KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week, we analyze what's happening in the markets and discuss how it might affect your investments.

KATHY: So hi, Liz Ann. Obviously this week, one of the big stories in terms of the economy and financial news was the Fed meeting. So the Federal Open Market Committee met on Wednesday and, as expected, did not change interest rates. So my quick takeaway was that inflation is … you know, getting very stubborn around 2.5% and not coming down over the last couple of months. Meanwhile, the unemployment rate is low, and job growth looks pretty steady. And that just doesn't give the Fed much leeway to cut rates right now. I did note, though, that Fed Chair Powell suggested that he thinks there's still room for rates to fall. He thinks the current policy set-up is restrictive, meaning it's enough to slow the economy and get inflation to come down. So he did open the door to some rate cuts down the road. But I think the big questions are on the policy side, tariffs, immigration, taxes, regulation, all this stuff that has a potential to affect the economic outlook, the inflation outlook, the employment outlook. So I'm in the camp the Fed sees no reason to cut rates at least for the first half of the year and maybe for the whole year. But what was your takeaway?

LIZ ANN: Yeah, obviously it wasn't a surprise. And as you've noted, I think we talked about it last time, it was also not an important meeting in the sense that we didn't get an update summary of economic projections or an update to the dots plot, that comes at the March meeting. So heading into the meeting, and in that half hour span from the announcement to when the press conference started, it was kind of a non-event. But these days the press conference can be fairly interesting, and it didn't surprise me, but Powell was pretty pointed again about "I'm not going to address the specific uncertainty with regard to tariffs and immigration and tax policy." It's just these are known unknowns, and he didn't go there and trying to speculate how that would impact their decision-making. There was one, maybe change/omission in the statement that did capture some attention. The prior statement said "Inflation has made progress toward the committee's 2% objective but remains somewhat elevated." They kind of cut out the middle part of that, and it now just says, "Inflation remains somewhat elevated." And naturally he was asked about that, and his response was, "We just decided to shorten it," saying it was not meant to send a signal kind of, "Hey, we live in a TikTok world, and everybody wants things in really, really tiny soundbites."

So whether that's truly the reason why they decided to do it. Again, he didn't want to go there in the meeting. But, you know, you were watching markets. I was watching markets, and you did see a bit of weakness in the equity market heading into the announcements and then in advance of the press conference. But then it had a reversal, and that was the opposite of what happened with bond yields and those related. So what did you make of just the kind of 2:00-to-now, as we're taping this, action in the bond market?

KATHY: Yeah, I agree with you. The bit about inflation staying elevated and omitting the phrase about it moving towards their target was the catalyst for bond yields to move up and the dollar to rally early on. And then Powell sort of walked back that whole thing. I think he referred to it as they were just cleaning up the sentences. So "Clean up on aisle four!" was enough to get the market to come back. But yeah, I think the more important part was his tone was still, "We think policy is restrictive. We think there's room for rates to fall, and inflation is going to come down, and that's still the direction we expect to go." And now it's more a question of, "Well, does it develop the way they expect, and will there be room for the Fed to cut later in the year?"

I'd say it's doubtful at this stage of the game. It's a 50-50 shot, but I'd be very surprised if they made any move before midyear because it's going to take time for these policies to get put in place and to have us evaluate what the potential impact might be.

So Liz Ann, tell us about our guest today.

LIZ ANN: Sure, so we have Rob Arnott. He's the founder and chairman of the board of Research Affiliates, and he plays an active role in the firm's research, portfolio management, product innovation, business strategy, and client-facing activities. Over his career, Rob has worked to bridge the worlds of academic theorists and financial markets.

He's challenged conventional wisdom, searched for solutions that add value for investors. And prior to establishing Research Affiliates, Rob was chair of First Quadrant LP. He was also global equity strategist at Salomon Brothers, now part of Citigroup, the founding president and CEO of TSA Capital Management. That's now part of Analytic Investors LLC, and a vice president at the Boston Company. Rob has published more than 150 articles in such publications as The Journal of Portfolio Management, Harvard Business Review, and Financial Analyst Journal. So I'm going to ask him about one of those articles here today. 

LIZ ANN: So Rob, this is exciting for us. Thanks so much for joining us. I really appreciate it.

ROB ARNOTT: It's a real privilege.

LIZ ANN: So let's start probably at the most basic level for the benefit of our listeners who may not be familiar with your company or you. So tell us a little bit about Research Affiliates. And I always found it interesting when you describe it as an innovation agent. So in the context of that comment that you make often, tell us a little bit about the firm.

ROB: Sure, I launched the company back in 2002, intending to be a source of new strategies and ideas for the broad marketplace. For the first two years I was still running First Quadrant, and so to avoid conflicts of interest, we made our strategies available through others rather than managing money directly, and we found that that business model actually works rather nicely. It allows us to stay singularly focused on R&D. We have only about 70 employees, and a good third of them in R&D.[1] So our focus is on product innovation, which begins by asking the question "What's the industry potentially doing wrong, and what are our thoughts about how we can do it better?" So we're best known for our work in global tactical asset allocation, where our largest relationship is with PIMCO on the All Asset suite and quantitative equity strategies, where our best known product is RAFI, the Fundamental Index®. The RAFI strategies that are used in parallel with your cap-weighted indexes.

LIZ ANN: So talk about RAFI, Research Affiliates Fundamental Index®, and for the layperson out there, how that contrasts with a traditional equal-weighted index or the more popular and well-known cap-weighted indexes like the S&P 500®.

ROB: The genesis for RAFI was a dear friend of mine who was running the Commonfund at the time and was on the board of New York and I think also Virginia State Pension was horrified in the aftermath of the dot-com bubble and burst. These indexes put huge amounts of money into small companies that were popular, powerful disruptors.

Cisco had 25,000 employees and was 4% of the S&P 500, briefly. Poof, there goes 4% of your wealth when it fails to live up to extravagantly lofty expectations. As an aside, I think we're in another tech bubble now. I think AI is the real deal. I think it is going to rock our world in ways we can't even imagine now, but I think it'll happen slower than the narrative suggests. And I think it will see disruptors get disrupted, just the same as happened in the dot-com bubble, where of the 10 most valuable tech stocks in the world in the dot-com bubble, two cease to exist within 10 years. And 10 out of 10 underperformed the S&P 500 over the next 15 years. Wow!

So his view was there's got to be a better way. And Marty Leibowitz of TIAA-CREF and subsequently Morgan Stanley was part of that conversation. And I long thought, why do we index based on market cap? Why don't we index based on the size of a company's business? Instead of studiously tracking the market, studiously track the look and composition of the macro economy. Now what's that going to do? Well firstly, how do you do it? You choose companies based on the size of their business, and then you weight them based on the size of their business instead of choosing them on their market value and weighting them on their market value. So it's just a slightly different paradigm.

Now, what happens when you do that? Firstly, how do you gauge the weight of a company in the macroeconomy? There's a lot of measures. We tested a bunch of them leading up to the publication in 2005 of a paper, "Fundamental Indexation," that looked at choosing companies by sales or profits or book value or dividends or number of employees or EBITDA[2] and found that it didn't matter which measure you used. You wound up beating the stock market by about 2% a year over the prior 30 years. 

What is a portfolio that does fundamental selection and fundamental weighting look like? You take the growth stocks trading at premium multiples, and you say, "Thank you for that nice high price. I'm going to reweight you down." You take a deeply out-of-favor value stock trading at a deep discount, and you say, "Thank you for that deeply discounted price. I'm going to top you up." Now this company, the growth company, is a better company. It's got tailwinds. It's got momentum. It's got product and innovation. It's got great reputation. This value company has troubles, headwinds.

So the question would be, "Why do you want to down weight this and up weight that?" Well, the growth company is only going to help you if it beats lofty expectations because the price already reflects those expectations.

The value company is only going to hurt you if it underperforms bleak expectations because the price already reflects those bleak expectations. So with Fundamental Index, you take on a stark value tilt relative to the market. Now, when we first introduced the idea, I spoke at the Super Bowl of indexing back in 2005, and the manager of a major bank's indexing operations stood up at the end of the presentation, and he was literally trembling with rage. He said, "How dare you call this an index? It's an active strategy." And I said, "Well, my Merriam-Webster doesn't mention cap weight in the definition of index, and relative to the economy, we're kind of neutral. Relative to the market, we're a value-tilted active strategy. You're absolutely right. Relative to the economy, you're a growth-tilted, momentum-chasing, popularity-weighted active strategy." So I just view it as a different way to view the world. Why bother?

What you find with Fundamental Index is that it has a value tilt, and that value tilt is every bit as much as the value indexes that are out there. Unlike the cap-weighted value indexes, we don't throw out the growth stocks. We reweight them down to their economic footprint. The Mag Seven are 35% of the S&P. They're about 19 or 20% of RAFI. So RAFI owns them.

But at the other end of the spectrum, the deep value stocks get scant weight in a value index because they're cap weighted. And the deep value stocks get up weighted to the size of their business. No matter how badly they're floundering, if their business is large, they're going to get a large weight. And so what happens is we reduce the value tilt of a value index by including growth stocks, and we increase the value tilt of a value index by up weighting the deep-value names. The result is a value strategy that has the advantage of looking just like the broad macroeconomy. And what's been just wonderful fun is since we launched the idea back in 2005, global applications have been live since 2007. So we're now looking at 18 years. How many of those 18 years did our global RAFI indexes beat MSCI ACWI Value[3]? 15 out of 18 years. Average of 2.5% a year, only 2% tracking error. So this is a powerful idea.

LIZ ANN: I want to dive a little bit more into sort of the labels and concepts of growth and value. And if you'll indulge me, I want to ask the question, maybe with a bit more detail and a bit more nuance than just maybe a typical question of growth versus value. I think of growth and value almost in three ways. And I think people generally do. Investors do. There's the indexes labeled as such, and I'll get back to that in a second. Then there's our preconceived notions of what type of stock is a growth stock, what type of stock is a value stock, or what sectors fit in one category or another. And then there's the actual characteristics that define a stock as either a growth stock or a value stock. And on the subject of the indexes labeled as such, whether it's Russell or S&P versions of the indexes, their construction methodology is different. The timing of their rebalancing is different. I will never forget back at the end of 2022, you probably remember this too, S&P has both a pure growth and a regular—I'm calling it regular growth—category of their indexes. And in their mid-December of 2022 rebalancing, their pure growth index, pre-rebalancing, had all seven of the Magnificent Seven, and technology was 37% of that index.

The next day when they rebalanced, only one of the Magnificent Seven was left in that pure growth index. The other six went to some combination of regular growth and regular value, because there can be an overlap. Energy became the highest-weighted sector, and healthcare was number two. Tech went from 37% to 13%, just because, at that time, the earnings growth was most powerful in a sector like energy.

Fast forward seven months later when Russell did their rebalancing, tech stayed at lofty weight. So people look at these indexes and think, "It's called growth. It has a lot of the same stock." So I would love your thoughts and maybe in particular how you think of value, how you define value. I'm assuming based on what I know about you, you define it based on the characteristics, as opposed to just blindly considering one particular value index as the holy grail for value.

ROB: Yeah. When you're creating an index, you create a rule book, and there's merit in having a simple rule book. Value indexes generally focus on stocks trading at deep discounts to the market. The naïve, academic approach focuses on price-to-book value. And if it's got a high price-to-book value, its growth. If it's got a low price-to-book value, it's value. That's the old Fama-French[4] definition. Now, think about that for a second. What you're basically saying is on the value side, you want companies with a low price-to-book value, but book value itself is a 19^th-century concept. We've all heard the cliche that our assets go up and down in the elevator every day. In a services-based economy, that's just about 100% true. And so if I buy a desk, spend a couple grand on a desk for the office, it's in the book value. If I spend $10 million on R&D, book value treats it as a $10 million bonfire. Just a total waste of money. I don't spend $10 million on R&D if I don't think it's going to pay off. So the simple measures of value that are most widely used each have their flaws. Accordingly, I like to do two things. I like to use multiple years of data. That way if you have a cyclical company or a growth company that hits an air pocket … Nvidia's profits fell by half in 2022. Their revenues flatlined, their profits went down by half, and then 2023 and '4 they went straight to the moon.

Using smoothed data, you don't fall prey to the idea that, "Oh, Nvidia is not a growth stock anymore," just before it goes up almost tenfold. So use multiple years of data. Use multiple measures. Now the other failing, and this is a little tricky, is that value is, in the industry, treated as cheap stocks. Doesn't matter the quality. Growth is treated as expensive stocks. Doesn't matter the growth rate. Growth is not defined based on growth. It's defined based on how richly priced is the stock, which … 

LIZ ANN: Just because you're expensive doesn't mean you're a robust growth stock.

ROB: Right. Tipping my hand a little bit at something that we're working on likely publishing in the next year or so, we're known as a value manager, and yet we're doing work on a growth factor. But it's a growth factor that focuses on metrics of growth. What are the things that matter for a growth company? Profitability and growth of profits, sales and growth of sales, assets and growth of assets. These are all measures that are interesting. And so strip away the whole issue of "If it's expensive, it's a growth stock" and just ask the question "If it's growing fast, it's a growth stock." Now all of a sudden you have something that's far less correlated with value and that has a positive alpha at times even when value is winning.

Value itself is a nuanced idea. The Russell Value Index, the granddaddy of value indexes, looks at valuation multiples and particularly favors companies if they have bad quality metrics.

Now, why do you want value stocks with particular focus on companies with bad quality metrics? What they want is to have the growth side of their portfolio, and they bifurcate everything is either in growth or value or a little bucket in the middle that's hybrid, but the growth stocks they want high valuation multiples and good growth metrics. The value stocks, therefore, you want cheap stocks and bad growth metrics. All right. If I'm a value manager, why do I want to do that? So there's issues on both sides. Bottom line is we like a nuanced approach that uses multiple measures. So for Fundamental Index, we use typically five-year average sales, profits, book value, book value adjusted for intangibles, very important innovation, dividends plus buybacks. These are the measures that we like to use. And by doing things over a multi-year basis, you wind up smoothing out the ups and downs, and you wind up tracking pretty closely to how big the company is in the macro economy.

I don't think of RAFI as a value index, although it looks like one. I think of it as a broad market economy index that has a value tilt because the cap-weighted market emphasizes the growth stocks. And the whole better-together narrative of diversify your sources of beta, have cap weight, have fundamental weight, is, I think, a really powerful way to apply this work.

LIZ ANN: Knowing you for a long time and listening to some recent interviews as well as reading some of your recent reports, one of the things that you have said consistently but I read recently, and it was just so music to my ears, was "Anyone who confidently forecasts next year's U.S. stock returns is either a fool or a shyster. But forecasting long-term returns over a decade or more is not difficult, albeit with some measure of error." The reason why it's music to my ears is one thing as strategists at Schwab that we don't do, have never done, I believe won't ever do, is fall into that trap, that game played by a lot of Wall Street strategists of year-end price targets that inevitably have to get adjusted throughout the course of the year. It's an impossible thing to do. And it's really not much value, I think, to individual investors. That's just gambling on moments in time. So expand on that a little bit. And in particular, what is it about stretching the time horizon that adds to that confidence in being able to forecast returns?

ROB: Sure. Anything you invest in produces return in three ways. The income it generates, the growth in that income, and the changes in the dollars you pay for each dollar of income. So changes in relative valuation levels. If you know those three numbers, you know the future. If you look at the past, you can disaggregate into those three numbers.

One thing that I find just fascinating is people will extrapolate the past without asking the question "Where did the returns come from?" One of my favorite examples of this is the second half of the 20th century. Now for most investors, 50 years is a reasonably long horizon. Most of us aren't investing with an eye towards maximizing our wealth in 2075.

But that 50-year span was a very interesting one. It started with stocks sporting a dividend yield of 8%. Every hundred dollars you invest, gave you eight dollars of income. You only had to wait 12 years to get your entire investment back just in dividends alone, even if there was no growth. Wow! That 50 years ended with the dot-com bubble, and stocks were priced at a 1.1% yield. You'd have to wait 90 years if there's no growth and if you want to get your money back out of dividends. So it went from a bet that growth might not be there, it might be another Great Depression, to a bet that growth was going to be stupendous as far as the eye could see. 

When people looked at those performance numbers, and this was true in the institutional arena, a lot of folks focused on what's called the Ibbotson-Sinquefield[5] data that showed stocks exhibiting a lofty incremental return relative to bonds. What we found was in those 50 years, stocks beat bonds by 8% a year. Now that's pretty stupendous. How much of that came from the rise in the price attached to each dollar of dividends? If your price-to-dividend ratio goes from 12 to 90, in 50 years, that compounds out to be 4% a year. So that 8% risk premium for stocks, half of it was revaluation upward, which you don't dare count on going into the future. In fact, the more you've earned from revaluation in the past, the more risk there is that the revaluation will reverse course. 

So if we look at today's markets, the dividend yield is 1.25%. All right, so you have to wait 80 years The consensus growth expectations on Wall Street are 12% long term. How do you get 12% growth unless you have an economy growing 12% a year? The reality is over the last century, inflation's been about 2.5%, and real growth's been about 2%. So that means earnings and dividends have grown about 4.5% a year over the last 100 years, not 12%. Take 4.5 and add 1.25, and you're a little short of 6%. So a reasonable expectation for stock market returns today is a little under 6% if you're wanting to invest in the long run. Now you can fiddle with those numbers. You can say it's not just 1.25%. There are stock buybacks. I like stock buybacks, but I don't like counting them as dividends because they can be stopped in a heartbeat. And if you're an investor, and you don't take advantage of the stock buyback, but you're a buy-and-hold investor, then the only way you make money off of a buyback is if it leads to faster earnings growth. And it often doesn't. So you could argue with the 1.25%. You could argue with the 4.5% growth. You could say, "It's a new era. AI is going to revolutionize the economy, and it's going to accelerate growth." All right, those are bets. 

The naive assumption would be the yield is the yield. Historical growth rates are a reasonable guesstimate for the future. And by the way, that's about a 1% premium over what you get in bonds. A 1% risk premium? One percent extra for taking on equity market risk? That doesn't sound very exciting. So I view the U.S. stock market today as being quite fragile on a long-term basis. Now there's another element here. If you look at price-to-trailing-earnings, everybody uses operating earnings or forward earnings. Price-to-forward is, to my way of thinking, price-to-fantasy, because it hasn't happened yet. But if you look at price relative to GAAP accounting earnings, trailing 12-month, we're at about 28 times. That's a 3.5% earnings yield. You get three and a half bucks of earnings for every hundred dollars you invest. That's not brilliant either. So what if valuation multiples mean revert towards historic norms?

The historic norms are a little under 20. Let's not be pessimists about it. Let's take a simple assumption that you go halfway there. You go from 28 to 24. If you do that, you've just lost another couple percent a year.

Now, that means you're down below the return available on bonds. So I look at the U.S. market as being vulnerable. You do the same arithmetic for Europe, Japan, emerging markets. OK, I buy the America First narrative that we're becoming the dominant economy in the world and we're doing things mostly right where a lot of the world is not.

But I also think there's mean reversion in political landscape too, and that where you've seen anemic growth, continental Europe for instance, there can be political pressures to change course. And that can lead to growth that regains its mojo. The valuation spread between the US and Europe is almost two to one.

The valuation spread between the U.S. and emerging markets is more than two to one. Emerging markets, does anyone think that emerging markets are going to grow slower than the U.S.? I don't think so. And so the question is, "Is the growth going to accrue to the shareholders or to kleptocrats?" That'll vary from country to country. But bottom line is if you have faster economic growth, and if it's not an excessively kleptocratic system, then there's no reason your earnings and dividend growth can't be faster than in the U.S. So bottom line is that 50% discount strikes us as a big opportunity. Any mean reversion there would boost the returns for Europe and emerging markets. So this is a very contrarian notion that some of the least-loved non-U.S. markets are actually more interesting to buy than the beloved and frothy Mag Seven. I see this as an opportunity-rich environment. Long-term returns, yield plus growth plus mean reversion, says U.S. stocks are expensive, U.S. growth stocks are frothy, U.S. value's OK, non-U.S. stocks are better than OK, and non-U.S. value's much better than OK, pretty cheap.

LIZ ANN: We've been in a relatively suppressed era of volatility for, at least the equity market, much more volatility in the fixed income side of things, but I know you're a big believer that volatility should be seen as a friend of investors and brings out opportunities. So give us your near-term perspective on the volatility landscape because ultimately, it's the sentiment side of things that I'm also curious about and contrarian investing, which you've talked about a lot as it relates to mean inversion. But as we also know, we've learned in history, you can see frothy markets develop either from valuation perspective or just investor attitudes or the combination thereof. And it can last for quite some time. Sometimes there's a catalyst. Sometimes there isn't. So give us your volatility thoughts in the somewhat near term.

ROB: Let me frame it this way. Volatility is volatile. When things are quiet, they're likely to get noisier. When things are chaotic, they're likely to stabilize. So volatility has more mean reversion than just about anything else in the economic world. Are there going to be geopolitical shocks that have market impact in the coming year? Almost certainly yes. In the coming four years, of course.

Are there going to be financial shocks? The way governments are spending around the world, there's liable to be fiscal crises sometime in the coming five to 10 years that could be pretty daunting. And so I see us currently in a benign environment of relatively low volatility with absolute certainty that we will see volatility spikes from time to time in the coming few years. 

I'd be surprised if any of those volatility shocks are as big as the COVID shock in March of 2020. But I wouldn't be surprised if we see the kind of volatility we had in the global financial crisis sometime in the coming 10 years. That kind of volatility happens with some regularity, and is it likely on a secular horizon? Yes. Is it likely on a three-to-five-year horizon? A little less so. This gets back to your earlier question on forecasting short-term. I've been asked, do I think that we're going to have a bear market under Trump? And my response was, that's a four-year span. Yes, we probably will. Doesn't matter who's president. We probably would.

I've been asked, do you think the market will go up or down this year? My response is it's up 80% of the time on a year-by-year basis. So probably it'll be up. But I do think the risk of a bear market is distinctly higher than the usual 20% solely because the market is expensive. That's as close as I feel comfortable coming to a short-term forecast. Short-term forecasts are inherently unstable.

When I mentioned the three constituent parts of return. Yield. We know what the yield is going to be this year with a good deal of precision. Growth. We know the historic norm is 4 or 5%. Could it be 8 or 10? Yeah. Could it be 0? Yeah. Those are kind of the extreme outliers. That increases your uncertainty on market returns. Mean reversion. Do we think valuation multiples will still be at the same place a year from now? I don't think so.

Could they be up 20% or down 20%? Absolutely. Now, if you're looking out 10 years, going up 30 or 40% or down 30 or 40% means three or four a year, not the 10 or 20 that I was alluding to for a one-year forecast. So one, short-term forecasts are inherently difficult. If you're forecasting the weather over the next week, you can do it pretty accurately. If you're forecasting the weather over the next 10 years, no. And it's the opposite with stocks and bonds and market returns.

LIZ ANN: So Rob, I want to go big picture again and ask one final question. You wrote a long-form report recently, I think it was in 2024, titled "Fifty Years of Innovation, Mythmaking, and Mythbusting: Personal Reflections." It was in conjunction with the 50th anniversary of TheJournal of Portfolio Management. And early in that piece, you discussed paradigm shifts.

And I'll quote you: "Scientific thought progresses through periods of 'normal science,' where it evolves within an existing framework or consensus (aka paradigm). Accumulating inconsistencies in the prevailing paradigm then trigger a crisis, leading to the emergence of new theories and ideas, resulting in a paradigm shift where the old framework is rapidly replaced by a new one. In finance this pattern has recurred time and time again." Have we had a paradigm shift? Are we in the midst of a paradigm shift? Has it happened recently, or do you anticipate one?

ROB: Well, firstly, that was a fun paper … 

LIZ ANN: It was a great read, great read.

ROB: Thank you. And folks can find it on our website, researchaffiliates.com, if you want to look for it. 

LIZ ANN: And we'll put it in the show notes as well. 

ROB: Fantastic. What we find is that paradigms last until they break. We've had a paradigm in the world of finance as a quasi-science built on a foundation of efficient-market hypothesis and the capital asset pricing model, both of which date back to the '60s.

Now, 60 years is a relatively long time in any science. The simple fact is that we've had relentless evidence for the last 60 years that markets aren't efficient. But inefficiencies change fast enough and often enough that anyone who sticks to a particular single rule is likely to get burned. But inefficiencies abound.

Capital asset pricing model says the return on any asset is tied to the non-diversifiable risk, beta, the sensitivity that an asset has to broad market movements. And Bill Sharpe's the first person who would acknowledge this is a beautiful model of the way the world ought to work, and it's an imperfect model of the way the world does work.

This paradigm, I think, is beginning to collapse under the weight of contrary evidence. What's missing is an alternative. So what causes paradigm shifts is when an alternative becomes evident. The procession of Mercury's orbit around the Sun mystified scientists in the 19th century until Einstein came up with his theory and showed that it would fully explain the shifts in Mercury's orbits. That is to say the warping of space-time creates dynamics that aren't explained by Newtonian physics. All right, buildup of evidence that Newtonian physics was limited, that it was mostly right, but wrong in some startlingly powerful ways. And Einstein came up with theory of relativity, then the general theory, and this upended science. It took about a generation for people to abandon the old paradigm.

But I think the efficient-markets hypothesis and capital asset pricing model built a very robust foundation for modern finance that has been crying out for decades to be upended, not throw out the old with and replace it, but throw out the old as the sole major drivers and find what's new. The whole efforts of finding factors was built on a foundation of trying to plug those holes. And the fact that there are now hundreds of factors really drives home the fact that the old paradigm needs attention. So one of the things I speculate on in that paper is that the whole notion of a risk premium might be wrong. It might be a fear premium. And fear of missing out can be just as powerful as the fear of losing money. Is an investor in Nvidia today concerned about the downside volatility or about missing the upside? Are they thinking, "Oh gosh, my bank account is much safer?" No, they're thinking, "My bank account is holding me back." And so one of the things we're playing around with is can you quantify fear, and does fear work as a better predictor than risk?

LIZ ANN: Love that. Well, this has been, not at all to my surprise, a fascinating conversation. And I'm sure it is for our listeners too. Your work has been just extraordinary over the decades, and we are really honored to have you as a guest. So thanks for joining us, Rob.

ROB: Thank you very much. This has been a real privilege.

KATHY: So Liz Ann, as we do every week, let's look ahead to what's coming up in the next few days. What do you think investors should be watching?

LIZ ANN: Well, we do get some updates on purchasing managers indexes. We get an update to the S&P Global version of the manufacturing PMI, for short. And then we also get, arguably the more widely watched versions of PMIs, which is the ISM Manufacturing and the ISM Services index. And as we've been noting since that represents survey data and we wrote about, I guess it was a week or two ago, Kevin and I, about the differential right now and at times in this cycle between the so-called soft economic data, which is the survey-based data, and the actual hard economic data. So it'll be interesting to see what we get there. We get the job opening and labor turnover survey from which we get job openings. You get the quits rate. You get a layoffs level. So that is something that is widely watched by Fed and Fed watchers. So that could be interesting. Get some durable goods and cap goods numbers, and we get productivity and unit labor costs in addition to the weekly jobless claims. And then I think, if I'm correct, right, we've got the big jobs report at the end of the week?

KATHY: Yeah, that's correct. And obviously that's going to be the big one everybody watches as usual. You know, I don't think there'll be, well, any fireworks with it. But one never knows with the jobs report, things happen. It's probably going to reflect a little bit of impact from the fires in California, which has displaced some people. We'll probably see that in jobless claims as well. But I think the overall numbers are going to be important. Do we maintain a still-healthy rate of job growth? Does the unemployment rate stay low, around 4.1%? And of course, how are wages doing? Last time around year-over-year, they're up about 3.9%, which is down from where they were just six months ago and a reassuring sign in terms of the Fed's inflation outlook. So as usual, we get into the first week of the month. We've got a lot going on, and then we get the Fed people out talking now that the meeting's over, you know, the quiet period's over, and they'll be out there telling us what they think.

So that's it for us this week. Thanks for listening. As always, you can keep up with us in real time on social media. I'm @KathyJones—that's Kathy with a K—on X and LinkedIn. And you can read all of our written reports, including charts and graphs, at schwab.com/learn.

LIZ ANN: And I'm @LizAnnSonders on X and LinkedIn. I'm not on Instagram. I'm not on Facebook. I'm not on WhatsApp. I'm not yet on BlueSky. I'm not on Threads. I only say this because as I often say at the end of these programs, I have had a rash of imposters, including ones recently that are increasingly using AI-generated videos. It's me, it's my voice, but the words coming out of the mouth is not mine. I do not have a private stock-picking club where I guarantee 100% returns, so make sure you are following the real me. 

And if you've enjoyed this show, we'd be really grateful if you'd leave us a review on Apple Podcasts, a rating on Spotify, or feedback wherever you listen. And you can also follow us for free in your favorite podcasting app. And we will be back with an exciting new episode next week.

For important disclosures, see the show notes or visit schwab.com/OnInvesting.

[1] R&D: Research and development.

[2]  Earnings before interest, taxes, depreciation, and amortization, https://www.investopedia.com/terms/e/ebitda.asp

[3] https://www.msci.com/indexes/index/106039

[4] https://www.investopedia.com/terms/f/famaandfrenchthreefactormodel.asp

[5]SBBI Data| CFA Institute Research and Policy Center