> 0:01:46.240 everybody was just party hopping afterwards and talking about n 0:01:46.280 --> 0:01:49.160 f t s and cryptos and all kinds of stuff. 0:01:49.760 --> 0:01:52.400 I think that's the deal with all crypto conferences. It's 0:01:52.480 --> 0:01:58.520 just some whatever panel and then some big nightclub spectacle. Yeah, exactly, 0:01:58.960 --> 0:02:00.600 I had I had no I do you going in? 0:02:00.760 --> 0:02:03.680 So you know, I got invites to parties for the 0:02:03.720 --> 0:02:07.080 first time in my life, the first time. I do 0:02:10.360 --> 0:02:12.280 wish you here is our guest. Let's bring him in 0:02:12.680 --> 0:02:15.440 built out a britroduce our guests. Yeah, I'm so happy 0:02:15.520 --> 0:02:17.640 to have Rob are not joined us. He's the founder 0:02:17.680 --> 0:02:21.000 and chairman of Research Affiliates. Thanks so much for coming back. 0:02:21.680 --> 0:02:24.600 Oh it's a privilege. And Rob, you're in Austin. I 0:02:24.639 --> 0:02:27.079 believe right, you're getting some some traveling this week, Is 0:02:27.080 --> 0:02:30.519 that right? I have been on one of my first 0:02:30.720 --> 0:02:35.720 business trips in the last eighteen months and visited Arizona 0:02:35.760 --> 0:02:37.480 in Texas, and I have a couple of sons in 0:02:37.560 --> 0:02:42.520 tech in Austin, so I'm spending the weekend here. Oh good, enjoy, Robert. 0:02:42.639 --> 0:02:44.400 I want to bring you in on that notion of 0:02:44.480 --> 0:02:47.680 bubbles Uh. I was reading one of the slide deck guy. 0:02:47.800 --> 0:02:51.880 I think you had his a presentation recently. We're maybe 0:02:51.880 --> 0:02:54.160 it's just on your website. I'm not sure, but I 0:02:54.280 --> 0:03:00.960 was sort of fascinating by one one slide in the deck. Say, uh, 0:03:01.120 --> 0:03:04.280 we're talking about the notion of bubbles um. You say, 0:03:04.320 --> 0:03:08.880 We'll offer a simple two part definition. One, we're using 0:03:08.880 --> 0:03:13.160 a value valuation model, for example, discounted cash flow model. 0:03:13.200 --> 0:03:18.359 We must make implausibly optimistic assumptions in order to justify prices. 0:03:19.160 --> 0:03:23.000 And then number two is the marginal buyer doesn't care 0:03:23.040 --> 0:03:27.160 about evaluation models. I wonder to me, number two seems 0:03:27.200 --> 0:03:31.480 to be usually the case when you enter bubble territories, 0:03:32.080 --> 0:03:35.480 people just turn off the logic, They turn off, sort 0:03:35.480 --> 0:03:38.440 of turn these models off or just ignormal. Is that 0:03:38.920 --> 0:03:41.600 is that that your opinion of what usually happens? And 0:03:41.880 --> 0:03:45.480 are we seeing any any signs of that right now? Um, 0:03:45.520 --> 0:03:48.680 of course we're seeing signs of that, and when it 0:03:48.760 --> 0:03:53.520 comes to people ignoring valuation models, that is characteristic of bubbles. 0:03:53.640 --> 0:03:55.840 That's there really is a cross check on the first one. 0:03:55.880 --> 0:03:58.560 I mean, there are people who will say, gosh, you'd 0:03:58.560 --> 0:04:01.560 have to make implausible assumption is about Microsoft to justify 0:04:01.560 --> 0:04:07.480 its current market cap? Um? Okay maybe, But is the 0:04:07.520 --> 0:04:14.000 marginal buyer uh an unsophisticated investor who doesn't care about 0:04:14.080 --> 0:04:20.880 valuation hardly, and so you can readily scratch that off 0:04:20.880 --> 0:04:23.760 the list. With Apple, uh, you don't even have to 0:04:23.760 --> 0:04:28.120 make implausible assumptions. You just have to make moderately aggressive 0:04:28.120 --> 0:04:32.200 assumptions and you can easily justify the price. When it 0:04:32.200 --> 0:04:37.440 comes to things like Tesla and Zelo and u uh, Netflix, 0:04:37.480 --> 0:04:41.680 you have to make very, very very aggressive assumptions. Uh 0:04:41.760 --> 0:04:45.000 I debated Cathy would about a month ago at at 0:04:45.400 --> 0:04:49.640 morning Star conference and um I asked her, what's your 0:04:49.720 --> 0:04:54.400 valuation model that would justify a target price of three thousand, 0:04:55.240 --> 0:04:59.039 and she said, well, that's simple. Um, it's gonna grow 0:04:59.080 --> 0:05:04.120 eighty nine year for the next five years, and um, 0:05:04.160 --> 0:05:05.680 at the end of the five years, it will be 0:05:05.760 --> 0:05:09.960 valued at the same multiples as today's fang stocks. And 0:05:10.120 --> 0:05:12.720 I was thinking at the time, I've been asked to 0:05:12.760 --> 0:05:16.800 play nice, but I was thinking at the time, Uh, 0:05:17.640 --> 0:05:22.359 a year for five years, that is umfold growth. So 0:05:23.560 --> 0:05:25.400 is she really saying it will be twenty five times 0:05:25.400 --> 0:05:28.760 as large in just five years as it is today? Amazon, 0:05:29.200 --> 0:05:33.520 the biggest growth story of a generation, grew fourteenfold in 0:05:33.520 --> 0:05:38.600 the last ten years, So tescitly, she's assuming twice Amazon's 0:05:38.680 --> 0:05:44.360 growth um in half as many years. That's really aggressive. 0:05:45.120 --> 0:05:48.440 So when I hear numbers like that, I think, Okay, 0:05:48.520 --> 0:05:54.440 that's implausible, and therefore it's potentially bubble territory. How many 0:05:54.480 --> 0:05:59.000 people use a valuation model to justify buying hardly anyone, 0:05:59.720 --> 0:06:04.760 and so that qualifies for the definition. Well, Rob just 0:06:05.120 --> 0:06:07.560 I'm gonna pull up Mike greag in here and ask 0:06:07.560 --> 0:06:10.279 you a multipart question. But I was I was really 0:06:10.320 --> 0:06:13.200 listening to the episode the last time you were on 0:06:13.200 --> 0:06:16.080 on this podcast, and I believe you had mentioned the 0:06:16.120 --> 0:06:20.159 Tesla example. Uh, and I think you had said in 0:06:20.240 --> 0:06:24.000 the market, we're seeing microbubbles all the time, and correct 0:06:24.040 --> 0:06:26.720 me if I got the term wrong. And then I 0:06:26.760 --> 0:06:28.720 was what I was looking through one of your your 0:06:28.760 --> 0:06:31.600 slide decks that you had put together recently, and you 0:06:31.640 --> 0:06:35.279 had said something like, you know, what is an anti bubble? 0:06:35.320 --> 0:06:38.240 So I'm hoping you can describe to us what you're 0:06:38.480 --> 0:06:41.640 what you see going on, what you might consider a 0:06:41.640 --> 0:06:45.080 bubble or a microbubble. Uh and uh And what exactly 0:06:45.120 --> 0:06:48.920 is an anti bubble? Well, firstly, microbubbles are single asset 0:06:48.960 --> 0:06:52.440 bubbles um tesla. If you buy into the notion that 0:06:52.480 --> 0:06:56.240 it's a bubble, as we do, um, there's a microbubble, 0:06:56.360 --> 0:07:01.880 is just one asset? Tech? Is it a bubble? Nope, Tech, 0:07:01.960 --> 0:07:06.000 there's lots of companies where people use valuation models to 0:07:06.080 --> 0:07:11.240 justify buying uh and uh. You have to make aggressive 0:07:11.280 --> 0:07:16.080 assumptions to collectively justify today's tech waiting in the indexes. 0:07:16.560 --> 0:07:19.640 But you don't have to use implausible assumptions. So it's 0:07:19.680 --> 0:07:21.960 not quite like the tech bubble of two thousand in 0:07:21.960 --> 0:07:29.520 that regard um. Anti bubbles are markets or investments where 0:07:30.200 --> 0:07:34.200 you would have to make implausibly pessimistic assumptions in order 0:07:34.240 --> 0:07:38.640 to not earn a decent return. So let me give 0:07:38.680 --> 0:07:43.280 you an example. Um state owned enterprises in China and Russia. 0:07:43.680 --> 0:07:48.680 The narrative is, don't buy these. These are state owned. 0:07:48.960 --> 0:07:53.120 The state has the right and the power to appropriate 0:07:53.160 --> 0:07:57.120 your wealth at will, and you could put money there 0:07:57.240 --> 0:08:01.560 and get nothing. Absolutely true, Like most narratives, that's true. 0:08:02.480 --> 0:08:06.120 But if they want continued access to global capital, the 0:08:06.200 --> 0:08:09.880 likelihood is they'll continue the current dividends, they'll increase them 0:08:09.880 --> 0:08:13.000 with the growth of the economy, and you won't get 0:08:13.080 --> 0:08:16.440 much more than that. Okay, what's the yield on s 0:08:16.480 --> 0:08:21.480 O s in China and Russia? It's about five If 0:08:21.520 --> 0:08:24.560 it grows with inflation, let alone growing with the economy. 0:08:24.560 --> 0:08:28.400 That's a five percent real return. M hm our work 0:08:28.480 --> 0:08:31.400 suggests that real returns in bond markets around the world 0:08:31.440 --> 0:08:36.280 are negative and in stock markets in the US barely positive. 0:08:36.679 --> 0:08:42.080 So is a five real return pretty good? Yeah, you'd 0:08:42.080 --> 0:08:47.520 have to make implausible assumptions not to justify buying. And 0:08:47.640 --> 0:08:54.080 does the marginal seller care about valuation models? No, they're 0:08:54.080 --> 0:09:05.600 selling because of the narrative. They know they're cheap. So 0:09:05.679 --> 0:09:07.840 if you're in either a bubble or an anti bubble, 0:09:07.880 --> 0:09:11.200 and you this notion that the marginal buyer seller just 0:09:12.520 --> 0:09:16.320 is ignoring the valuation models, at least that's part of it. 0:09:16.640 --> 0:09:19.600 I mean, I'm guessing eventually, you know, what happens is 0:09:19.640 --> 0:09:23.480 something sort of you know, shakes people up and you 0:09:23.760 --> 0:09:27.559 sort of revert to caring about valuations again and correct 0:09:27.600 --> 0:09:29.400 me if I'm wrong about any of this. But you know, 0:09:29.480 --> 0:09:32.120 to me, the main candidate that would do that in 0:09:32.160 --> 0:09:35.200 this instance, a lot of people would would claim would 0:09:35.200 --> 0:09:39.360 be the Fed changing policy. And um, we did get 0:09:39.400 --> 0:09:42.480 a little hint this week, uh more than a hint. 0:09:42.480 --> 0:09:44.760 You know, the Fed is basically coming out and saying 0:09:45.000 --> 0:09:48.679 they do plan the taper asset purchases. Um, is that 0:09:48.800 --> 0:09:51.240 enough to do it? Or you know, is the policy 0:09:51.320 --> 0:09:54.920 still for the foreseeable future so loose that it shouldn't 0:09:54.960 --> 0:09:58.280 really sort of slap some sense back into the market 0:09:58.840 --> 0:10:03.160 right away, Cattle. This question is a fun one, um, 0:10:03.200 --> 0:10:05.560 because whatever the catalyst is, it's got to come as 0:10:05.559 --> 0:10:08.959 a surprise to the market. And what the market is 0:10:09.040 --> 0:10:15.160 unsurprised by is already baked into the price. So FED tapering, No, 0:10:15.559 --> 0:10:19.640 that's not a catalyst because it's totally expected. Um, But 0:10:19.720 --> 0:10:21.840 it is a fun parlor game to guess what the 0:10:21.880 --> 0:10:27.600 catalyst could be rising interest rates in the years ahead 0:10:28.080 --> 0:10:32.000 if that happens. There's a narrative out there that says 0:10:32.040 --> 0:10:37.160 growth stocks are worth a lot of money because you're 0:10:37.240 --> 0:10:41.320 discounting future growth at a very low rate, well below 0:10:41.400 --> 0:10:45.800 the growth rate, and so the value of future growth 0:10:46.200 --> 0:10:50.480 goes through the roof. No wonder these stocks are expensive. Well, 0:10:50.480 --> 0:10:52.640 it turns out if you go back historically and asked 0:10:52.679 --> 0:10:57.319 did changes in real rates effect the relative performance of 0:10:57.360 --> 0:10:59.920 growth and value, the answer is no. It's a right 0:11:00.679 --> 0:11:05.200 random relationship. There is no evident linkage in the data. 0:11:05.440 --> 0:11:10.440 So when you have a narrative that says growth stocks 0:11:10.440 --> 0:11:14.240 are starting because interest rates are falling, UH, it becomes 0:11:14.240 --> 0:11:18.640 a self fulfilling prophecy until it doesn't. And if it's 0:11:18.679 --> 0:11:23.520 a narrative that is incorrect, the self fulfilling prophecy is 0:11:23.559 --> 0:11:28.680 a self fulfilling prophecy that is in error, creating an inefficiency, 0:11:28.760 --> 0:11:32.560 creating a miss price, and creating an opportunity. So I 0:11:32.640 --> 0:11:36.680 look at that and I think, well, one catalyst for 0:11:37.400 --> 0:11:41.600 um FANG type stocks to take a hit would be 0:11:41.840 --> 0:11:46.880 rising interest rates. Another catalyst would be gosh, these companies 0:11:46.920 --> 0:11:50.560 have done awfully well partly because of COVID. Most of 0:11:50.559 --> 0:11:54.600 them are extraordinarily well positioned for a world UH with 0:11:54.720 --> 0:11:58.120 a pandemic. Most of them are well positioned for the 0:11:58.200 --> 0:12:03.160 aftermath of the pandemic because behaviors will change in their favor. Well, 0:12:03.200 --> 0:12:08.360 that's good, um. But by the same token, uh, I 0:12:08.440 --> 0:12:13.280 love to ask the question, what's what problems are we 0:12:13.400 --> 0:12:17.760 facing today that will be facing still in five years 0:12:17.760 --> 0:12:20.839 and what are going to be irrelevant in five years? 0:12:21.440 --> 0:12:25.520 Is COVID going to be uh stalking the world as 0:12:26.160 --> 0:12:30.640 uh a lethal death machine five years from now? No, 0:12:31.240 --> 0:12:34.920 We'll have global herd immunity by then. It'll still kill people, 0:12:35.160 --> 0:12:39.760 but not in vast numbers. Um. Is our supply chain 0:12:39.800 --> 0:12:44.640 disruption is going to be uh make breaking havoc with 0:12:45.440 --> 0:12:48.800 global economy five years from now? No? No, I mean 0:12:48.840 --> 0:12:51.719 that's a perfect example of the kind of thing that 0:12:51.720 --> 0:12:56.840 that a healthy economy figures out a fixed reasonably quickly. 0:12:57.320 --> 0:13:01.200 Are demographics still going to be an issue? Uh five 0:13:01.280 --> 0:13:04.000 years from now? My goodness? Yes? How often do you 0:13:04.040 --> 0:13:08.840 hear the media talking about the demography um our, debt 0:13:08.840 --> 0:13:11.160 and deficit going to be an issue five years from now? 0:13:11.760 --> 0:13:16.760 My goodness? Yes? And so it helps you focus on 0:13:16.840 --> 0:13:23.280 which relationships, which narratives deserve attention and which may just 0:13:23.400 --> 0:13:29.200 be roiling markets creating opportunities for you to contratrade. I 0:13:29.200 --> 0:13:31.280 want to take us back to something Mike mentioned in 0:13:31.320 --> 0:13:34.280 your introduction, which is that we're being pulled higher by 0:13:34.440 --> 0:13:36.679 just a handful of stocks, And I know it's something 0:13:36.720 --> 0:13:39.720 you focus a lot on and you've written about this 0:13:40.120 --> 0:13:42.960 quite a bit, so I'm I'm hoping you could break 0:13:43.000 --> 0:13:46.480 down for us what the concerns are around that, and 0:13:46.480 --> 0:13:50.440 then maybe you slightly hinted at the next part of 0:13:50.440 --> 0:13:54.400 my question, which is something we don't really hear about 0:13:54.559 --> 0:13:58.559 very frequently, which is what what actually might make that 0:13:59.000 --> 0:14:03.000 trend come apart? If that makes sense, it's under what 0:14:03.040 --> 0:14:05.079 what what would need to happen for the Big five 0:14:05.400 --> 0:14:10.760 to not be pulling stocks higher all the time? Well, firstly, 0:14:10.920 --> 0:14:15.920 plain old gravity can come into play. Uh. I'm often asked, uh, 0:14:15.960 --> 0:14:19.320 what finished off the tech bubble in the year two thousand. 0:14:19.800 --> 0:14:24.680 I have yet to hear are really compelling, uh, catalyst 0:14:24.840 --> 0:14:28.520 that could have caused the tech bubble to burst other 0:14:28.600 --> 0:14:32.760 than gravity? And so part of it may just be gravity. Now, 0:14:32.760 --> 0:14:34.960 you've got to be careful with bubbles because they can 0:14:35.000 --> 0:14:40.880 go far longer and carry much further than anyone might expect. 0:14:41.680 --> 0:14:44.960 My favorite example is the Zimbabwe stock market during their 0:14:45.040 --> 0:14:48.600 hyper inflation in two thousand eight. As you came into summer, 0:14:48.680 --> 0:14:53.200 you might have said this, country's got hyper inflation. It's 0:14:53.240 --> 0:14:56.520 a mess. I want to not only do I want 0:14:56.520 --> 0:14:58.960 to not own that that stock market, I'm gonna short 0:14:58.960 --> 0:15:01.800 sell it, but I don't know much about it, So 0:15:01.840 --> 0:15:03.960 I'm going to short sell two percent of my net worth. 0:15:04.960 --> 0:15:08.080 Well over the next six weeks, their currency fell tenfold 0:15:09.200 --> 0:15:13.520 and their stock market went up five hundred fold, five 0:15:13.720 --> 0:15:18.560 hundred fold, which means in US dollar terms, fiftyfold, which 0:15:18.600 --> 0:15:21.800 means you're short position just cost you a percent of 0:15:21.840 --> 0:15:25.160 your net worth. Eight weeks later, the currency had fallen 0:15:25.200 --> 0:15:29.680 another hundred fold and the stock market basically went to 0:15:29.800 --> 0:15:32.840 zero and stop trading. So you were right, but bankrupt. 0:15:33.120 --> 0:15:38.840 Be very careful about bubbles. Now the we look at 0:15:38.880 --> 0:15:43.239 the fangs, we actually broaden it to include Apple and Microsoft, 0:15:43.280 --> 0:15:47.600 the big winners from the first tech bubble. And what 0:15:47.640 --> 0:15:50.360 we find is those six companies, which we refer to 0:15:50.400 --> 0:15:53.320 as the fan mags, are worth more than the top 0:15:53.360 --> 0:15:57.000 five companies in the SMP five hundred. Why because the 0:15:57.040 --> 0:16:00.080 top five are all in the fan mags. Five of 0:16:00.120 --> 0:16:04.800 the six are the top five companies in the SMP UM. 0:16:04.840 --> 0:16:08.720 This level of concentration has not been seen since the 0:16:08.840 --> 0:16:14.200 late forties or early fifties. Um. And what's interesting is 0:16:14.240 --> 0:16:18.480 the total value of these six companies is approximately eight 0:16:18.480 --> 0:16:22.360 and a half trillion dollars. All right, that's just a 0:16:22.400 --> 0:16:25.440 really big number. Um. How do we put it into 0:16:25.440 --> 0:16:29.160 a context. Well, the entire stock market of Japan is 0:16:29.200 --> 0:16:35.680 six trillion, So you can buy Japan for these six companies. Uh. 0:16:35.960 --> 0:16:42.120 The three largest economies in Europe Germany, France and the UK, 0:16:43.160 --> 0:16:50.600 with collectively nearly two hundred million citizens, worth less than 0:16:51.720 --> 0:16:55.200 the fan max. So I look at that and I think, gosh, 0:16:55.240 --> 0:17:01.000 that seems awfully stretched and so um, I view that 0:17:01.080 --> 0:17:05.760 as kind of classic bubble territory. But like I said, 0:17:05.960 --> 0:17:08.000 bubbles can go on for a long time and can 0:17:08.080 --> 0:17:11.800 carry a long way. This is not a totally serious question, 0:17:11.840 --> 0:17:14.280 but I have you know you mentioned fanmags, and I 0:17:14.320 --> 0:17:17.360 know on Twitter there were so many jokes after Facebook 0:17:17.480 --> 0:17:19.760 changed its name to Meta. I don't know if you 0:17:19.800 --> 0:17:27.159 guys are reconsidering a new acronym. Uh no, um uh. 0:17:27.680 --> 0:17:34.280 We may want to replace Netflix with Tesla uh, which 0:17:34.320 --> 0:17:38.400 would turn it into fat mag. But never mind that 0:17:38.400 --> 0:17:44.240 that's a nice ring to it. Rob. So for listeners 0:17:44.280 --> 0:17:47.440 who aren't familiar with research affiliates, I mean a lot 0:17:47.520 --> 0:17:52.040 of your pioneering work is fundamental indexing, UH waiting an 0:17:52.040 --> 0:17:56.320 index based on the true fundamentals of a company rather 0:17:56.440 --> 0:17:59.720 than just a market cap index, uh like the sp 0:17:59.840 --> 0:18:05.160 F under um. But with so many investors just going 0:18:05.240 --> 0:18:09.640 passively into an S and P five hundred fund um 0:18:10.040 --> 0:18:14.120 regardless of the you know, the collected wisdom of fundamental indexing, 0:18:14.520 --> 0:18:16.960 does it just make it such an uphill task to 0:18:16.960 --> 0:18:19.920 to go against that flow? You know what I mean? 0:18:20.160 --> 0:18:22.919 And and is you know, speaking of self fulfilling prophecies. 0:18:23.000 --> 0:18:26.159 Does it just you know, it's hard to take the 0:18:26.200 --> 0:18:27.800 other side of that trade, is what I'm saying. With 0:18:27.840 --> 0:18:30.720 so many, so much, so much money flowing right into 0:18:30.720 --> 0:18:34.119 market cap how do you think about that? Here's a 0:18:34.119 --> 0:18:38.879 couple of observations. Firstly, every billion dollars flowing into index funds, 0:18:39.000 --> 0:18:41.480 and there's a lot of billions of dollars flowing into 0:18:41.520 --> 0:18:46.520 index fund involves two hundred million dollars moved from non 0:18:46.720 --> 0:18:53.120 SMP members to SMP members size weighted or market cap weighted, 0:18:53.760 --> 0:18:57.080 hence favoring the largest cap stocks, which tend to be 0:18:57.200 --> 0:19:01.600 underweighted in most active port folios. So you're gonna have 0:19:01.920 --> 0:19:07.600 two billion dollars flow into large cap and out of 0:19:07.880 --> 0:19:10.280 non members of the index. So there have been those 0:19:10.280 --> 0:19:13.960 in academia who try to quantify what's the valuation gap 0:19:14.119 --> 0:19:18.080 difference of being a member versus a non member UM, 0:19:18.080 --> 0:19:21.920 and it's pretty large. Now here's another factor that's just fascinating. 0:19:22.960 --> 0:19:25.600 Stocks that are added to the S and P are 0:19:25.720 --> 0:19:31.560 companies that have just recently soared UM. They're popular, they're beloved. 0:19:32.040 --> 0:19:35.439 The index committee is embarrassed that they don't have it 0:19:35.480 --> 0:19:39.040 in the index. Yet, let's fix that. And what do 0:19:39.119 --> 0:19:43.400 they replace a company that's in free fall unloved, where 0:19:43.440 --> 0:19:46.640 the index committee is embarrassed that it is in the index. 0:19:47.240 --> 0:19:50.399 Tesla and a I V are beautiful case study in 0:19:50.440 --> 0:19:56.280 that UM. Now what happens to the stocks that are added. 0:19:57.240 --> 0:20:00.679 Tesla's an outlier. On average, they under form the market 0:20:00.720 --> 0:20:03.600 by one to two in their first year, not much, 0:20:03.680 --> 0:20:09.600 but underperform. The stocks that are deleted from the index 0:20:09.840 --> 0:20:13.600 on average beat the market by two thousand basis points 0:20:13.600 --> 0:20:16.800 twenty percentage points in the first year after they're deleted. 0:20:17.680 --> 0:20:19.600 Now that means that if you wanted to create a 0:20:19.600 --> 0:20:23.040 better index fund, you could just invest in the SMP 0:20:23.440 --> 0:20:27.120 and then when SMP changes the index, write it down 0:20:27.160 --> 0:20:29.200 on a post it note, stick it on your fridge, 0:20:29.600 --> 0:20:31.479 look at it a year later, and say, Okay, now 0:20:31.480 --> 0:20:35.120 I'll do the trade. That kind of utterly naive approach 0:20:35.200 --> 0:20:38.080 gives you SMP returns plus eight team basis points a 0:20:38.160 --> 0:20:42.480 year over the last thirty years. That's pretty cool. So, 0:20:42.480 --> 0:20:48.920 so indexing creates inefficiencies that can be easily exploited, that 0:20:48.960 --> 0:21:09.199 can create interesting investment opportunities. So you and I actually 0:21:09.200 --> 0:21:12.240 talked about this, I think it was over the summer, 0:21:12.280 --> 0:21:15.000 so a couple of months ago, and it was about 0:21:15.320 --> 0:21:18.680 Tesla's addition, and you had done some research showing that 0:21:19.400 --> 0:21:21.880 really large companies that are added to an index tent 0:21:22.080 --> 0:21:27.200 to lag. You just mentioned Tesla Tesla as an outlier. 0:21:27.400 --> 0:21:29.520 So what is your thinking on this one, because it 0:21:29.560 --> 0:21:33.520 did just have one of its best months in the 0:21:33.600 --> 0:21:37.240 last year and a half and it was one of 0:21:37.280 --> 0:21:40.560 the biggest advancers in the SMP five hundred in the 0:21:40.560 --> 0:21:43.680 month of October. So how are you thinking about it? Well, 0:21:44.040 --> 0:21:49.000 um stocks, whether expensive or inexpensive, go up and down. 0:21:49.600 --> 0:21:52.800 They just do. You can have cheap stocks that that 0:21:53.160 --> 0:21:55.840 go get cheaper. You can have expensive stocks that get 0:21:55.880 --> 0:21:58.560 more expensive, and like I said, bubbles can go further 0:21:58.600 --> 0:22:05.320 than anyone could possibly man engent um. It's interesting when 0:22:05.359 --> 0:22:10.640 we last spoke, Tesla was roughly flat from its being 0:22:10.680 --> 0:22:12.760 added to the index, but the market was up about 0:22:14.520 --> 0:22:17.119 so it was behind the market. And a I V 0:22:18.040 --> 0:22:23.200 Apartment investment, so tiny company that does that's a reet 0:22:23.359 --> 0:22:27.360 for for apartments. My god, have you seen how apartment 0:22:27.440 --> 0:22:32.600 rents have soared? Okay, a I V, a company that 0:22:32.840 --> 0:22:39.640 is a reat specializing in apartments, was up six when 0:22:39.720 --> 0:22:43.760 we last spoke. Now, I think what's happened to rents 0:22:43.800 --> 0:22:46.560 around the country in the last year. That's a solid 0:22:46.640 --> 0:22:51.040 found foundation for the rebound in price. And so it 0:22:51.119 --> 0:22:54.040 was six ahead of Tesla at the time. It's still 0:22:54.080 --> 0:22:58.800 ahead of Tesla. It's still gone up more than Tesla has. 0:22:59.040 --> 0:23:05.600 And so when we look at um these patterns of behavior, 0:23:06.080 --> 0:23:12.400 when we look at um uh the way indexing royals 0:23:12.480 --> 0:23:17.720 the markets. One of the strangest narratives coming out of 0:23:17.720 --> 0:23:23.680 the indexing world is we don't move prices. Well, they 0:23:23.680 --> 0:23:27.760 say that because a stock is added and the price 0:23:27.840 --> 0:23:32.520 doesn't move when they add it. Okay, that's because it 0:23:32.600 --> 0:23:37.639 already moved. Tesla was up between the date it was 0:23:37.680 --> 0:23:40.800 announced and the date it was added. Why didn't some 0:23:40.880 --> 0:23:44.680 index funds buy it when it was announced in anticipation 0:23:44.720 --> 0:23:47.520 of it going up. They've got the world very well 0:23:47.600 --> 0:23:51.960 trained that any tracking error, any mismatch between their performance 0:23:52.560 --> 0:23:55.480 and the market index, is a sign of sloppiness or 0:23:55.520 --> 0:24:00.960 even incompetence. And so they zero in on the actual 0:24:01.640 --> 0:24:04.200 price at which the stock will come into the index. 0:24:04.840 --> 0:24:09.160 How do they do that? They enter a blocked trade, 0:24:09.280 --> 0:24:13.960 that is, a market on close trade. Market unclosed means, 0:24:14.840 --> 0:24:19.320 by it, whatever the price is, no price limit, market prices, 0:24:19.359 --> 0:24:24.280 anything goes and at unclosed means I want this to 0:24:24.320 --> 0:24:28.600 be part of the closing price transaction. So well, over 0:24:28.600 --> 0:24:31.359 a hundred billion dollars of Tesla changed hands in one 0:24:31.480 --> 0:24:38.000 blocked trade at the close of December eighteen of last year. 0:24:38.840 --> 0:24:42.240 All right, well, that's kind of interesting. Why why would 0:24:42.240 --> 0:24:45.560 you do a market trade to lock in the price, 0:24:46.800 --> 0:24:49.600 not to lock in the best price, to lock in 0:24:49.640 --> 0:24:52.639 the exact price at which the stock is entering the 0:24:52.760 --> 0:24:57.520 SMP five kind of interesting, SMP. Don't get me wrong. 0:24:57.920 --> 0:25:01.600 SMP has done a wonderful favor for the world by 0:25:01.680 --> 0:25:07.399 creating the world's first and largest index fund that the 0:25:07.520 --> 0:25:11.320 normal retail investor could buy. They have shaken up the 0:25:11.359 --> 0:25:16.560 active management arena by demonstrating that the average active manager 0:25:16.600 --> 0:25:20.639 doesn't win. Doesn't mean that active managers can't win. But 0:25:20.760 --> 0:25:23.119 an active manager wins only if there's a loser on 0:25:23.160 --> 0:25:25.400 the other side of their trades. And if you ask 0:25:25.640 --> 0:25:28.840 most active managers who's the loser on the other side 0:25:28.880 --> 0:25:32.439 of your trade, they don't have a clue. If they 0:25:32.440 --> 0:25:36.440 don't have a clue, they probably don't have value. Add Rob, 0:25:36.440 --> 0:25:39.000 I wanted to before we get to our our crazy 0:25:39.080 --> 0:25:42.639 things of the week, I wanted to UM ask you 0:25:42.720 --> 0:25:46.480 about one of the scattered plots I saw in a 0:25:46.520 --> 0:25:50.520 recent report of years was kind of showing where you know, 0:25:50.560 --> 0:25:54.520 the attractive expected returns are. I couldn't help a notice 0:25:54.680 --> 0:25:59.040 Emerging market value seems to screen very well UM on 0:25:59.080 --> 0:26:01.480 both accesses. Alt to describe it to the chart to 0:26:01.560 --> 0:26:04.159 two readers. You know you've got your expected return and 0:26:04.240 --> 0:26:10.439 you're expected volatility on the X axis. UM. I know 0:26:10.520 --> 0:26:15.120 it's not the first time e M equities have screened attractively, right, 0:26:15.160 --> 0:26:17.719 I mean they kind of always doing. I'm wondering if 0:26:17.720 --> 0:26:21.280 those you know, if if the one access is UH 0:26:21.800 --> 0:26:23.920 is ruining the fun on the other access In other words, 0:26:24.040 --> 0:26:29.160 is that expected volatility so much that for investors thinking 0:26:29.160 --> 0:26:32.919 about risk adjusted returns that they just stay away from it, 0:26:32.960 --> 0:26:36.320 and then you don't get the the expected return that 0:26:36.400 --> 0:26:39.800 it's screening for. Is there is there a relationship there? 0:26:39.840 --> 0:26:44.840 Do you think the relationship is actually more in the 0:26:44.880 --> 0:26:50.200 camp of behavioral finance, and that is UM market prices 0:26:50.200 --> 0:26:53.639 are set based on narratives, based on think of it 0:26:53.680 --> 0:27:02.960 as memes UM widely accepted UH opinions that are shared 0:27:03.000 --> 0:27:07.439 to an extent that it creates the price. Now, the 0:27:07.560 --> 0:27:12.720 narrative in two thousand eight was emerging markets are emerging, 0:27:13.840 --> 0:27:19.200 and you have the Arab spring and you have UH 0:27:19.640 --> 0:27:22.639 rapid growth as far as the eye can see. And 0:27:23.160 --> 0:27:27.400 so of course you should pay more for an emerging 0:27:27.440 --> 0:27:30.480 markets portfolio than for U stocks. You're gonna have higher growth. 0:27:31.920 --> 0:27:36.679 And so the Emerging Markets Index was priced at thirty 0:27:36.760 --> 0:27:41.640 eight times the valuation UH the thirty eight times it's 0:27:41.760 --> 0:27:45.679