Jason Hsu, the chief investment officer at Rob Arnott’s fundamental indexing firm, Research Affiliates, sees a real possibility that markets may be heading into another 2008-like storm. If there’s a silver lining to such dark clouds, it’s that any sell-off would create prime buying opportunities for patient investors.

The problem, Hsu told IndexUniverse.com Managing Editor Olivier Ludwig, is that the “three D’s”—debt, deficit and demographics—will keep recovery in the developed world sluggish for a long time, and markets haven’t yet fully faced that fact. That’s why hedging for the day they do is important—not least by owning almost anything from emerging markets.

Ludwig: When I hear someone like Jeremy Siegel say that stocks look attractive right now based on price/earnings ratios, I’m not sure I agree. And, knowing you guys are proponents of what Pimco has called “The New Normal,” I wanted to get a counterpoint.

Hsu: Well, in the interest of proper disclosure, I think it’s important to note that just as everyone knows that Jeremy is somewhat of a permanent optimist with regard to equities, we at Research Affiliates—Rob Arnott and myself included—are somewhat more  “perma-bears.” So, we certainly do give a counterbalance to Jeremy’s perspective.

Ludwig: When you say “perma-bear,” is that something that’s relatively recent, since the meltdown? Or were you guys seeing storm clouds, say, five or more years ago?

Hsu: I’d say we’ve been perma-bears since 2006, when we really thought many things were priced to perfection. Equity valuations were then near historical highs—obviously not as high as during the tech days, but certainly high relative to history. So we’ve been perma-bears for about five years.

Ludwig: And what’s the metric that led you to that judgment? Was it P/E ratios, but you’re just seeing them differently than, say, Jeremy Siegel does?

Hsu: There are many ways of calculating P/E ratios. Jeremy looks at his own version and conducts research with his own definition. And we tend to side with Prof. Bob Shiller’s calculation, which is a price-to-trailing-10-year-earnings ratio. From that perspective, stocks are not cheap. At best, they’re neutral relative to history.

And this is where I think the whole notion of the “new normal,” that Pimco very much has been talking about, is very relevant. Because, if you think that we are moving into a world where the normal trend-level growth will be lower than before, then the normal amount of risk and risk appetite will be lower than before, too.

Our hypothesis is that we’re going into a much slower growth period where higher debt will lead to a crowding out of capital, which becomes a drag on economic growth, and where demographics will also become a drag on economic growth.

Ludwig: You’re hinting at the “three D’s” that you wrote about in your recent paper: debt, deficit and demographics, yes?

Hsu: That’s right.

Ludwig: The three D’s, at least at first blush, look daunting. But the game’s not over, is it, for the world’s biggest economy?

Hsu: Here, we’re very careful in terms of the dichotomy between the economy and the market. The economy—this macroeconomic head wind we’re facing, the three D’s—they’re predictable, but very structural. You just cannot change demographics. And with the amount of debt we have, you can’t undo that in a short period of time either.

But the equity market does change very rapidly, and prices could go from today, where they’re not appropriately reflecting these risks, to potentially—maybe over the next few months—rapidly and violently adjusting to these concerns. And that could then present buying opportunities.

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