Four Conditions Reminiscent of 1999

Rob Arnott, founder and chairman of Research Affiliates, says that the recent market environment is reminiscent of 1999, just before the tech bubble burst. Writing in Barron’s, Arnott argues that the following four “conditions parallel the extremes of the late 1990s:”

  1. “Falling inflation expectations,” which Arnott argues “snap back in reasonably short order.” He observes that “after inflation expectations hit a basement low of 0.9% in December 1998, within six months they had jumped to 2.0%” and “over the past three years, 10-year inflation expectations have plummeted by over 50% . . . to 1.2% in early February 2016” but had “rebounded to 1.6%” by the end of March.
  1. “Tumbling emerging market currencies,” of which Arnott says: “when we measure emerging market (EM) currencies on a purchasing power parity (PPP) basis, we find they have only been this cheap once before – in 1998.” This matters, he says, because “cheap EM currencies translate into an improvement in export competitiveness which in turn leads to positive earnings shocks in EM equities.”
  1. “Extreme relative valuations for EM versus U.S. stocks and bonds,” as reflected in August 1998’s CAPE ratio of a “70% discount to the S&P 500 Index” and the current 60% discount. Arnott notes that the 7-year U.S. bull market and a 5-year bear market for EM stocks have created relative valuations that have “historically set the stage for double-digit returns over the subsequent decade,” although he forecasts an 8% return.
  1. “Protracted growth-stock bull market and underperforming value stocks,” as demonstrated by a nearly 11% disparity in the relative performance of value versus growth stocks in the three-year period ending March 31, 2016. Arnott observes that “consequently, value stocks are the cheapest now relative to growth stocks than at any time other than the tech bubble (1998-2000) and the global financial crisis (2008-2009),” which has historically preceded a period of value stocks’ “prolonged, massive outperformance.”

Arnott then notes that “in the first quarter of 2016, each of the four trends reversed.” The appropriate strategy, he contends, is to “cautiously pivot into out-of-favor markets, averaging in over time because it is not possible to know when the turn will come” or if it has already come. “Buying what’s unloved is, simply put, the most profitable way to invest,” he argues.