November 3, 2025 • 43 mins
Is the AI boom just a bubble or the start of something bigger? Host Merryn Somerset Webb sits down with Rob Arnott, founder and chairman of the board of Research Affiliates, to compare artificial intelligence mania with the dot-com era, unpack sky-high valuations and market concentration while exploring what rising competition, power constraints and Capex mean for Nvidia and the “Magnificent Seven.” Arnott shares a pragmatic playbook—fade frothy winners, favor fundamentals (including his RAFI approach) and look to small caps, the UK and emerging markets—plus candid takes on Bitcoin and holding a little gold as insurance.
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Speaker 1 (00:02):
Bloomberg Audio Studios, Podcasts, Radio News.
Speaker 2 (00:18):
Welcome to Meren Talk's Money, the podcast in which people
who know the markets explain the markets. I am Meren
Sumset Web. Now. This week we welcome back to the show.
Rob Arnott. Rob is founder and chairman of the board
of Research Affiliates are research intensive asset management firm. Now, Rob,
I've asked you back on for a couple of reasons.
First because we always have really interesting chats, and I
(00:39):
know that the listeners super enjoyed the show that we
did last time. But also because the question that we
get asked the most on the show out and about
everywhere we go is is there an AI bubble? And
if there is spoiler alert, almost everybody thinks there is.
What do I do? What do I do now? You
(01:00):
wrote back in March, you wrote a great report about
this about you know, whether this is a bubble or not,
comparing it to the dot com bubble, looking at in
a wider context, etc. There was quite a few months back,
and that was at the point when it looked like
things were cracking slightly. Right. Since then, if it is
a bubble, it's an even bigger bubble. And one thing
that we do know is that whether there is a
(01:22):
bubble in AI or not, there is definitely a bubble
in people asking us questions about whether there is a
bubble in AI, and in politicians and eccentral bankers and
supernational organizations looking at you the IMF suggesting that there
might be a disorderly correction as we you'phemistically like to
call these things at a later date. So all this
(01:44):
is going on, which is why I thought you Rob
of a perfect guest. So Rob, welcome to Meren Talks Money,
Thank you onwards. So let's start then with that report
that you wrote in March, and am I okay to
put a link to that in the show note so
everyone can look at themselves later.
Speaker 3 (02:04):
Yeah, of course, absolutely, please please propelling.
Speaker 2 (02:07):
Okay, So there will be a link to this report
in the show notes so everyone can read it in FULD.
But let's start with talking about that. Basically, what you're
doing is you're comparing it to the dot com bubble,
which really was a proper bubble and obvious bubble from
so long in advance and back then we looked at
that bubble, all of us and said, well that's a bubble.
But we couldn't tell you when it was going to burst.
(02:27):
So one of the things you do is you compare
the AI bubble, which going to call it a bubble
for shorthand here the AI bubble with that bubble. So
let's talk first about what's similar, what is the same
between these two situations.
Speaker 3 (02:40):
You've got froth evaluations. You've got to spread and valuation
between growth stocks and value stocks. That's become to borrow
the British term ginormous uh, and it's uh. You've got
to spread and valuation between large cap and small cap stocks.
That's at w reck extremes. Now. One of the things
(03:03):
that people say now that they also said in the
dot com bubble is this isn't a bubble, this is real.
Back then, they said the Internet is going to change everything.
It'll change how we buy and sell goods and services.
It'll change how we get our news, how we do
our research. It'll change how we interact and network with friends,
(03:26):
with family, with clients. It's going to change everything. And
these are the dominant players and they're going to build
our future. Most of that was true.
Speaker 2 (03:37):
All of the first bet was true, right, all of
the first bet.
Speaker 3 (03:41):
Yes, Now where the narrative failed is that newcomers came in, competed,
and the leading players weren't all leading players ten years later.
In fact, the ten most valuable tech stocks in the
world coming into the year two thousand, z ro out
of ten beat the S and P over the next
(04:02):
fifteen years. You had to wait eighteen years for one
Microsoft to actually edge past the S and P. Eighteen
years is a long time to wait. The other things
that happened were the adoption of the Internet happens slower
than the advocates expected. The adoption of AI is happening
(04:22):
slower than the advocates of this revolution suggest. So the
narrative AI will change everything, My goodness, it absolutely will.
It's breathtaking. Anybody who's used chat GPT five, it's astonishing
how intelligent it is. We wrote an article fundamental growth
(04:43):
that's on the Internet and is likely to appear at
a journal early in the new year, and we gave
it to Chat GPT five point zero and said, tell
us what's good and bad about this paper. Tell us
where there's repetition we can trim, tell us whether there
(05:04):
are references or citations that we missed. It gave a
two page summary of the paper that was better than
anything I or Cam Harvey or the other authors could
possibly have written. Beautiful, wonderful synopsis. Then it gave us
a rundown of ways to improve the paper. We took
most of its suggestions. Then it gave us a list
of ten citations. We missed four of them. We looked
(05:27):
at them and we thought, wow, why didn't we think
of that? Yes, put it in. Four of them were
more borderline. We ignored them. Two of them didn't exist.
So it still hallucinates. It creates stuff out of thin air,
which is something that you've got to be very careful about.
But it's breathtaking. The leaders of the AI revolution our
leaders today. Will they be disrupted? Disruptors get disrupted. Think
(05:54):
of the most valuable tech stocks in the world in
two thousand, Microsoft, It went through it off decade, and
then it regained its footing and became the world leader
that it is today, Cisco. Cisco's chairman in March of
two thousand said, I don't see why we can't grow
forty percent a year. As far as I can see,
(06:15):
forty percent a year means you're going to get be
six times as large in five years. How big are
they now? They're six times as large. It took twenty
five years.
Speaker 1 (06:24):
Not five.
Speaker 3 (06:25):
Yeah, it's a yeah.
Speaker 2 (06:26):
This is exactly the kind of thing that we hear
from Nvidia, which by the way, as we're speaking, has
been hitting new highs. Exactly the kind of thing we
hear from them, that this growth can go on indefinitely.
Speaker 3 (06:38):
If you can find power stations to power. I read
somewhere that's something like five percent of the US power
supply is now used by AI, and they're wanting it
to double every year for the next three years. Well,
that would take it to forty percent.
Speaker 2 (06:56):
Yeah.
Speaker 3 (06:57):
There's a wonderful paper by Aschenbrenner, one of the co
founders of Open Ai, called Situational Awareness, that talks about
the future of AI. And it's wonderful because it's so
insightful on how many ways it can change the world.
It's off target in a couple of ways. He says,
(07:19):
we need to increase the power generation capability of the
US grid by forty percent by twenty twenty seven. Well,
maybe we should, but it's not going to happen.
Speaker 2 (07:31):
And even of course, if you manage to increase the
power going into the grid. Making the grid resilient enough
to carry that huge increase in power would be verging
on impossible, and a timeframe like that, right, So there
are power constraints on AI, there are regulatory constraints on AI,
maybe ethical constraints on AI. And then I guess it's
(07:53):
also the case if we stick with this comparison to
the dot com bubble and possibly even too maybe even
the smart the smartphone boom or whatever you like to
call it, in from two thousand and seven on, it's
around that Chinese competition, which didn't exist in quite the
same way in the same volume. Then we've moved, we've
moved from the similarities to the differences too quickly. That
(08:15):
was what I meant to do, but we've done it.
So there's more competition, global competition that suggests that maybe
first mover advantage isn't quite what it might have been,
and maybe there's a first mover disadvantage or there certainly
there certainly was in the dot com bubble.
Speaker 3 (08:28):
Yeah, well, rounding out the top five back in two thousand,
you have Intel, who was that disrupted? Good lord, yes,
you've got Nokia. It still makes phones. It was fifth
most valuable company on the planet. Back in two thousand,
(08:49):
you've got loosened. Loosen doesn't exist anymore. I mean, it's
it's a graveyard. And the other part that's just fascinating
is March of two thousand, when the bubble burst. Roll o'
clock forward two years, the Nasdaq was down fifty percent
on its way to an eighty percent drop Russell two
thousand value. Remember, value was trading cheap. Small cap was
(09:12):
trading cheap again, same thing today, Russell two thousand value
was up fifty three percent in those two years. The
bull market of the nineteen nineties for most stocks didn't
end until March of two thousand and two, and that
was two years into the bursting of the bubble. The
big cap indexes were dragged down, but the median stock
(09:34):
was up for those next two years. The same thing
could play out today. I'm not predicting that, but what
I am saying is that decoupling of frothy large cap
popular names from very successful mainstream businesses in valuation can
(09:57):
mean revert and I think likely, Well.
Speaker 2 (10:00):
Well, you say can mean revert historically always have mean
reversal correct, which doesn't mean that it happens this time
and doesn't tell us when it might happen. But there
has never previously been a point when this kind of
disparity has not reverted to a historical mean of some kind.
Speaker 3 (10:17):
Yeah, here's a fun factoid. Members of the S and
P five hundred or of the Russell one thousand are
at valuation multiples that are two and a half times
as large as non members. Now people will say, yeah,
that's because these are wonderful companies and these aren't pardon me,
over the last thirty years, roll o' clock back thirty
(10:38):
years they were at parody. They were about the same
valuation multiples. So they blew out one hundred and fifty
percentage point gap opened up. These guys. The non members
have had earnings and dividend growth one percent a year
faster than the members. Oh so they're better companies on
average that are valued at forty percent the valuation multiples
(11:02):
of the index members. We have a short paper membership
has its privileges that's in draft form that examines this difference,
and it just points out the obvious that if you're
a member of the index, membership has its privileges, you
are entitled one to a higher valuation multiple. Because you're
a member two, you're entitled to steady inflows of capital
(11:27):
propping the price up and holding it higher. And both
of those facts are realities of today's market. Indexing has
really swamped the markets and has compromised the price discovery
mechanism of figuring out what companies are actually worth.
Speaker 2 (11:44):
Yeah, the point being that, because of the rise of
passive investing, companies automatically get flows every time anyone buys
an index, so the differentiation between between the valuation of
stocks becomes most least.
Speaker 3 (11:57):
That's exactly right.
Speaker 2 (11:58):
Okay, But here we are, and I think you know,
we're already talking ourselves into agreeing that this is a
bubble and that it shows all the characteristics of a bubble.
And then we have the few things we haven't discussed,
like the insane levels of concentration in the US market
any global we've been at and global markets, so we've
been at concentration levels like this before. Have we been
(12:20):
quite the highest? I think we have been near these levels,
but it's always a massive danger sign, not even not
even near.
Speaker 3 (12:26):
No, this is the highest concentration in global and particularly
US because it's US concentration that leads to the global concentration.
I mean, the US is two thirds of the world
stock market. It's three fourths of the developed world stock market.
So it's the magnificent seven thirty percent of the US
stock market. They're twenty percent of the world stock market,
(12:49):
these seven companies. And yes they're magnificent. Yes they have
product that everybody wants. Yes they have product that everyone needs.
Yes they're reshaping the future of the world. But this
is a competitive landscape. Look at Intel. I mean, even
the Chips Act couldn't save Intel, and a fifty billion
(13:10):
dollars infusion from the US government could couldn't help it
defend itself against the rise of Nvidia, because in Nvidia
disrupted them. And disruption is normal. Disruption happens regularly in
a healthy capital economy. Creative destruction is a real thing.
If you are behind the curve, you're going to lose
(13:34):
business and lose market share and be pushed aside. And
that's actually a good thing. It means that the better
ideas get a chance to gain traction and grow. And
these seven companies are all disruptors and are all very
powerful in their industry, but none of them is immune
(13:57):
to competition, and Vidia has already a number of organizations
lapping at their heels with new super chips that are
in some ways better than in videos, and Video got
a head start which was tremendous. The story behind that's
also fun. Jensen Wang said, these super chips that we're building,
(14:18):
let's save some real estate on them and just not
fill it with circuitry because the next round of circuitry
is going to be better and we won't have to
redesign the whole chip. Who builds a chip with dead
space in it? It was a stroke of genius. It
allowed them to plunk in the new, better stuff faster
(14:39):
a year or two faster than they would have otherwise.
And boy, what a stroke of genius. So these are
brilliant companies. That was his disruption of the whole silicon industry.
Speaker 2 (14:49):
I suppose one thing we should just say and side
is that it's not the concentration in itself that is
necessarily a problem. In the UK, stop market is also
very concentrated, doing a very large percentage of it is
just our biggest stocks. But part of the problem with
this concentration is the correlation. So they're all in the
same industry, all in the same business and if you
look at the UK market, for example, while we have concentration,
(15:12):
the big companies are generally and in different businesses. So
it's both things, the concentration and the correlation between them, right,
and the business connections between them.
Speaker 3 (15:20):
Of course, here's a couple of fun factoids. The market
value of the Magnificent Seven was twenty trillion at the
end of September. That's bigger than all stock markets in
Europe combined. That's bigger than all of the Chinese stock market. Basically,
(15:41):
the market's value for a company is supposed to be
the market's best gas at future profit distributions back to
the shareholders discounted back to today, so the net present
value of future profits. What the market is saying is
that the future profits of these seven companies will exceed
all profits generated by all of Europe, bigger than all
(16:05):
profits generated by all of China. Is that possible? Yes?
Is that likely? I don't think so. These companies compete
against one another, and Vidia's fifty percent profit margins are
not going to continue more than two or three more
years because competition is coming into play. If they're roll o'
(16:27):
clock forward ten yures, if they are forty percent of
the super chip market instead of ninety, if their profit
margins are still a robust thirty percent not fifty. If
the pricing power means that revenues per chip are down
by two thirds over the next ten years, and that's
(16:47):
probably conservative. Plug those into a spreadsheet and what you
find is okay, goodness, Their two and thirty five profits
are going to be no better than their twenty twenty
five profits, and yet their priced is if they're going
to see stupendous growth. Pallunteers another fabulous example. How many
companies get to be priced at triple digit multiples of sales,
(17:10):
not of profits. It peaked at one hundred, one hundred
eighty times sales. So with sales last year of two
to three billion, they were they're worth about four hundred billion. Now,
how do you justify four hundred billion market cap when
your sales are two to three billion. The only way
(17:31):
to do it is to have those sales grow to
twenty billion, forty billion, one hundred billion and profits to
match and do that fast enough. Is that possible? Yeah?
Is it likely? I don't think so. So I see
bubbles galore. I also see some very profitable, highly successful
(17:52):
companies priced it premium multiples, but not nosebleed levels. And
so I think there's a lot of stocks in this
bubble that are not nonsensically priced. And yeah, that's a
good thing. That's a healthy side of the market.
Speaker 2 (18:12):
Okay, I get this my feeling that you don't think
it's quite ready to burst yet. We're not quite at
you know, Cisco levels.
Speaker 3 (18:20):
Well, some of them are at Cisco level. Cisco crested
it in early two thousand, one hundred and eighty times
earnings and pallunteers way past that.
Speaker 2 (18:34):
But I just want to read that one of the
sentence that you write in this report, which I think
kind of sums up everything you're saying, which is a
very simple, fast developing sectors writing waves of innovation and
optimism are inherently volatile, which is what you mean when
you talk about the regular disruption of these things. And
one of the extraordinary things about a bubble is that
(18:54):
inside the stories that people tell themselves inside a bubble,
that the general narrative that there is no volatility, there
isn't competition, there isn't the disruptors remain the disruptors. They
do not become the disrupted. That's how the story works exactly.
And the thing that tends to break these bubbles is either,
you know, well, it's either it's a change in the
cost of capital, it's a change in the wider environment,
(19:16):
or it's the realization that the narrative doesn't include the
next wave of disruption.
Speaker 3 (19:21):
Yeah, and people talk about the jobs lost. Every technological
revolution since the industrial revolution has destroyed millions of jobs.
The thing is that painful to those whose jobs or
whose families members' jobs get destroyed. Yes, do people care
(19:43):
about those job losses a generation later?
Speaker 2 (19:46):
No.
Speaker 3 (19:47):
The thing that is different is that the computers will
be more intelligent than we are in the not too
distant future. In some ways, they already are. My CEO,
Chris Bright likes to play with AI every weekend for
three to five hours, testing its capabilities, and he had
a conversation with GPT five about how AI fits in
(20:12):
the realm of human evolution, and it gave a discourse,
short discourse that was so insightful you'd think it was
from a double PhD in anthropology and philosophy. And it
closed with the observation, we don't know yet whether human
intelligence and machine intelligence will merge, or whether human intelligence
(20:38):
will at some stage be a fond and distant memory
for AI. And then it closes with the sentence the
wonderful thing in this revolution is that we get to choose.
And I thought, who the heck is we?
Speaker 2 (20:57):
Well, that's an interesting question, isn't it who we? In
this context? I don't think it's me. It might be you,
but I'm not feeling like it's me.
Speaker 3 (21:05):
But anyway, existential threat, Yeah, do I worry about that?
I don't because I try to worry about things I
can have any influence over. This revolution is coming and
it's big. But who's going to be the disruptor in
the coming decade? Who will be the market leaders ten
years from now? Some of market leaders today will be
(21:28):
the market leaders in ten years. Some won't. They're all
chrisd as if they will be the market leaders.
Speaker 2 (21:47):
So I think where we are now is that we
are agreeing that we are at the very least in
bubble territory, that valuations are in bubble territory, that there
is not enough understanding of the next round of disruption.
One thing we haven't mentioned, actually is the extent of
the capex and the extent which AI capex is crowding
(22:09):
out everything else in the US, and when stuff gets very,
very capex heavy, of course, if you do get disrupted,
you're in a whole lot of trouble, right. I mean,
a lot of the dot com bubble with very capex light,
and same with smartphones, platforms, et cetera. Capex light. But
this is pretty capex heavy.
Speaker 3 (22:26):
I'm glad you mentioned that. One of the fascinating facts
about growth stocks is that R and D is positively
and reasonably strongly correlated with future growth for companies. I mean,
it's not perfect. You can waste money on R and
D just like you can waste money on anything else.
(22:48):
Capex spending is negatively correlated with future growth. Really surprising.
Speaker 2 (22:53):
We don't tell the AI found that.
Speaker 3 (22:56):
Well, here's an example. In a healthy capitalist system, happy
customers are the essential component of success. If you're going
to succeed, you must have happy customers who value your
product more highly than what you charge for it. In
Vidia has happy customers. They line up for the privilege
(23:16):
of getting on a waiting list to buy massive quantities
of super chips. In Vidia's customers have yet to figure
out how to monetize that capex. They're having trouble figuring
out how to earn money on AI And so is
that going to happen? Yes, it will, But is it
(23:37):
happening fast enough to support the prices of these stocks?
Probably not, And therein lies one of the key challenges.
Speaker 2 (23:45):
Okay, So add that infa mix, and we could say,
when you wrote this back in March, you said, and
maybe we're in nineteen ninety seven, maybe we're in the
late nineteen nineties, or maybe we're right on the edge
of that nasty that beginning of two thousand. We can't
be sure. It sounds like you would put yourself closer
to the late nineties at the moment.
Speaker 3 (24:06):
No, No, I would. I would say that we're more
likely to be near the cusp than not.
Speaker 2 (24:12):
Now, okay, we say, let's put ourselves at November ninety nine.
You want to do that, Sure we're in November ninety nine.
If we were in November ninety nine, what would be done.
The first thing we'd do is we'd sell our Cisco
because we've already made pushing three thousand percent on that
right then, what would we do?
Speaker 3 (24:28):
The trick about bubbles is never short them because they
can go longer, last longer, and go further than you
can imagine.
Speaker 2 (24:38):
That's what a lot of spread patter is found out
in the UK in nineteen ninety nine.
Speaker 3 (24:42):
And so what you do is you underweight, you fade
your exposure to bubbly stocks, and do it gradually. So
just let people average in to a bargain, you average
out of froth and take take some profits, and do
it gradually and take your time at it because you
don't know when the turn's going to happen. The same
(25:03):
thing works when it comes to bargains. We're in the
only major business in the global macroeconomy where people hate bargains.
I mean, imagine if Tiffany's posted a sign saying everything
marked down twenty percent before Christmas, and Cartier across the
street posts a banner sign saying shiny beautiful stuff for
(25:25):
Christmas only twenty percent more than last year, and people
flood Cartier and shun Tiffany's. When it comes to retail,
people don't behave that way. When it comes to investing,
people absolutely behave that way, and so you have to
be careful with bubbles. It doesn't mean you have to
own them. It doesn't mean you have to fully weight them.
(25:46):
So a fundamental index, which we invented twenty years ago,
simply reweights the growth stocks down to their economic footprint.
It doesn't kick them out. So the Magnificent seven is
thirty four percent of the S and P five hundred,
but it's eighteen percent of RAFFI. It's it's big, it's
very big, but it's not thirty four percent. And so
(26:11):
that's one tool in our tool kit. Fundamental index.
Speaker 2 (26:14):
Explain that a bit further, because you know, you've been
known before, and they'll be some listeners you understand completely
about your fundamental indices, and they'll be others who simply don't.
So tell us a little bit more about how that works.
Speaker 3 (26:26):
We came up with a strategy twenty years ago called
RAFFI Research Affiliate It's fundamental index. Instead of choosing companies
based on their market value, the more expensive they are,
the more likely they are to be in the index,
we choose stocks based on their economic footprint. How big
is their business? What are their sales as a percentage
of all public companies? What are their profits as a
(26:47):
percentage of all public companies? If it's a big enough business,
it's included. And then it's weighted by the fundamental size
of the business.
Speaker 2 (26:54):
And what do we mean by fundamental size of the business.
Speaker 3 (26:56):
Well, just as an example, what are the sales of
Nvidio as a percentage of all companies in the world.
It's a fraction of a percent, but it's close to
five percent of world stock market capitalization. And so it's
this big a company, it's this big in market cap.
Fundamental index says, thanks for that lovely gain, I'm going
(27:17):
to weight you down here. It doesn't say I'm going
to kick you out. And so fundamental index is one answer.
So fundamental index has two interesting attributes. It downweights the
gross stocks. It upweights the value stocks. It gives you
a stark value tilt. Always value has been terrible for
fifteen years, so why would you want to do that?
(27:38):
Because it also has a rebalancing alpha. If a stock
sores and the fundamentals of the company don't validate that rise,
RAFFI will say, thanks for the nice gain, I'm going
to trim you. The market's constantly changing its price on
what a company's worth. You're concratrating against those whenever they're
not validated by fundamental changes in the scope of the business,
(28:00):
and so that contratrating is a source of incremental return.
So the cool thing is that RAFI globally has beat
global value indexes by over two percent a year since
the launch of RAFI twenty years ago, and has beat
value indexes in roughly three out of every four years.
(28:21):
There's hardly anything out there with that kind of consistency.
And if you're able to steadily beat value by two
two and a half percent a year and win three
years out of four, then to the extent you want
a toe hold in value as a safety net for
your portfolio, why would you do it any other way?
(28:41):
So this represents one of the possible answers.
Speaker 2 (28:45):
It's interesting, isn't it, because when you talk about the
divergence between value and value and growth to the extent
you can make this distinction value and growth, and also
the divergence of value were seen between large and small caps.
The tempting thing for most investors, or certainly investors with
mone inclinician, is to go pure value, go pure small cap,
et cetera. But I think what you're explaining is that
(29:06):
that doesn't really work because you have to wait so long.
Very often, you know your weight can be years. Suddenly
this time around, there have been little moments where you think, oh,
look it's back. Value's back, active management is back, etc.
Then and then suddenly often the video goes again, and
you know the value investors don't looks are great again.
So you know your weight can be very very long
(29:28):
for a pure value investor.
Speaker 3 (29:29):
Your weight can be very very long for any style
that's out of favor. Growth has been out of favor
for long stretches of time, and we haven't seen that recently,
and so folks with less gray hair than me will
often say, yeah, but that was that was ancient history.
Growth hasn't had any troubles in the last fifteen years,
(29:51):
absolutely true, But history has a knack for repeating, if
slowly and if imperfectly. And when you get to these
vast spreads and valuation two and a half to one
between members of the index and non members eight to
one between growth and value measured on price to book
(30:11):
value twelve to one for growth versus value measured on
price to sales ratios twelve to one, that's extraordinary. And
so when we look at today's markets, you see things
very very stretched. You see a narrative that explains why
they deserve to be stretched, But narrative set prices. You
(30:33):
don't make money by betting on a narrative. You make
money by finding where the narrative might be missing something.
And what it might be missing is competition.
Speaker 2 (30:40):
Yeah, what about a pure equal weighted index? So you know,
most most passive investing takes place in market cap weighted
in disease, which is why you end up with such
a bias towards the bigger equities. And so if you're
investing passively at the moment, the reason you have such
enormous exposure to the Magnificent seven and to America is
because you are You're doing this on a market weighted basis.
(31:01):
But there's a good argument to be made for the
regular automatic rebalancing that comes with a pure equal weighted index.
Speaker 3 (31:09):
It's interesting. Equal weighting has been around for a long
time and it works for the very patient investor. It
gives you a stark small cap tilt because the big
cap stocks are being reweighted down, and it gives you
a relatively deep value tilt. But it's alpha engine is
(31:30):
the same as Raffi's, same as fundamental index for stock sores,
you're going to trim it with RAFFI. If the stock
sores and the fundamentals don't, you're going to trim it.
But if the fundamentals rise with the price, you're going
to be perfectly happy and stay of the course. Yep,
RAFI has the advantage relative to equal weighting of firstly
(31:52):
working a little better. It's about one hundred basis points
per anum better performance. Secondly, it still buys large businesses,
and so large businesses are often large cap, so it
doesn't have the stark small cap tilt that equal waiting does,
and therefore it has huge capacity. Equal Waiting if it
(32:13):
was run on globally on one hundred billion dollar scale,
would run into some serious problems of having to buy
more of the smallest stock in the index than exists.
Speaker 2 (32:24):
Okay, that seems like a reasonable argument against it. Yeah, okay,
so so not equal weight or an equal weight. It's
an answer, but maybe not the best answer. Going straightforward
value not necessarily the best answer. So fundamental index approach
that you are using sounds very compelling, and the risks
(32:46):
to it.
Speaker 3 (32:46):
Are The risks to it are very simple. It has
a stark value tilt. When value is out of favor,
it will struggle to keep up with the market, but
it won't struggle to beat value. It beats value relentlessly.
So to the extent you want value in your portfolio.
Like I said, why would you do it any other ways?
It's so compelling, it's so simple, and it's so powerful.
(33:08):
That's its biggest disadvantage is the value tilt.
Speaker 2 (33:12):
Robert, what would make you change your mind about the
idea that AI is in a bubble? What would make
you go that, you know what, that's worth one hundred
and ninety pe or in video, yeah, it's going to
grow thirty percent forever. What would make you look up
and go, actually, do you know we all go on
about bubble. The bubble story is very compelling as well, right,
(33:33):
I mean it's compelling as the narratives around bubbles are
the fact that there is a bubble that you should
avoid and it's all quite exciting, and there'll be a
crash and you can be the clever person who predicts
the bubble, et cetera. We will want to be that person, right,
it's the top Look, they rang the bell. I'm right.
Everyone wants to be involved in that bubble narrative too,
But what could make us wrong about that?
Speaker 3 (33:52):
I love your mention of the ringing of a bell.
People who buy bubble stocks need to think about one thing.
What's my cell discipline? What would prompt me to sell?
Will I hear a bell chime that says now's the time?
If not, fading your exposure gradually over time has the
(34:17):
benefit of not having to wait for the bell, and
has the drawback of you will look and feel like
an idiot until the turn happens. None of us likes
to feel like an idiot. As for what would make
me think, gosh, this isn't a bubble, it's that the
fundamentals actually catch up to the price, and to some
(34:37):
extent that's been happening. In Vidia's profits and sales swored
and continue to surge strongly, But it is priced to
reflect an expectation of, oh, let's say twenty thirty percent
growth per annum for the next decade, and that's a stretch.
That's a lot of growth for a long time. It's
(34:59):
not impossible, but it is implausible in a marketplace where
competitors are coming onto the scene with new super chips
that in some ways are better than in NVIDIAs, and
so at a minimum they're going to see that fifty
percent profit margin come down and the ninety percent market
(35:19):
share come down.
Speaker 2 (35:21):
For those who aren't interested in index investing a school,
who aren't interested in straightforward indices or fundamental indices, et cetera.
Where do you see value? I mean small caps? Obviously
you've said we like to think there's a lot of
value in the UK market despite our appalling politics and
miserable economy, that UK is.
Speaker 3 (35:39):
A value market.
Speaker 2 (35:43):
You say that it's a bad thing.
Speaker 3 (35:44):
I don't think it's a bad thing at all. I
think UK stocks over the coming decade will soundly outperform
US stocks. US stocks have to deliver growth well ahead
of what we've seen historically and well ahead of the
rest of the world. Now that narrative is out there,
(36:05):
the American exceptionalism story, Okay, is there American exceptionalism. We're
not smarter than Europeans or East Asians. We do have
less regulation than Europe and punitive regulation that treats success
as a bad thing, impedes success and impedes growth. So yes,
(36:28):
that element of exceptionalism I think is slightly true. We're
over regulated, but not to the extent that Europe is.
But be that as it may. Does it make sense
for the US to be three fourths of the developed
world stock market? I don't think so. Does it make
sense for seven companies to be twenty percent of world
(36:48):
stock market capitalization? I don't think so. This does represent
an unusually concentrated, in frothy market. I think that European
stocks broadly are cheap, relatively attractive. They're cheap for a reason.
The narrative tells us exactly why they deserve to be cheap,
and the narrative is partly true. Emerging markets are they're
(37:12):
going to have better growth than us. Yeah, they're just
imitating us and borrowing ideas from us will allow them
to course.
Speaker 2 (37:20):
And no correlation between growth and stock markets, we know that, right, correct?
Speaker 3 (37:24):
Correct?
Speaker 2 (37:25):
It's all about where we start. It's all about starting valuation.
Speaker 3 (37:28):
Starting valuation is low. Fundamental index in emerging markets has
a has a PE ratio of eight. If you can
buy half the world's economy at a PE ratio of eight,
why would you should buy the US at PE ratios
in the thirties China? China is now cheap. It is
(37:48):
headed by a guy who is a Maoist to the core,
and so as long as she is at the helm,
if you succeed in China, you'll be punished for it.
And if you succeed in China and question the wisdom
of the CCP, you're going to be disappeared for it.
China is relatively inexpensive today and for the patient investor
(38:15):
is probably a goodbye. It probably won't really get out
of its way until you get another dang shoping at
the helm. Somebody who believes that success is not evil Argentina,
I think Malay is marvelous. He's courageous. Anytime you're paying
people on government salaries to do more or less nothing,
(38:38):
you've got a formula for stasis. And there are lots
of government employees everywhere in the world who are doing
great work. But when you get a hyper regulated economy. Again,
in Argentina, success was seen as evil. If you were successful,
(38:58):
you had to have done something wrong and you needed
to be punished. That's a terrible attitude for promoting future success,
for promoting prosperity.
Speaker 2 (39:12):
And living standards.
Speaker 3 (39:14):
All right, Yeah, it is far too common Argentina and
Malaya is changing the narrative. I think he's a remarkable man,
a little self absorbed, but hey, so are a lot
of leaders.
Speaker 2 (39:29):
Yeah, definitely going to be a little stomach of volatility there, Rob. Listen,
I'm taking out too much of your time. I'm really sorry.
I promised you thirty five minutes and here we are.
This is irresponsible interviewing. But listen, tell me bitcoin. You
got any bitcoin in your portfolio? Yes, it's not something
for the indices, but you've got something new you do.
Speaker 3 (39:47):
In twenty thirteen, I was intrigued by bitcoin. I didn't
see why it would be worth anything discounted and at
present value as zero, But as a libertarian, I thought
kind of cool to cut the cut the links with
central bankers trying to control everything. And so I went
out and I bought a bitcoin. And I still own
(40:08):
one bitcoin. I've owned it since twenty thirteen. My cost
basis is two hundred and twenty five bucks.
Speaker 2 (40:15):
Amazing. And and you haven't lost the pass code, have you,
not like some other people on this podcast.
Speaker 3 (40:20):
And I have no intention of selling it.
Speaker 2 (40:23):
You still have access to your bitcoin.
Speaker 3 (40:26):
I still have the code to get into my bitcoin,
and yes, I could still sell it.
Speaker 2 (40:30):
Fantastic. I still have the phone that once had the code.
Speaker 3 (40:37):
Anyway, there's supposedly something like twenty twenty five percent of
all bitcoin that is simply lost.
Speaker 2 (40:42):
Yeah, on holiday with my bitcoin, happy times.
Speaker 3 (40:45):
Yeah yeah, never to be by anybody. It's just poof evaporated.
Speaker 2 (40:50):
Yeah, which is of course that one thing that I've
always had trouble with a bitcoin. No customer services, no
one to call, right, how do I reset my password?
Would you like to know the name of my childhood pat?
Would you like to know where I went to school?
I can tell you my mother's maiden name. Just give
me my bitcoin. But doesn't work like that. I'm very
naive about it anyway. Listen, moving on from bitcoin gold,
you got any golden your put photo?
Speaker 3 (41:11):
Yes, I have a little gold in a safe at home,
and burglars who are watching please don't go and break
into my safe anyway. It's there for peace of mind.
But it's not a lot.
Speaker 2 (41:25):
It's enough to sustain the ultimate insurance, right, Yeah, And I.
Speaker 3 (41:29):
Don't know how good it would be in a financial
crisis severe enough that dollar bills no longer worked in
credit cards and no longer work, So I don't know
that gold would work amazing.
Speaker 2 (41:39):
Thank you. One last final question, because I'm guessing that
you're answered this might be interesting, Rob. What are you
reading right now?
Speaker 3 (41:46):
Ah, this is funny being on a British broadcast. I'm
reading a history of the American Civil War. It's a
three volume by an historian named Atkinson, who's brilliant writer.
And the first of the three is the British are Coming.
Speaker 2 (42:06):
No one will be frightened these days, and.
Speaker 3 (42:08):
So it's a fascinating book. It's a dive into the
personalities and personal interests and the thinking processes of the
people who led both sides of the Revolutionary War.
Speaker 2 (42:21):
Okay, well, that is a great tip, and I'm sure
everyone will rush out to buy them. So I'm not
sure they Well, I'm pretty I'm not sure we have
that many listeners you will want to go for a
whole three volumes, but we'll see, we'll see. Rob. Thank
you very very very much for joining us today. Absolutely fascinating.
Speaker 3 (42:38):
Thank you for reaching out and this has been wonderful
fun as always.
Speaker 2 (42:44):
As ever, ever, thank you thanks for listening to this
week's Marrin Talks Money. If you like us, show, rate, review,
and subscribe wherever you listen to podcasts and keep sending
your questions or comments and marror money at Bloomberg. You
can also follow me in John on Twitter or X.
Are you on on Twitter?
Speaker 1 (43:04):
Rob?
Speaker 3 (43:04):
I am, but I've never actually done it personally.
Speaker 2 (43:08):
Do you know what your handle is? Rob? What? What's
your what's your Twitter name? You don't go, We'll look
it up. We'll look it up nowhere about that.
Speaker 3 (43:13):
It's probably it's probably at Rob or not, but I.
Speaker 2 (43:16):
Don't know bound to be something like that, right, Okay,
As I was saying, you can also follow me in
John on Twitter all X, I'm Marinus W and John
is John Underscore Stepec. This episode was hosted by me
Maren's Unset Web, produced by Sersadian Moses and sound designed
by Blake Mabel's and Aaron Caspers. And special thanks of
course to Rob. Thank you
Bloomberg Audio Studios, Podcasts, Radio News.
Speaker 2 (00:18):
Welcome to Meren Talk's Money, the podcast in which people
who know the markets explain the markets. I am Meren
Sumset Web. Now. This week we welcome back to the show.
Rob Arnott. Rob is founder and chairman of the board
of Research Affiliates are research intensive asset management firm. Now, Rob,
I've asked you back on for a couple of reasons.
First because we always have really interesting chats, and I
(00:39):
know that the listeners super enjoyed the show that we
did last time. But also because the question that we
get asked the most on the show out and about
everywhere we go is is there an AI bubble? And
if there is spoiler alert, almost everybody thinks there is.
What do I do? What do I do now? You
(01:00):
wrote back in March, you wrote a great report about
this about you know, whether this is a bubble or not,
comparing it to the dot com bubble, looking at in
a wider context, etc. There was quite a few months back,
and that was at the point when it looked like
things were cracking slightly. Right. Since then, if it is
a bubble, it's an even bigger bubble. And one thing
that we do know is that whether there is a
(01:22):
bubble in AI or not, there is definitely a bubble
in people asking us questions about whether there is a
bubble in AI, and in politicians and eccentral bankers and
supernational organizations looking at you the IMF suggesting that there
might be a disorderly correction as we you'phemistically like to
call these things at a later date. So all this
(01:44):
is going on, which is why I thought you Rob
of a perfect guest. So Rob, welcome to Meren Talks Money,
Thank you onwards. So let's start then with that report
that you wrote in March, and am I okay to
put a link to that in the show note so
everyone can look at themselves later.
Speaker 3 (02:04):
Yeah, of course, absolutely, please please propelling.
Speaker 2 (02:07):
Okay, So there will be a link to this report
in the show notes so everyone can read it in FULD.
But let's start with talking about that. Basically, what you're
doing is you're comparing it to the dot com bubble,
which really was a proper bubble and obvious bubble from
so long in advance and back then we looked at
that bubble, all of us and said, well that's a bubble.
But we couldn't tell you when it was going to burst.
(02:27):
So one of the things you do is you compare
the AI bubble, which going to call it a bubble
for shorthand here the AI bubble with that bubble. So
let's talk first about what's similar, what is the same
between these two situations.
Speaker 3 (02:40):
You've got froth evaluations. You've got to spread and valuation
between growth stocks and value stocks. That's become to borrow
the British term ginormous uh, and it's uh. You've got
to spread and valuation between large cap and small cap stocks.
That's at w reck extremes. Now. One of the things
(03:03):
that people say now that they also said in the
dot com bubble is this isn't a bubble, this is real.
Back then, they said the Internet is going to change everything.
It'll change how we buy and sell goods and services.
It'll change how we get our news, how we do
our research. It'll change how we interact and network with friends,
(03:26):
with family, with clients. It's going to change everything. And
these are the dominant players and they're going to build
our future. Most of that was true.
Speaker 2 (03:37):
All of the first bet was true, right, all of
the first bet.
Speaker 3 (03:41):
Yes, Now where the narrative failed is that newcomers came in, competed,
and the leading players weren't all leading players ten years later.
In fact, the ten most valuable tech stocks in the
world coming into the year two thousand, z ro out
of ten beat the S and P over the next
(04:02):
fifteen years. You had to wait eighteen years for one
Microsoft to actually edge past the S and P. Eighteen
years is a long time to wait. The other things
that happened were the adoption of the Internet happens slower
than the advocates expected. The adoption of AI is happening
(04:22):
slower than the advocates of this revolution suggest. So the
narrative AI will change everything, My goodness, it absolutely will.
It's breathtaking. Anybody who's used chat GPT five, it's astonishing
how intelligent it is. We wrote an article fundamental growth
(04:43):
that's on the Internet and is likely to appear at
a journal early in the new year, and we gave
it to Chat GPT five point zero and said, tell
us what's good and bad about this paper. Tell us
where there's repetition we can trim, tell us whether there
(05:04):
are references or citations that we missed. It gave a
two page summary of the paper that was better than
anything I or Cam Harvey or the other authors could
possibly have written. Beautiful, wonderful synopsis. Then it gave us
a rundown of ways to improve the paper. We took
most of its suggestions. Then it gave us a list
of ten citations. We missed four of them. We looked
(05:27):
at them and we thought, wow, why didn't we think
of that? Yes, put it in. Four of them were
more borderline. We ignored them. Two of them didn't exist.
So it still hallucinates. It creates stuff out of thin air,
which is something that you've got to be very careful about.
But it's breathtaking. The leaders of the AI revolution our
leaders today. Will they be disrupted? Disruptors get disrupted. Think
(05:54):
of the most valuable tech stocks in the world in
two thousand, Microsoft, It went through it off decade, and
then it regained its footing and became the world leader
that it is today, Cisco. Cisco's chairman in March of
two thousand said, I don't see why we can't grow
forty percent a year. As far as I can see,
(06:15):
forty percent a year means you're going to get be
six times as large in five years. How big are
they now? They're six times as large. It took twenty
five years.
Speaker 1 (06:24):
Not five.
Speaker 3 (06:25):
Yeah, it's a yeah.
Speaker 2 (06:26):
This is exactly the kind of thing that we hear
from Nvidia, which by the way, as we're speaking, has
been hitting new highs. Exactly the kind of thing we
hear from them, that this growth can go on indefinitely.
Speaker 3 (06:38):
If you can find power stations to power. I read
somewhere that's something like five percent of the US power
supply is now used by AI, and they're wanting it
to double every year for the next three years. Well,
that would take it to forty percent.
Speaker 2 (06:56):
Yeah.
Speaker 3 (06:57):
There's a wonderful paper by Aschenbrenner, one of the co
founders of Open Ai, called Situational Awareness, that talks about
the future of AI. And it's wonderful because it's so
insightful on how many ways it can change the world.
It's off target in a couple of ways. He says,
(07:19):
we need to increase the power generation capability of the
US grid by forty percent by twenty twenty seven. Well,
maybe we should, but it's not going to happen.
Speaker 2 (07:31):
And even of course, if you manage to increase the
power going into the grid. Making the grid resilient enough
to carry that huge increase in power would be verging
on impossible, and a timeframe like that, right, So there
are power constraints on AI, there are regulatory constraints on AI,
maybe ethical constraints on AI. And then I guess it's
(07:53):
also the case if we stick with this comparison to
the dot com bubble and possibly even too maybe even
the smart the smartphone boom or whatever you like to
call it, in from two thousand and seven on, it's
around that Chinese competition, which didn't exist in quite the
same way in the same volume. Then we've moved, we've
moved from the similarities to the differences too quickly. That
(08:15):
was what I meant to do, but we've done it.
So there's more competition, global competition that suggests that maybe
first mover advantage isn't quite what it might have been,
and maybe there's a first mover disadvantage or there certainly
there certainly was in the dot com bubble.
Speaker 3 (08:28):
Yeah, well, rounding out the top five back in two thousand,
you have Intel, who was that disrupted? Good lord, yes,
you've got Nokia. It still makes phones. It was fifth
most valuable company on the planet. Back in two thousand,
(08:49):
you've got loosened. Loosen doesn't exist anymore. I mean, it's
it's a graveyard. And the other part that's just fascinating
is March of two thousand, when the bubble burst. Roll o'
clock forward two years, the Nasdaq was down fifty percent
on its way to an eighty percent drop Russell two
thousand value. Remember, value was trading cheap. Small cap was
(09:12):
trading cheap again, same thing today, Russell two thousand value
was up fifty three percent in those two years. The
bull market of the nineteen nineties for most stocks didn't
end until March of two thousand and two, and that
was two years into the bursting of the bubble. The
big cap indexes were dragged down, but the median stock
(09:34):
was up for those next two years. The same thing
could play out today. I'm not predicting that, but what
I am saying is that decoupling of frothy large cap
popular names from very successful mainstream businesses in valuation can
(09:57):
mean revert and I think likely, Well.
Speaker 2 (10:00):
Well, you say can mean revert historically always have mean
reversal correct, which doesn't mean that it happens this time
and doesn't tell us when it might happen. But there
has never previously been a point when this kind of
disparity has not reverted to a historical mean of some kind.
Speaker 3 (10:17):
Yeah, here's a fun factoid. Members of the S and
P five hundred or of the Russell one thousand are
at valuation multiples that are two and a half times
as large as non members. Now people will say, yeah,
that's because these are wonderful companies and these aren't pardon me,
over the last thirty years, roll o' clock back thirty
(10:38):
years they were at parody. They were about the same
valuation multiples. So they blew out one hundred and fifty
percentage point gap opened up. These guys. The non members
have had earnings and dividend growth one percent a year
faster than the members. Oh so they're better companies on
average that are valued at forty percent the valuation multiples
(11:02):
of the index members. We have a short paper membership
has its privileges that's in draft form that examines this difference,
and it just points out the obvious that if you're
a member of the index, membership has its privileges, you
are entitled one to a higher valuation multiple. Because you're
a member two, you're entitled to steady inflows of capital
(11:27):
propping the price up and holding it higher. And both
of those facts are realities of today's market. Indexing has
really swamped the markets and has compromised the price discovery
mechanism of figuring out what companies are actually worth.
Speaker 2 (11:44):
Yeah, the point being that, because of the rise of
passive investing, companies automatically get flows every time anyone buys
an index, so the differentiation between between the valuation of
stocks becomes most least.
Speaker 3 (11:57):
That's exactly right.
Speaker 2 (11:58):
Okay, But here we are, and I think you know,
we're already talking ourselves into agreeing that this is a
bubble and that it shows all the characteristics of a bubble.
And then we have the few things we haven't discussed,
like the insane levels of concentration in the US market
any global we've been at and global markets, so we've
been at concentration levels like this before. Have we been
(12:20):
quite the highest? I think we have been near these levels,
but it's always a massive danger sign, not even not
even near.
Speaker 3 (12:26):
No, this is the highest concentration in global and particularly
US because it's US concentration that leads to the global concentration.
I mean, the US is two thirds of the world
stock market. It's three fourths of the developed world stock market.
So it's the magnificent seven thirty percent of the US
stock market. They're twenty percent of the world stock market,
(12:49):
these seven companies. And yes they're magnificent. Yes they have
product that everybody wants. Yes they have product that everyone needs.
Yes they're reshaping the future of the world. But this
is a competitive landscape. Look at Intel. I mean, even
the Chips Act couldn't save Intel, and a fifty billion
(13:10):
dollars infusion from the US government could couldn't help it
defend itself against the rise of Nvidia, because in Nvidia
disrupted them. And disruption is normal. Disruption happens regularly in
a healthy capital economy. Creative destruction is a real thing.
If you are behind the curve, you're going to lose
(13:34):
business and lose market share and be pushed aside. And
that's actually a good thing. It means that the better
ideas get a chance to gain traction and grow. And
these seven companies are all disruptors and are all very
powerful in their industry, but none of them is immune
(13:57):
to competition, and Vidia has already a number of organizations
lapping at their heels with new super chips that are
in some ways better than in videos, and Video got
a head start which was tremendous. The story behind that's
also fun. Jensen Wang said, these super chips that we're building,
(14:18):
let's save some real estate on them and just not
fill it with circuitry because the next round of circuitry
is going to be better and we won't have to
redesign the whole chip. Who builds a chip with dead
space in it? It was a stroke of genius. It
allowed them to plunk in the new, better stuff faster
(14:39):
a year or two faster than they would have otherwise.
And boy, what a stroke of genius. So these are
brilliant companies. That was his disruption of the whole silicon industry.
Speaker 2 (14:49):
I suppose one thing we should just say and side
is that it's not the concentration in itself that is
necessarily a problem. In the UK, stop market is also
very concentrated, doing a very large percentage of it is
just our biggest stocks. But part of the problem with
this concentration is the correlation. So they're all in the
same industry, all in the same business and if you
look at the UK market, for example, while we have concentration,
(15:12):
the big companies are generally and in different businesses. So
it's both things, the concentration and the correlation between them, right,
and the business connections between them.
Speaker 3 (15:20):
Of course, here's a couple of fun factoids. The market
value of the Magnificent Seven was twenty trillion at the
end of September. That's bigger than all stock markets in
Europe combined. That's bigger than all of the Chinese stock market. Basically,
(15:41):
the market's value for a company is supposed to be
the market's best gas at future profit distributions back to
the shareholders discounted back to today, so the net present
value of future profits. What the market is saying is
that the future profits of these seven companies will exceed
all profits generated by all of Europe, bigger than all
(16:05):
profits generated by all of China. Is that possible? Yes?
Is that likely? I don't think so. These companies compete
against one another, and Vidia's fifty percent profit margins are
not going to continue more than two or three more
years because competition is coming into play. If they're roll o'
(16:27):
clock forward ten yures, if they are forty percent of
the super chip market instead of ninety, if their profit
margins are still a robust thirty percent not fifty. If
the pricing power means that revenues per chip are down
by two thirds over the next ten years, and that's
(16:47):
probably conservative. Plug those into a spreadsheet and what you
find is okay, goodness, Their two and thirty five profits
are going to be no better than their twenty twenty
five profits, and yet their priced is if they're going
to see stupendous growth. Pallunteers another fabulous example. How many
companies get to be priced at triple digit multiples of sales,
(17:10):
not of profits. It peaked at one hundred, one hundred
eighty times sales. So with sales last year of two
to three billion, they were they're worth about four hundred billion. Now,
how do you justify four hundred billion market cap when
your sales are two to three billion. The only way
(17:31):
to do it is to have those sales grow to
twenty billion, forty billion, one hundred billion and profits to
match and do that fast enough. Is that possible? Yeah?
Is it likely? I don't think so. So I see
bubbles galore. I also see some very profitable, highly successful
(17:52):
companies priced it premium multiples, but not nosebleed levels. And
so I think there's a lot of stocks in this
bubble that are not nonsensically priced. And yeah, that's a
good thing. That's a healthy side of the market.
Speaker 2 (18:12):
Okay, I get this my feeling that you don't think
it's quite ready to burst yet. We're not quite at
you know, Cisco levels.
Speaker 3 (18:20):
Well, some of them are at Cisco level. Cisco crested
it in early two thousand, one hundred and eighty times
earnings and pallunteers way past that.
Speaker 2 (18:34):
But I just want to read that one of the
sentence that you write in this report, which I think
kind of sums up everything you're saying, which is a
very simple, fast developing sectors writing waves of innovation and
optimism are inherently volatile, which is what you mean when
you talk about the regular disruption of these things. And
one of the extraordinary things about a bubble is that
(18:54):
inside the stories that people tell themselves inside a bubble,
that the general narrative that there is no volatility, there
isn't competition, there isn't the disruptors remain the disruptors. They
do not become the disrupted. That's how the story works exactly.
And the thing that tends to break these bubbles is either,
you know, well, it's either it's a change in the
cost of capital, it's a change in the wider environment,
(19:16):
or it's the realization that the narrative doesn't include the
next wave of disruption.
Speaker 3 (19:21):
Yeah, and people talk about the jobs lost. Every technological
revolution since the industrial revolution has destroyed millions of jobs.
The thing is that painful to those whose jobs or
whose families members' jobs get destroyed. Yes, do people care
(19:43):
about those job losses a generation later?
Speaker 2 (19:46):
No.
Speaker 3 (19:47):
The thing that is different is that the computers will
be more intelligent than we are in the not too
distant future. In some ways, they already are. My CEO,
Chris Bright likes to play with AI every weekend for
three to five hours, testing its capabilities, and he had
a conversation with GPT five about how AI fits in
(20:12):
the realm of human evolution, and it gave a discourse,
short discourse that was so insightful you'd think it was
from a double PhD in anthropology and philosophy. And it
closed with the observation, we don't know yet whether human
intelligence and machine intelligence will merge, or whether human intelligence
(20:38):
will at some stage be a fond and distant memory
for AI. And then it closes with the sentence the
wonderful thing in this revolution is that we get to choose.
And I thought, who the heck is we?
Speaker 2 (20:57):
Well, that's an interesting question, isn't it who we? In
this context? I don't think it's me. It might be you,
but I'm not feeling like it's me.
Speaker 3 (21:05):
But anyway, existential threat, Yeah, do I worry about that?
I don't because I try to worry about things I
can have any influence over. This revolution is coming and
it's big. But who's going to be the disruptor in
the coming decade? Who will be the market leaders ten
years from now? Some of market leaders today will be
(21:28):
the market leaders in ten years. Some won't. They're all
chrisd as if they will be the market leaders.
Speaker 2 (21:47):
So I think where we are now is that we
are agreeing that we are at the very least in
bubble territory, that valuations are in bubble territory, that there
is not enough understanding of the next round of disruption.
One thing we haven't mentioned, actually is the extent of
the capex and the extent which AI capex is crowding
(22:09):
out everything else in the US, and when stuff gets very,
very capex heavy, of course, if you do get disrupted,
you're in a whole lot of trouble, right. I mean,
a lot of the dot com bubble with very capex light,
and same with smartphones, platforms, et cetera. Capex light. But
this is pretty capex heavy.
Speaker 3 (22:26):
I'm glad you mentioned that. One of the fascinating facts
about growth stocks is that R and D is positively
and reasonably strongly correlated with future growth for companies. I mean,
it's not perfect. You can waste money on R and
D just like you can waste money on anything else.
(22:48):
Capex spending is negatively correlated with future growth. Really surprising.
Speaker 2 (22:53):
We don't tell the AI found that.
Speaker 3 (22:56):
Well, here's an example. In a healthy capitalist system, happy
customers are the essential component of success. If you're going
to succeed, you must have happy customers who value your
product more highly than what you charge for it. In
Vidia has happy customers. They line up for the privilege
(23:16):
of getting on a waiting list to buy massive quantities
of super chips. In Vidia's customers have yet to figure
out how to monetize that capex. They're having trouble figuring
out how to earn money on AI And so is
that going to happen? Yes, it will, But is it
(23:37):
happening fast enough to support the prices of these stocks?
Probably not, And therein lies one of the key challenges.
Speaker 2 (23:45):
Okay, So add that infa mix, and we could say,
when you wrote this back in March, you said, and
maybe we're in nineteen ninety seven, maybe we're in the
late nineteen nineties, or maybe we're right on the edge
of that nasty that beginning of two thousand. We can't
be sure. It sounds like you would put yourself closer
to the late nineties at the moment.
Speaker 3 (24:06):
No, No, I would. I would say that we're more
likely to be near the cusp than not.
Speaker 2 (24:12):
Now, okay, we say, let's put ourselves at November ninety nine.
You want to do that, Sure we're in November ninety nine.
If we were in November ninety nine, what would be done.
The first thing we'd do is we'd sell our Cisco
because we've already made pushing three thousand percent on that
right then, what would we do?
Speaker 3 (24:28):
The trick about bubbles is never short them because they
can go longer, last longer, and go further than you
can imagine.
Speaker 2 (24:38):
That's what a lot of spread patter is found out
in the UK in nineteen ninety nine.
Speaker 3 (24:42):
And so what you do is you underweight, you fade
your exposure to bubbly stocks, and do it gradually. So
just let people average in to a bargain, you average
out of froth and take take some profits, and do
it gradually and take your time at it because you
don't know when the turn's going to happen. The same
(25:03):
thing works when it comes to bargains. We're in the
only major business in the global macroeconomy where people hate bargains.
I mean, imagine if Tiffany's posted a sign saying everything
marked down twenty percent before Christmas, and Cartier across the
street posts a banner sign saying shiny beautiful stuff for
(25:25):
Christmas only twenty percent more than last year, and people
flood Cartier and shun Tiffany's. When it comes to retail,
people don't behave that way. When it comes to investing,
people absolutely behave that way, and so you have to
be careful with bubbles. It doesn't mean you have to
own them. It doesn't mean you have to fully weight them.
(25:46):
So a fundamental index, which we invented twenty years ago,
simply reweights the growth stocks down to their economic footprint.
It doesn't kick them out. So the Magnificent seven is
thirty four percent of the S and P five hundred,
but it's eighteen percent of RAFFI. It's it's big, it's
very big, but it's not thirty four percent. And so
(26:11):
that's one tool in our tool kit. Fundamental index.
Speaker 2 (26:14):
Explain that a bit further, because you know, you've been
known before, and they'll be some listeners you understand completely
about your fundamental indices, and they'll be others who simply don't.
So tell us a little bit more about how that works.
Speaker 3 (26:26):
We came up with a strategy twenty years ago called
RAFFI Research Affiliate It's fundamental index. Instead of choosing companies
based on their market value, the more expensive they are,
the more likely they are to be in the index,
we choose stocks based on their economic footprint. How big
is their business? What are their sales as a percentage
of all public companies? What are their profits as a
(26:47):
percentage of all public companies? If it's a big enough business,
it's included. And then it's weighted by the fundamental size
of the business.
Speaker 2 (26:54):
And what do we mean by fundamental size of the business.
Speaker 3 (26:56):
Well, just as an example, what are the sales of
Nvidio as a percentage of all companies in the world.
It's a fraction of a percent, but it's close to
five percent of world stock market capitalization. And so it's
this big a company, it's this big in market cap.
Fundamental index says, thanks for that lovely gain, I'm going
(27:17):
to weight you down here. It doesn't say I'm going
to kick you out. And so fundamental index is one answer.
So fundamental index has two interesting attributes. It downweights the
gross stocks. It upweights the value stocks. It gives you
a stark value tilt. Always value has been terrible for
fifteen years, so why would you want to do that?
(27:38):
Because it also has a rebalancing alpha. If a stock
sores and the fundamentals of the company don't validate that rise,
RAFFI will say, thanks for the nice gain, I'm going
to trim you. The market's constantly changing its price on
what a company's worth. You're concratrating against those whenever they're
not validated by fundamental changes in the scope of the business,
(28:00):
and so that contratrating is a source of incremental return.
So the cool thing is that RAFI globally has beat
global value indexes by over two percent a year since
the launch of RAFI twenty years ago, and has beat
value indexes in roughly three out of every four years.
(28:21):
There's hardly anything out there with that kind of consistency.
And if you're able to steadily beat value by two
two and a half percent a year and win three
years out of four, then to the extent you want
a toe hold in value as a safety net for
your portfolio, why would you do it any other way?
(28:41):
So this represents one of the possible answers.
Speaker 2 (28:45):
It's interesting, isn't it, because when you talk about the
divergence between value and value and growth to the extent
you can make this distinction value and growth, and also
the divergence of value were seen between large and small caps.
The tempting thing for most investors, or certainly investors with
mone inclinician, is to go pure value, go pure small cap,
et cetera. But I think what you're explaining is that
(29:06):
that doesn't really work because you have to wait so long.
Very often, you know your weight can be years. Suddenly
this time around, there have been little moments where you think, oh,
look it's back. Value's back, active management is back, etc.
Then and then suddenly often the video goes again, and
you know the value investors don't looks are great again.
So you know your weight can be very very long
(29:28):
for a pure value investor.
Speaker 3 (29:29):
Your weight can be very very long for any style
that's out of favor. Growth has been out of favor
for long stretches of time, and we haven't seen that recently,
and so folks with less gray hair than me will
often say, yeah, but that was that was ancient history.
Growth hasn't had any troubles in the last fifteen years,
(29:51):
absolutely true, But history has a knack for repeating, if
slowly and if imperfectly. And when you get to these
vast spreads and valuation two and a half to one
between members of the index and non members eight to
one between growth and value measured on price to book
(30:11):
value twelve to one for growth versus value measured on
price to sales ratios twelve to one, that's extraordinary. And
so when we look at today's markets, you see things
very very stretched. You see a narrative that explains why
they deserve to be stretched, But narrative set prices. You
(30:33):
don't make money by betting on a narrative. You make
money by finding where the narrative might be missing something.
And what it might be missing is competition.
Speaker 2 (30:40):
Yeah, what about a pure equal weighted index? So you know,
most most passive investing takes place in market cap weighted
in disease, which is why you end up with such
a bias towards the bigger equities. And so if you're
investing passively at the moment, the reason you have such
enormous exposure to the Magnificent seven and to America is
because you are You're doing this on a market weighted basis.
(31:01):
But there's a good argument to be made for the
regular automatic rebalancing that comes with a pure equal weighted index.
Speaker 3 (31:09):
It's interesting. Equal weighting has been around for a long
time and it works for the very patient investor. It
gives you a stark small cap tilt because the big
cap stocks are being reweighted down, and it gives you
a relatively deep value tilt. But it's alpha engine is
(31:30):
the same as Raffi's, same as fundamental index for stock sores,
you're going to trim it with RAFFI. If the stock
sores and the fundamentals don't, you're going to trim it.
But if the fundamentals rise with the price, you're going
to be perfectly happy and stay of the course. Yep,
RAFI has the advantage relative to equal weighting of firstly
(31:52):
working a little better. It's about one hundred basis points
per anum better performance. Secondly, it still buys large businesses,
and so large businesses are often large cap, so it
doesn't have the stark small cap tilt that equal waiting does,
and therefore it has huge capacity. Equal Waiting if it
(32:13):
was run on globally on one hundred billion dollar scale,
would run into some serious problems of having to buy
more of the smallest stock in the index than exists.
Speaker 2 (32:24):
Okay, that seems like a reasonable argument against it. Yeah, okay,
so so not equal weight or an equal weight. It's
an answer, but maybe not the best answer. Going straightforward
value not necessarily the best answer. So fundamental index approach
that you are using sounds very compelling, and the risks
(32:46):
to it.
Speaker 3 (32:46):
Are The risks to it are very simple. It has
a stark value tilt. When value is out of favor,
it will struggle to keep up with the market, but
it won't struggle to beat value. It beats value relentlessly.
So to the extent you want value in your portfolio.
Like I said, why would you do it any other ways?
It's so compelling, it's so simple, and it's so powerful.
(33:08):
That's its biggest disadvantage is the value tilt.
Speaker 2 (33:12):
Robert, what would make you change your mind about the
idea that AI is in a bubble? What would make
you go that, you know what, that's worth one hundred
and ninety pe or in video, yeah, it's going to
grow thirty percent forever. What would make you look up
and go, actually, do you know we all go on
about bubble. The bubble story is very compelling as well, right,
(33:33):
I mean it's compelling as the narratives around bubbles are
the fact that there is a bubble that you should
avoid and it's all quite exciting, and there'll be a
crash and you can be the clever person who predicts
the bubble, et cetera. We will want to be that person, right,
it's the top Look, they rang the bell. I'm right.
Everyone wants to be involved in that bubble narrative too,
But what could make us wrong about that?
Speaker 3 (33:52):
I love your mention of the ringing of a bell.
People who buy bubble stocks need to think about one thing.
What's my cell discipline? What would prompt me to sell?
Will I hear a bell chime that says now's the time?
If not, fading your exposure gradually over time has the
(34:17):
benefit of not having to wait for the bell, and
has the drawback of you will look and feel like
an idiot until the turn happens. None of us likes
to feel like an idiot. As for what would make
me think, gosh, this isn't a bubble, it's that the
fundamentals actually catch up to the price, and to some
(34:37):
extent that's been happening. In Vidia's profits and sales swored
and continue to surge strongly, But it is priced to
reflect an expectation of, oh, let's say twenty thirty percent
growth per annum for the next decade, and that's a stretch.
That's a lot of growth for a long time. It's
(34:59):
not impossible, but it is implausible in a marketplace where
competitors are coming onto the scene with new super chips
that in some ways are better than in NVIDIAs, and
so at a minimum they're going to see that fifty
percent profit margin come down and the ninety percent market
(35:19):
share come down.
Speaker 2 (35:21):
For those who aren't interested in index investing a school,
who aren't interested in straightforward indices or fundamental indices, et cetera.
Where do you see value? I mean small caps? Obviously
you've said we like to think there's a lot of
value in the UK market despite our appalling politics and
miserable economy, that UK is.
Speaker 3 (35:39):
A value market.
Speaker 2 (35:43):
You say that it's a bad thing.
Speaker 3 (35:44):
I don't think it's a bad thing at all. I
think UK stocks over the coming decade will soundly outperform
US stocks. US stocks have to deliver growth well ahead
of what we've seen historically and well ahead of the
rest of the world. Now that narrative is out there,
(36:05):
the American exceptionalism story, Okay, is there American exceptionalism. We're
not smarter than Europeans or East Asians. We do have
less regulation than Europe and punitive regulation that treats success
as a bad thing, impedes success and impedes growth. So yes,
(36:28):
that element of exceptionalism I think is slightly true. We're
over regulated, but not to the extent that Europe is.
But be that as it may. Does it make sense
for the US to be three fourths of the developed
world stock market? I don't think so. Does it make
sense for seven companies to be twenty percent of world
(36:48):
stock market capitalization? I don't think so. This does represent
an unusually concentrated, in frothy market. I think that European
stocks broadly are cheap, relatively attractive. They're cheap for a reason.
The narrative tells us exactly why they deserve to be cheap,
and the narrative is partly true. Emerging markets are they're
(37:12):
going to have better growth than us. Yeah, they're just
imitating us and borrowing ideas from us will allow them
to course.
Speaker 2 (37:20):
And no correlation between growth and stock markets, we know that, right, correct?
Speaker 3 (37:24):
Correct?
Speaker 2 (37:25):
It's all about where we start. It's all about starting valuation.
Speaker 3 (37:28):
Starting valuation is low. Fundamental index in emerging markets has
a has a PE ratio of eight. If you can
buy half the world's economy at a PE ratio of eight,
why would you should buy the US at PE ratios
in the thirties China? China is now cheap. It is
(37:48):
headed by a guy who is a Maoist to the core,
and so as long as she is at the helm,
if you succeed in China, you'll be punished for it.
And if you succeed in China and question the wisdom
of the CCP, you're going to be disappeared for it.
China is relatively inexpensive today and for the patient investor
(38:15):
is probably a goodbye. It probably won't really get out
of its way until you get another dang shoping at
the helm. Somebody who believes that success is not evil Argentina,
I think Malay is marvelous. He's courageous. Anytime you're paying
people on government salaries to do more or less nothing,
(38:38):
you've got a formula for stasis. And there are lots
of government employees everywhere in the world who are doing
great work. But when you get a hyper regulated economy. Again,
in Argentina, success was seen as evil. If you were successful,
(38:58):
you had to have done something wrong and you needed
to be punished. That's a terrible attitude for promoting future success,
for promoting prosperity.
Speaker 2 (39:12):
And living standards.
Speaker 3 (39:14):
All right, Yeah, it is far too common Argentina and
Malaya is changing the narrative. I think he's a remarkable man,
a little self absorbed, but hey, so are a lot
of leaders.
Speaker 2 (39:29):
Yeah, definitely going to be a little stomach of volatility there, Rob. Listen,
I'm taking out too much of your time. I'm really sorry.
I promised you thirty five minutes and here we are.
This is irresponsible interviewing. But listen, tell me bitcoin. You
got any bitcoin in your portfolio? Yes, it's not something
for the indices, but you've got something new you do.
Speaker 3 (39:47):
In twenty thirteen, I was intrigued by bitcoin. I didn't
see why it would be worth anything discounted and at
present value as zero, But as a libertarian, I thought
kind of cool to cut the cut the links with
central bankers trying to control everything. And so I went
out and I bought a bitcoin. And I still own
(40:08):
one bitcoin. I've owned it since twenty thirteen. My cost
basis is two hundred and twenty five bucks.
Speaker 2 (40:15):
Amazing. And and you haven't lost the pass code, have you,
not like some other people on this podcast.
Speaker 3 (40:20):
And I have no intention of selling it.
Speaker 2 (40:23):
You still have access to your bitcoin.
Speaker 3 (40:26):
I still have the code to get into my bitcoin,
and yes, I could still sell it.
Speaker 2 (40:30):
Fantastic. I still have the phone that once had the code.
Speaker 3 (40:37):
Anyway, there's supposedly something like twenty twenty five percent of
all bitcoin that is simply lost.
Speaker 2 (40:42):
Yeah, on holiday with my bitcoin, happy times.
Speaker 3 (40:45):
Yeah yeah, never to be by anybody. It's just poof evaporated.
Speaker 2 (40:50):
Yeah, which is of course that one thing that I've
always had trouble with a bitcoin. No customer services, no
one to call, right, how do I reset my password?
Would you like to know the name of my childhood pat?
Would you like to know where I went to school?
I can tell you my mother's maiden name. Just give
me my bitcoin. But doesn't work like that. I'm very
naive about it anyway. Listen, moving on from bitcoin gold,
you got any golden your put photo?
Speaker 3 (41:11):
Yes, I have a little gold in a safe at home,
and burglars who are watching please don't go and break
into my safe anyway. It's there for peace of mind.
But it's not a lot.
Speaker 2 (41:25):
It's enough to sustain the ultimate insurance, right, Yeah, And I.
Speaker 3 (41:29):
Don't know how good it would be in a financial
crisis severe enough that dollar bills no longer worked in
credit cards and no longer work, So I don't know
that gold would work amazing.
Speaker 2 (41:39):
Thank you. One last final question, because I'm guessing that
you're answered this might be interesting, Rob. What are you
reading right now?
Speaker 3 (41:46):
Ah, this is funny being on a British broadcast. I'm
reading a history of the American Civil War. It's a
three volume by an historian named Atkinson, who's brilliant writer.
And the first of the three is the British are Coming.
Speaker 2 (42:06):
No one will be frightened these days, and.
Speaker 3 (42:08):
So it's a fascinating book. It's a dive into the
personalities and personal interests and the thinking processes of the
people who led both sides of the Revolutionary War.
Speaker 2 (42:21):
Okay, well, that is a great tip, and I'm sure
everyone will rush out to buy them. So I'm not
sure they Well, I'm pretty I'm not sure we have
that many listeners you will want to go for a
whole three volumes, but we'll see, we'll see. Rob. Thank
you very very very much for joining us today. Absolutely fascinating.
Speaker 3 (42:38):
Thank you for reaching out and this has been wonderful
fun as always.
Speaker 2 (42:44):
As ever, ever, thank you thanks for listening to this
week's Marrin Talks Money. If you like us, show, rate, review,
and subscribe wherever you listen to podcasts and keep sending
your questions or comments and marror money at Bloomberg. You
can also follow me in John on Twitter or X.
Are you on on Twitter?
Speaker 1 (43:04):
Rob?
Speaker 3 (43:04):
I am, but I've never actually done it personally.
Speaker 2 (43:08):
Do you know what your handle is? Rob? What? What's
your what's your Twitter name? You don't go, We'll look
it up. We'll look it up nowhere about that.
Speaker 3 (43:13):
It's probably it's probably at Rob or not, but I.
Speaker 2 (43:16):
Don't know bound to be something like that, right, Okay,
As I was saying, you can also follow me in
John on Twitter all X, I'm Marinus W and John
is John Underscore Stepec. This episode was hosted by me
Maren's Unset Web, produced by Sersadian Moses and sound designed
by Blake Mabel's and Aaron Caspers. And special thanks of
course to Rob. Thank you
Host
Merryn Somerset Webb
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