Arnott Likes EMs Over U.S. -- For Stocks And Gov't Bonds

Fundamental indexing guru Rob Arnott says U.S. stocks aren’t cheap, and thinks emerging market equities are offering much more value.

“U.S. stocks are actually pretty expensive today, and here’s why,” Arnott recently told Fortune. “Earnings regularly swing above or below trend by a wide margin. Wall Street is brilliant at taking peak earnings and predicting big future growth from those high levels. But history is replete with reversion to the long-term averages. When you have peak earnings, as companies do now, competition mounts and earnings falter. Earnings as a percentage of GDP are the highest since 1929, and wages as a percentage of GDP are the lowest since 1937. Mean reversion takes it the other way, where wages rise and profits fall. Using Robert Shiller’s cyclically adjusted price/earnings ratio, which uses 10-year average earnings rather than peak earnings, today’s P/E ratio is 22 or 23. That’s pretty high.”

Emerging market stocks, however, trade at a 20% to 30% discount to U.S. stocks, Arnott contends. “Everyone sees emerging markets as the growth engine for the world economy,” Arnott notes. “If so, why are they trading at a big discount to the parts of the world that are not the growth engine?”

Arnott also likes broad baskets of emerging market bonds, and higher-yielding U.S. corporate bonds. He thinks a good stock allocation right now is between 20% and 30% of one’s portfolio, with less than half of that in the U.S. And he says the U.S. allocation should focus on the value end of the spectrum.