Morningstar Advisor - Winter 2008 - 58

Morningstar Conversation representing a 40-year peak as a percentage of GDP at a time when wages are an all-time minimum share of GDP. I think the notion that you can take these peak earnings and extrapolate historical earnings growth is just naïve. Even if it continues for another year or so, watch out for the political backlash. It’ll be huge. Now, earnings do revert to the mean over time. Historically, they tend to grow 1% to 2% faster than CPI over a very long span. Recently, they’ve done far better than that, and there are folks who extrapolate that growth and say, “Well, they’ve grown faster and they’ll continue to grow faster.” I don’t think that’s plausible. If you go back historically and ask what’s the precedent for 8% earnings growth—the consensus expectation off of peak earnings— there is none in the entire history. One of the things that strikes me as I look at the market today is that some of the best values are large-cap companies. In my mind, that argues in favor of traditional indexes. Kunal Kapoor KK: But some would argue that a lot of those earnings are coming from outside the United States. Doesn’t that change the picture somewhat? RA: Absolutely correct. But it’s naïve to assume that U.S. companies can earn a growing share of non-U.S.-sourced profits relative to the domestic providers. KK: They certainly seem to be doing okay, even small, most of the time, the market pays a premium for large companies and discounts small companies. Fundamental Index in that environment says, “Well, wait a minute. These companies are bigger than they’re given credit for. Let’s weight them according to their economic scale.” So you have a small-cap tilt. Today, it’s the opposite. The market’s paying a premium for small caps, so Fundamental Index says, “Well, wait a minute. These companies aren’t that big. Let’s reweight them to their economic scale,” which creates a large-cap tilt. It’s a myth that this idea has a structural small-cap tilt. It only has a small-cap tilt when the market’s pricing small caps at a discount. We are asked, “Aren’t you going to be disappointed if big caps rebound and outperform small caps?” No. We’ll be pleased, because we now have a large-cap tilt. KK: Speaking about the broader market, let’s shift gears a little bit and talk about your view of the markets right now. You indicated earlier that you’re not optimistic on equities. RA: I have a cautious view on equities. The if they’re not taking a majority share. simple fact is most of our clients and most clients of financial advisors will have most of their money in stocks. So the question is to what extent that you really have to have stocks in the portfolio. If you’re an FA and you say, “Get out of stocks,” and you’re wrong, that’s a career-ending decision. Given that equities will remain a major part of the portfolio, what equity structures do best in a weak market? That’s the beauty of Fundamental Index in that context. But I think equities have some vulnerabilities. The vulnerabilities for equities today relate largely to the fact that we have earnings RA: But how sustainable is that as the domestic competition in these overseas markets get up to speed on how to compete effectively? What we find historically is that when earnings are 50% to 60% above their 10-year average, as they are today, the subsequent 10-year growth in earnings averages a little less than inflation, a little negative in real terms, which would mean very low single-digit growth, 1% or 2% in notional terms over the next 10 years. The market is expecting much faster growth, so 58 Morningstar Advisor Winter 2008

Morningstar Advisor - Winter 2008

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