Podcast Summary: The Compound and Friends – Episode "Big Market Delusion"

Release Date: March 14, 2025
Host: Downtown Josh Brown
Guests: Michael Batnick and Rob Arnott
Episode Title: Big Market Delusion

1. Introduction and Guest Welcome (06:11 – 07:14)

In this episode, Josh Brown welcomes Rob Arnott, the founder and chairman of Research Affiliates, renowned for his expertise in multi-asset active equity and alternative indexation strategies. Rob Arnott is also a co-portfolio manager for the PIMCO All Asset and PIMCO Rae funds. The hosts express their enthusiasm for having Rob join them in New York, reminiscing about their previous interactions and events they've hosted together.

2. Current Market Sentiment and Potential Bubbles (07:14 – 11:14)

The conversation swiftly transitions to the prevailing market sentiment, with Josh Brown highlighting the "MAG7" (a group of seven major growth stocks) rally and Tesla's fluctuating stock performance. Rob Arnott expresses his nervousness about the market's stability, stating:

“I think we may be seeing early stages of a bursting bubble, but I also see lots of cheap assets out there. So I think turbulence is going to be great.”
(00:46)

Michael Batnick concurs, emphasizing the existence of undervalued assets in areas like emerging markets (EM) and international small-cap value stocks. The discussion underscores concerns about overvalued growth stocks and the potential for significant market corrections.

3. The EV Market as a Big Market Delusion (11:14 – 19:26)

Rob Arnott delves into the concept of "Big Market Delusion," a term he and Michael Batnick coined to describe bubbles where numerous companies within a newly created market are overvalued based on unrealistic growth expectations. He explains:

“Big market delusion is a special kind of bubble...the narrative takes shape that these folks are creating a new world...the bad news about narratives is that they're 100% reflected in share prices already.”
(11:28)

Using the Electric Vehicle (EV) market as a case study, Rob highlights the surge in EV stocks since 2020, noting that despite the influx of new companies, only a few like Tesla and BYD have managed to outperform the S&P 500. The median performance of these EV specialists has been bearish, with a weighted average showing an 80% decline.

4. AI Stocks and the Next Big Market Delusion (19:26 – 31:31)

The hosts transition to discussing Artificial Intelligence (AI) stocks, pondering whether AI could be the next Big Market Delusion. Michael Batnick shares his skepticism about the sustainability of AI-driven growth, particularly highlighting the immense data requirements for effective AI applications. He notes:

“AI is massively data hungry...If your investment horizon is multiple quarters or years, which ours is, there's not enough data. AI is not very useful.”
(28:54)

While acknowledging some firms might be leveraging AI for short-term gains, Batnick remains cautious about the long-term prospects, suggesting that the hype surrounding AI may not translate into fundamental value.

5. Valuations: CAPE Ratio and Current Trends (32:25 – 44:57)

Rob Arnott brings attention to the Cyclically Adjusted Price-to-Earnings (CAPE) ratio, questioning its relevance given historical shifts in valuation trends. He observes that:

“Valuations have been trending higher for 25 years... If you drew a line of best fit through that left graph, it would be upward sloping and it would end at around 25.”
(41:56)

Michael Batnick echoes concerns about the overreliance on valuation metrics, emphasizing that high earnings multiples suggest unsustainable profit margins. He warns:

“In a steady state economy...that's a big deal because tacitly, that says 50% profit margin...that's not priced into the share price.”
(25:03)

The discussion highlights the risks associated with extrapolating past growth rates and the potential for multiple contractions in high-growth sectors.

6. International Markets' Outperformance (56:54 – 64:10)

A significant portion of the dialogue focuses on the recent rally in international stocks, particularly in Europe and emerging markets, contrasting sharply with the underperformance of U.S. stocks. Josh Brown remarks on the unprecedented inflows into European equities:

“The Stocks Europe 600 index have outperformed US stocks by 12 percentage points in dollar terms over the past 20 trading days. That is astoundingly rare.”
(60:32)

Rob Arnott attributes this outperformance to geopolitical factors, such as fear of Russia and increased defensive spending, rather than improvements in corporate fundamentals. The hosts discuss how this shift presents opportunities for investors to pivot towards undervalued international and emerging market stocks.

7. Investment Strategies and Opportunities (64:10 – 70:17)

The panel explores various investment strategies to navigate the current market landscape. Michael Batnick introduces Research Affiliates' strategies, including diversification through lesser-known asset classes like commodities, high-yield emerging market securities, and TIPS (Treasury Inflation-Protected Securities). He emphasizes the importance of "asymmetric risks," advocating for buying undervalued assets that have significant upside potential when the market corrects.

Rob Arnott highlights the resilience of certain diversified funds during market downturns, comparing their performance favorably to traditional 60/40 portfolios. He points out:

“In the US bear market during the global financial crisis, all asset was down roughly half as much as 60:40 was down.”
(73:30)

8. Discussion on Recession and Government Policy (70:17 – 78:39)

The conversation shifts to macroeconomic policies, particularly government spending and its impact on GDP growth. Michael Batnick criticizes deficit spending, arguing that excessive government expenditure hampers private sector efficiency and economic growth. He references their research showing a negative correlation between government spending and per capita GDP growth:

“If you simply take the magnitude of government spending over any five-year span and correlate it with the magnitude of per capita GDP growth, the correlation is minus 50%.”
(49:00)

Rob Arnott and Josh Brown discuss the challenges of predicting economic outcomes amidst volatile policies, such as fluctuating tariffs. They debate the sustainability of current economic models and the implications of potential austerity measures on the stock market and broader economy.

9. Conclusion and Final Thoughts (78:09 – End)

As the episode wraps up, Rob Arnott and Michael Batnick share their personal interests and future plans, offering listeners a glimpse into their lives beyond the financial discourse. The hosts encourage listeners to explore Research Affiliates' resources for deeper insights into diversified investment strategies.

Notable Quotes:

• Rob Arnott (00:46):
  “I think we may be seeing early stages of a bursting bubble, but I also see lots of cheap assets out there. So I think turbulence is going to be great.”

• Michael Batnick (11:28):
  “Big market delusion is a special kind of bubble...the narrative takes shape that these folks are creating a new world...the bad news about narratives is that they're 100% reflected in share prices already.”

• Michael Batnick (28:54):
  “AI is massively data hungry...If your investment horizon is multiple quarters or years, which ours is, there's not enough data. AI is not very useful.”

• Michael Batnick (25:03):
  “In a steady state economy...that's a big deal because tacitly, that says 50% profit margin...that's not priced into the share price.”

• Rob Arnott (41:56):
  “Valuations have been trending higher for 25 years... If you drew a line of best fit through that left graph, it would be upward sloping and it would end at around 25.”

• Michael Batnick (49:00):
  “If you simply take the magnitude of government spending over any five-year span and correlate it with the magnitude of per capita GDP growth, the correlation is minus 50%.”

Conclusion

In "Big Market Delusion," the hosts and guests dissect the complexities of current market dynamics, emphasizing the risks of overvalued growth stocks, the potential bubble in the EV sector, and the skepticism surrounding AI-driven investment strategies. They advocate for diversification into undervalued international and emerging markets as a hedge against market turbulence. Additionally, they critique government fiscal policies, highlighting the detrimental effects of excessive spending on economic growth. The episode serves as a comprehensive analysis for investors seeking to navigate a potentially volatile and inflationary market environment.