Podcast Summary – Excess Returns: “The Bubble You Can't Short | Rob Arnott on What You Can Do Instead”

Podcast: Excess Returns
Episode: The Bubble You Can't Short | Rob Arnott on What You Can Do Instead
Date: November 19, 2025
Guest: Rob Arnott (Founder/Chairman, Research Affiliates)
Hosts: Jack Forehand, Justin Carbonneau, Matt Zeigler

Episode Overview

This episode features Rob Arnott, acclaimed quantitative investor and founder of Research Affiliates, discussing the definition and dynamics of market bubbles, the perils of shorting them, lessons from the dot-com era, the impact of AI and Capex on markets, the evolution of index construction, and actionable strategies for investors facing richly valued markets—particularly in US large-cap growth. Arnott shares both data-driven insights and practical takeaways based on decades of market research and experience.

Key Discussion Points & Insights

1. What Defines a Bubble? (01:01, 03:48)

• Implausible Growth Assumptions: To justify currently lofty prices, you must make implausible (not impossible) growth assumptions.
• Narrative Dominance: The marginal buyer is motivated by narrative, not by rigorous discounted cash flow (DCF) modeling.
• Asset-by-Asset Phenomenon: Bubbles rarely encompass an entire market; they’re typically concentrated in specific assets.

“You have to make implausible, not impossible, but implausible growth assumptions to justify today's price. That's part one and part two. The marginal buyer doesn't care about discounted cash flow models—they care about the narrative.”
— Rob Arnott (01:01)

• Critical Caution:
  • Never short sell a bubble; they can last longer and go further than you can imagine.

2. Dot-Com Bubble Lessons for Today (07:21–13:09)

• Similarities:
  • Today's tech/AI exuberance echoes the late-'90s/2000 dot-com era, with dominant companies and visionary leadership.
• Differences:
  • AI may be an even bigger technological change than the Internet itself.
• Company Case Studies:
  • Only one of the top six most valuable companies from 2000 (Microsoft) outperformed the S&P 500 over 25 years; the rest (GE, Cisco, Intel, Lucent, Nokia) lagged or disappeared.
• Narratives & Disruption:
  • Disruption is constant—“disruptors get disrupted.”
  • The bubble narrative in the dot-com era was right about transformation but wrong about speed and invincibility.
• Impact on Indices:
  • The bubble's collapse hit cap-weighted indices hardest, while average stocks (especially small-cap value) performed well.

“One of the lessons of the dot-com bubble is disruptors get disrupted. Another lesson is narratives shape prices. So don’t bet on the narrative—it’s already in the price. Look for where the narrative might be off target.”
— Rob Arnott (09:50)

3. Practical Investing Takeaways: Diversification, RAFI, and Value (13:09–18:02)

• Portfolio Implications:
  • Investors heavily concentrated in tech or growth are exposed to bubble risk.
• RAFI Approach:
  • Fundamental indexing weights companies by business size (not market cap), systematically trimming overpriced winners and topping up on “cheap” fallers—a value-tilted, contrarian rebalancing approach.
  • Over 20 years, global RAFI outperformed MSCI value by ~2.5% per year.
• Global Valuations:
  • US stocks are historically expensive (Shiller PE > 40); value stocks are near historical lows; emerging market value is especially attractive (Shiller PE ~12).
• Averaging Out:
  • Take gains systematically from markets or segments that have soared, reallocating to unloved, lower-priced segments.

“US stocks are expensive... Value is really cheap now. RAFI is a fantastic way to do it... Emerging markets value is priced at a Shiller PE ratio of about 12. That's 70% off from U.S. S&P 500.”
— Rob Arnott (15:55)

4. AI, Capex, and Stock Returns (19:01–25:32)

• Capex vs. R&D:
  • Historically, R&D spending is positively correlated with future stock returns; Capex is negatively correlated.
  • High Capex sectors may fail to generate corresponding profits, despite technological promise.
  • Nvidia’s customers, for example, are spending heavily on AI infrastructure but “have yet to find any way to transform that Capex into revenues and profits.”
• AI’s Societal Impact:
  • The ultimate beneficiaries of AI will be users and society at large, not just infrastructure builders or prominent players.
• Technological Comparisons:
  • Like railroads, telegraphs, and the internet, most economic benefit accrues to consumers and indirect users, not always to initial infrastructure providers.

“If you look at Nvidia, they have very happy customers. People are lining up... for the most expensive chips in the history of computing. Nvidia's customers have yet to find any way to transform that Capex into revenues and profits.”
— Rob Arnott (19:25)

5. Is AI "Different" This Time? (23:00–25:51)

• Historic Parallels:
  • People routinely overestimate the investment payoff from new technologies for infrastructure providers.
  • AI’s transformative power is real, but the best-performing stocks might not be the most obvious tech leaders.
• Disruption Uncertainty:
  • Even dominant players like OpenAI, Google, and others can be abruptly disrupted.

“When I’m asked, who are the big beneficiaries of AI? My answer is—you, me, everybody. We’re all big beneficiaries... It’s going to rock our lives, because it’ll be made part of our lives in ways that we don’t even notice.”
— Rob Arnott (23:16)

6. Personal Use of AI (30:33–33:40)

• Rob’s Practices:
  • Uses AI tools for research, data gathering, and creative work (e.g., using DALL-E and ChatGPT for research paper images, replacing graphic artists).
  • AI enables trivial queries and rapid insight, which would have been impossible or time-consuming a few years ago.

7. Job Disruption and Technological Progress (33:40–37:07)

• Creative Destruction:
  • White-collar automation, like prior blue-collar waves, will both destroy and create millions of jobs.
  • Media focuses on losses, rarely discussing the subsequent gains.
• Long-run Productivity:
  • Every generation's productivity gains depend on transformative innovations.

8. Reinventing Index Construction & Growth Investing (37:07–53:23)

• Beyond Simple Value & Growth:
  • RAFI method: weights based on real business size, systematically rebalances toward value.
  • RAC WE (Research Affiliates Cap Weighted Index): tweaks for more “economic” cap weight; has added ~81bps of alpha with >95% overlap versus S&P 500.
  • Proposes new “fundamental growth” indices—selecting fast-growing companies by objective past growth, weighting by dollar rather than percent growth.
  • Not all expensive stocks are growth; “expensive and slow-growing” stocks have the worst long-term returns.
• Magnificent Seven Analysis:
  • Not all “Magnificent Seven” qualify for Arnott’s new growth index (e.g., Amazon and Alphabet don’t currently make the cut).

“Why do you want to own expensive companies with sluggish growth? ... Over 2% per annum under the market, per annum for 55 years, was expensive and slow growing.”
— Rob Arnott (43:35)

• Index Flaws:
  • Cap-weighted indices are not always passive: turnover (through index additions/deletions) often leads to buying high, selling low—driven more by price moves than business fundamentals.
  • Arnott lampoons this as being “like Cathie Wood on crystal meth.”

9. International and Emerging Markets Outlook (53:23–57:32)

• Arnott’s Personal Portfolio:
  • Skewed to emerging markets and value globally, finds these markets deeply undervalued with high forward return prospects.
• Long-Term Approach:
  • Invest with a 5–10 year horizon; short-term performance is unpredictable, but odds favor value and emerging markets beating US growth over a decade.
• US Large Cap Growth:
  • Priced “for perfection”—does not need to crash, but even modestly missed expectations could lead to underperformance.
• Behavioral Advice:
  • “Average your way into what’s cheap, average your way out of what’s expensive.”

“The highest return for major markets is emerging markets value at 10% annualized return expectation. Large cap growth for the US is 1½% per year for the next 10 years. 10% versus 1½%—I’ll take the 10.”
— Rob Arnott (54:56)

10. Future Research and Product Development (59:17–61:55)

• Active Research:
  • New indices in development, including “fundamental growth” and leveraged long/short products based on the RAC WE index.
• Personal Skin in the Game:
  • Arnott personally implements these strategies—“I eat my own cooking.”

Notable Quotes & Memorable Moments

• On Bubbles:
  “Never short sell a bubble. Bubbles can go further and can last longer than you can possibly imagine.”
  — Rob Arnott (01:01, 03:48, 57:32)

• On Capex vs. R&D:
  “If you go back historically and you sort companies based on R&D expenditure, that's positively correlated with subsequent success as a stock. Capex tends to be negatively correlated with future stock market performance.”
  — Rob Arnott (01:01, 19:25)

• On the Perils of Market Indices:
  “The active side of indexing is like Cathie Wood on crystal meth.”
  — Rob Arnott (47:35)

• On Averaging Out:
  “We all hear about averaging in. How about averaging out? Averaging out is just as powerful a discipline and is overlooked.”
  — Rob Arnott (58:14)

Timestamps for Key Segments

• Definition of a Bubble: 01:01, 03:48
• Dot-Com Lessons & Asset Bubbles: 07:21–13:09
• Practical Takeaways & RAFI: 13:09–18:02
• AI, Capex & Stock Outcomes: 19:01–25:32
• Disruption & Use of AI: 30:33–33:58
• Technology, Jobs & Productivity: 33:58–37:07
• Index Construction – Innovations: 37:07–53:23
• Emerging Markets & Diversification: 53:23–57:32
• Behavioral Guidance (“Averaging Out”): 58:14
• Future Research & Product Pipeline: 59:17–61:55

Conclusion

Rob Arnott offers a sophisticated but pragmatic framework for navigating periods of extreme market valuations, with a strong emphasis on the historical hazards of excessive narrative-driven hype, the importance of diversification and disciplined rebalancing, and the potential for structural improvements in index investing. He remains bullish on value and emerging markets over the next decade, skeptical but not dismissive of US large-cap growth, and deeply attuned to the cyclical—and sometimes perilous—nature of investor sentiment and market structure.

Useful for:
Investors seeking a comprehensive, data-driven perspective on market bubbles, future opportunities in global markets, index construction improvements, and the interplay between new technologies (like AI) and long-term investment returns.