Similarly, certain companies in the consumer discretionary sector (notably the auto companies) have been priced as if they are "dead men walking." General Motors was down 52% in the first six months of 2008, a 54-year low. Ford was off by 28%. Are they all truly on their way to the executioner's block?

In an effective capitalist system, no. They cannot all fail. Those that do fail—if they are allowed to do so—increase the pricing power of the survivors, which can then survive and prosper. In an effective capitalist system, those that made the most grievous errors exit the scene and clear the way for the future success of those that made fewer or less-serious blunders.[1] Efforts to prop up the failed enterprises, as was done repeatedly for the airlines, means that those that did not make strategic blunders share the consequences of those blunders with those that did. Perhaps this is why eight of the nine sectors (excluding financials[2]) outperformed in the three years after experiencing their worst relative year. Moreover, the recoveries were not trivial; on average, these sectors beat the S&P 500 by 8.2% annually.

As with bubbles, anti-bubbles can be profitable for momentum players—until the anti-bubble bursts. One of the beauties of the Fundamental Index concept is that it provides us an anchor—the economic scale of a company or industry—for contratrading against the market's most extreme bets. Relative to the cap-weighted market portfolio, the FTSE RAFI US 1000 Index was overweight financials by only 1% as recently as March 2008; today, it is overweight financials by more than 7%. Why? Because it contratrades against the market's loathing of anything and everything in the financial sector. It is not rational to price the entire financial sector as though it has 50/50 odds of survival. Indeed, betting against that outcome is, in time, a profitable endeavor.

Bubbles and anti-bubbles are built on the two poles of our emotional globe—greed and fear. Greed pushes prices too high relative to economic worth, and fear pushes prices too low. Both bubbles and anti-bubbles rely on some extreme, implausible future outcome for justification. The financial sector and certain consumer discretionary companies certainly face challenges, but we believe they will avoid the dire outcomes embedded in their stock prices. (In fact, the gap between reasonable prices and panic-driven prices closed fast in recent weeks, after the demise of IndyMac Bank and near demise of Fannie Mae and Freddie Mac.) In short, although our belief in a turnaround for financials and consumer discretionary companies may prove to be premature, we believe this anti-bubble burst in mid-July.

© Research Affiliates^®, LLC 2008. The material contained in this newsletter is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any securities transaction. The information contained herein should not be construed as financial or investment advice on any subject matter. Neither Robert D. Arnott nor Research Affiliates and its related entities warrants the accuracy of the information provided herein, either expressed or implied, for any particular purpose. Nothing contained in this newsletter is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this newsletter should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

ROBERT ARNOTT, Chairman and Founder of Research Affiliates, LLC.

JOHN WEST, CFA, Associate Director, Marketing & Affiliate Relations of Research Affiliates, LLC

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