Mr. Arnott, you said once that buying when there is peak fear will result in the highest performance. Fear in the market seems to be very high – so it is a good time to buy?

Now is obviously a better time than at the beginning of the year. The difficulty is of course to know if fear has peaked as things might get worse than the market expects. In general, my credo is when assets are objectively cheap and fear is high, then it is a good time to start averaging in. And in European equities we see that.

But there are good reasons why European equities are cheap. A recession seems imminent.

Of course, there are good reasons for the fear, but the market is already aware of those reasons and it’s reflected in the price. The narratives in the market have an advantage: they are usually true, because there are real risks. But their disadvantage is that these risks are all already incorporated in market valuations. When fear is high, it is more likely that this reflects a worst case scenario; reality is rarely as bad. As the crisis in the Ukraine and the Nord Stream situation evolves, we will remain in a period of great fear. It is an interesting opportunity to start increasing equity positions in Europe.

Things still could turn out worse than now.

Yes, it is possible that it is getting worse. But if the fear is so great, reality is often less bad than feared. Maybe there will be suffering due to the shortage of gas, but the effects will probably be milder than what is currently feared. In Europe we have my two conditions for investing fulfilled: fear and low valuations. This is especially true for value stocks in Europe, the UK, and the emerging markets.

But are they truly cheap if there is a depression or a stagflation?

If you have a long-enough time horizon, you do not have to be afraid of bear markets. If you are putting more money into the market, you actually should be delighted by bear markets as you can buy cheaply. Only if you need to disinvest, do you need a bull market. I have been called a «perma-bear» because I do not like to buy when stocks are expensive. If the outlook is rosy, the downside is high. But at the market trough I want to have maximum exposure. My investors don’t appreciate when I say it, but I like it when markets are down. This creates interesting opportunities.

That means you are a contrarian investor?

Yes, there are many examples where even for great companies valuations were just too optimistic. Just look at Netflix or Meta. They now have to face lower customer growth or even a diminishing customer base. Earlier these growth stocks had huge valuations, which made their downside risk very high. The problem as a contrarian investor is that when you are right, you are perceived to be lucky. When you are wrong, people think you are an idiot.

And if you invest according to narratives, you won’t have this problem?

As a growth investor, people will praise you as a genius when you are right and they will say «bad luck» when you are wrong. Cathie Wood is such an example. She is a classic stock picker with great narratives. She knows these companies well. Her wonderful performance did not come from the business success of the companies she held, but by soaring valuations. If you pull back the valuations rise, not much is left. Many of her stocks fulfilled my definition of a bubble.

What is your definition of the term bubble?

It is very simple: in any conventional valuation model, if you have to make implausibly optimistic assumptions to justify current valuations, and the marginal buyers stocks do not care about valuation models, then you have a bubble. I debated Ms. Wood last year where I challenged her price target for Tesla of 3000 $. She said that she assumes 89% growth per year for the next five years, after which Tesla would have the same valuation multiples as today’s FANG stocks. This is twice as much growth as Amazon achieved in the past decade, in half the time. Such growth is not impossible, but completely implausible.

Would you look only on value criteria to select stocks?

Our RAFI strategy invests in stocks according to their footprint in the real economy, not according to their market weight. During the global financial crisis, the RAFI index fell more than the market, alongside value indexes, but afterwards it snapped back. If you want to have a more comfortable ride, you can put a quality filter on top of the RAFI strategy to avoid value traps, but returns will be lower.

If you weight stocks by their economic footprint, shouldn’t Apple be also a big part of your portfolio?

Apple is an enormous business, but its market weight is still too large compared to its economic weight. I do not think Apple is a sell, but its market valuation is still high, because of the assumption of continuous growth. The world changes and the top dog stocks eventually lose their place at the top.

High valuations might not only result from good narratives, but also from lower interest rates. Since rates increase, growth stocks are under pressure.

Many people say that low interest rates are good for growth stocks. It is not so simple, because low interest rates are also correlated with low growth. These two factors mostly cancel out in terms of valuations. But there is a much stronger link between inflation and valuations: low inflation is good for growth stocks and high inflation is good for value stocks. In rising inflationary environments, value stocks have historically performed better than the market.

Why is that?

Because there is a lot of uncertainty when inflation is high. In such times it might give some comfort that value stocks are cheaply priced.

You mentioned value opportunities in Europe and emerging markets. The US market is more expensive – but is that not for a reason?

Of course, again the narrative is true. For many stocks in the US market (the expensive ones), the good news for them is already incorporated in the price. The Shiller PE for US stocks is now at 28, which is almost identical to the market top before the global financial crisis. A bear market was needed this year, to bring valuations down to levels matching the 2007 peak. Valuations in Europe and emerging markets are at bargain levels. You can buy three-fourths of the world’s GDP, using Global ex-US RAFI or value, for a PE below 10. For me that looks like a wonderful buying opportunity. These positions will be profitable when people do not look anymore for countless excuses why these stocks should be cheap.

However, the cheapest stocks are dominated by financial and energy companies. Aren’t these sectors attached with a lot of uncertainty?

These concerns are reflected in the prices. Investors are afraid that energy companies won’t be able to exploit all their reserves in the future. This fear of stranded assets is overblown. Even in optimistic scenarios, fossil fuel consumption should only fall from 83 to 60% of total energy consumption by 2050. Due to consumption growth and increasing demand for energy however, fossil fuel consumption in absolute terms should not decline. We shouldn’t see any stranded assets in our lifetime.