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Stimulus is like heroin, 'it doesn’t do you a lot of good long-term': Wall Street heavy-hitter

Yahoo Finance's Brian Sozzi, Julie Hyman, and Myles Udland speak with Rob Arnott, Research Affiliates Founder & Chairman about market outlook for 2021 under a Biden administration.

Video Transcript

JULIE HYMAN: I want to turn back to the markets now and to Janet Yellen, who is set to begin her testimony before the Senate Finance Committee any moment. She, in her statement that she released, already talked about acting big in terms of stimulus to support the US economy. I want to bring in Rob Arnott now. He is founder and chairman of Research Affiliates. Rob, it's great to see you.

So as we hear this talk about stimulus, that $1.9 billion plan that the President-elect has proposed, what do you think continues to be the knock-on effect in the markets? It seems like as long as the taps are on, markets have gone up.

ROB ARNOTT: That sure seems to be the pattern. Words matter. Applying the word stimulus to spending large quantities of money on a fiscal basis that we don't already have, creating new money from the Central Bank, it all feels good. Stimulus, think of it as a little bit like heroin. I've heard that heroin feels good. But it doesn't do you a lot of good long-term.

The reduced spending from the lockdowns paired with the fiscal and monetary so-called stimulus pours money into the markets. There really is no alternative. With zero yields, you might as well go into stocks at any price. Retail is surging. Retail investors are surging in their activity, chasing the market darlings, creating bubbles. And when fiscal and monetary stimulus don't promote spending in the macro economy, it goes into Wall Street not Main Street.

MYLES UDLAND: Rob, I want to stay on the retail side of the equation. It's certainly an interesting dynamic, not only because there's a global pandemic, tens of millions of people lost their job last year, but because it had been so long, you know, really 15, 20 years since we'd seen retail participation en masse within the market.

How does that change the character of the market in your view as we try to figure out what the next big trends are? I mean, having this kind of money in there has certainly changed the character of things at various points of this year.

ROB ARNOTT: Well, retail investors, for the most part, certainly ample numbers of exceptions, aren't all that sophisticated. They buy based on narratives. They buy based on stories. Elon Musk is reshaping the way we travel, the way we get from place to place. He's reshaping the nature of the landscape for the auto industry and soon the trucking industry and space.

And boy, he's got the talent to take over Google's book of business and search, Apple's book of business in creating technology and social media companies like Facebook. He could supplant all of them. OK. That's an interesting narrative. It doesn't have a lot of substance to it. But what you wind up with is retail investors chasing stories. We wrote a paper a couple of years ago in which we defined the term bubble in a fashion that can be used in real time, not years after the fact.

Yes, we know there was a tech bubble in 2000. OK. But at the time, could you have said this is a bubble? Yeah, our definition is actually really simple. One, you'd have to use implausible assumptions in a discounted cash flow model or some similar model for valuation, implausible assumptions to justify today's price. Part two of the definition, the marginal buyer doesn't use those tools and doesn't care about them.

So you look at Apple, expensive. But is it a bubble? No, no, you can use aggressive assumptions. They don't have to be implausible assumptions to justify today's price. And there's lots of buyers who buy it based on that kind of analysis. Tesla, the marginal buyer does not care about valuation models. So bubbles are percolating galore across the markets. And that's part of the consequence of the massive fiscal and monetary stimulus we're seeing.

BRIAN SOZZI: You know, Rob, going back to your-- your earlier analogy, your heroin analogy, I would argue a lot of retail investors wake up in the morning eat, sleep, and breathe Tesla throughout the trading session. And this has been going on for well over a year now.

ROB ARNOTT: My son's one of them.

BRIAN SOZZI: What-- what pops that bubble? What's the trigger point a professional like you is looking for to say, you know what? The bubble, it's about to burst. And here are the trades that I put on to avert that plunge.

ROB ARNOTT: , Well here's the deal. Bubbles can persist longer and take markets further than you can possibly imagine. And so short selling a bubble is very dangerous, the old cliche about a market can remain irrational far longer than you can remain solvent. So short selling a bubble is really dangerous. But the catalyst question is an interesting one. Catalysts by definition take the market by surprise, otherwise they wouldn't be a catalyst.

So the vast majority of investors don't see it coming. Now the other thing that's interesting is, after the fact, sometimes you can't even identify the bubble years later. What was the catalyst? What was the catalyst that burst the tech bubble in the year 2000? I have yet to hear a compelling story for why that bubble burst that would be strong enough to justify that market rolling over and the tech sector dying.

The same thing will apply here. I could speculate on causes, possible causes, of today's bubbles bursting. But the simple fact is it'll happen. Bubbles burst. And so the question is, do you want to be picking up nickels in front of a steamroller? Or do you want to invest? If you want to buy Tesla, buy Tesla. Have an exit strategy. Have a reason in mind in advance for what's going to cause you to sell.

And the same thing applies to Bitcoin and other bubbly assets of today.

JULIE HYMAN: And Rob, my other question is, who does it take down with it, right? Obviously, we've had different kinds of bubbles over the decades. Some of them have been systemic. Some of them have-- their popping repercussions have been widespread. And some have not. So here, if you're looking at a Tesla, although it's a lot bigger than it used to be, or you're looking at a Bitcoin, or you're looking at SPACs, or you're looking at IPOs or renewable energy, to take another area that we have seen valuations really go high, how-- how systemic are those bubble pops going to be?

ROB ARNOTT: Well, one of my friends in the business is fond of saying that the role of the market is to inflict maximum pain on the maximum number of people from time to time. So the simple fact is that when bubbles burst they have repercussions that affect lots and lots of investors. Any index investor has a large investment in Tesla now. Any institutional investor who has a part of their money in indexes has a large chunk of their money in Tesla.

And I'm using Tesla as an illustrative example. I don't mean to single it out. There's lots of bubbles percolating right now. But when you have Tesla trading for more than the entire rest of the auto industry, excluding companies that deals exclusively, exclusively in electric vehicles, fully electric vehicles, those stocks, a lot of them have no sales and are priced at $100 billion market cap. Not a lot, several.

And take those out of the picture, the folks who make 100 million cars a year nearly collectively are worth less than Tesla that made 400,000 cars a year the last couple of years. So what you're looking at is an extraordinary spread in valuations. Now the other thing that's interesting is those automakers that are worth less collectively than Tesla make twice as many electric vehicles as Tesla does. Isn't that interesting?

So you could buy all of the producers, the major company producers, of electric vehicles for a fraction what you pay for Tesla. So this is the nature of bubbles. Bubbles exist until they don't. When they burst, there's a lot of carnage. There's a lot of tears.

JULIE HYMAN: We will see who's crying when it finally happens. Rob Arnott, great to get some time with you. Thank you so much for joining us this morning, Founder and Chairman of Research Affiliates. Thanks, Rob.

ROB ARNOTT: Thanks for the invitation.