Research Affiliates' Arnott Sees 'Bubbles Galore' in Stock Market

Tesla was among the 10 largest publicly traded companies by market capitalization at the beginning of the year, but it likely won’t be in 10 years, according to Arnott. He showed a chart of the top 10 stocks by market cap for every 10-year period between 1980 and 2010. Usually only one or two of the “top dogs,” as he calls them, remain a top dog in the next decade, although they can stay on top for a long period of time. But when they fall, “they lose big,” Arnott said. “There’s a lot of rotation at the top.”

The top 10 stocks are constantly changing (Chart: Research Affiliates)

In addition to Tesla, today’s top dogs include five of the six FANMAG stocks: Facebook, Apple, Microsoft, Amazon and Google (Alphabet); Netflix is excluded. The FANMAG stocks account for close to 25% of the S&P 500, which is a “remarkable concentration,” Arnott said.

Arnott is not calling for these bubbles to burst imminently. “Bubbles can last longer and go farther than anyone can possibly imagine.”

Overall, he favors value stocks, which he says are now one-eleventh as expensive as growth stocks and can expect to beat growth stocks by 4.5% or more. “There’s lots of juice left in their orange,” he says.

As for the S&P 500, Arnott is forecasting a 1.9% average annual nominal return over the next 10 years.

The forecast is based on current dividend yield (1.5%), real fundamental growth (1.2%), inflation (2.4% using the Consumer Price Index) and change in valuation (-3.2%), the latter reflecting a Shiller Cyclically Adjusted Price to Earnings Ratio (CAPE), which Arnott pegged near 34 using data from the end of March, falling to around 26, as a halfway reversion to the mean. The current CAPE ratio is now near 37.

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