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KAREN GIBBS: And if our next guest is right, the very basis of investing as we know it will crumble. If you've heard it once you've heard it a million times over the long run stocks outperform bonds. It's one of the few truisms in investing. Our entire investing foundation is built upon it, but what if it's no longer true?

Rob Arnott is challenging that long held belief, saying that over the long haul bonds will outperform stocks. In addition to being one of the leading financial thinkers in the country, Rob manages billions of pension fund dollars for First Quadrant.

Rob, welcome.

ROBERT ARNOTT: Thank you.

GIBBS: We've got millions of Americans saving for a college education and retirement based on the tenet that stocks are going to outperform bonds. You're saying it's not so. Tell us why.

ARNOTT: Well, firstly it's worth noting that in difficult markets there are interesting opportunities. They aren't always found in the conventional markets. Stocks yield about 1.7 percent if you buy a broad market average like the S&P 500. Historically, stocks provide earnings and dividend growth that's only about 1.2 percent faster than inflation.

GIBBS: So that puts us at about 2.9 percent for stocks.

ARNOTT: It's about a 2.9 percent real return as compared with over 7 percent historically. The big difference is that in history we had 4 and 5 percent yields as the norm. And now we've got 1.7 percent yields. Now right now you can get 2.7 percent from inflation indexed government guaranteed bonds. So what's called the risk premium for stocks relative to bonds is very close to zero. It's better than it was two years ago, but it's not very good.

GIBBS: Now you also, you've done a lot of studies on this and you've been recently named the editor of the Financial Analysts Journal. Some of your studies and reports have said that we are entering a perfect storm for equities. Can we go through some of that right now? First you're looking at the valuation still being too high. Explain that.

ARNOTT: Yeah, valuation levels are not cheap. We've seen a 40 percent bear market through last September. But even after a 40 percent bear market, if you look at the price of the market relative to long-term average earnings over the last decade to smooth out the economic cycle, we're looking at a P/E ratio of 25 times earnings. That's almost as high as it was at the peak in 1929, and it's above all prior peaks other than 1929.

GIBBS: Now you said stocks are too pricey. Also you're saying earnings remain questionable, and you're looking at the baby boomer bust. Let's talk about the questionable earnings now.

ARNOTT: Earnings are overstated.

GIBBS: Is this on the EBITDA measure or are you talking core earnings?

ARNOTT: If we're looking at reported earnings, reported earnings include pension expense.

GIBBS: Yes.

ARNOTT: Pension expense is based on expected earnings for the pension funds of 8 to 10 percent. In a market in which bonds are yielding 5, stocks are yielding less than 2, it's hard to imagine where they'll get their 8 to 10 percent.

Now if they were using a more sensible number in the 6 percent range, earnings of American industry would be about $72 billion lower. The pension expense would be about $72 billion higher. The S&P earnings would be about $8 lower. We also have companies not expensing management stock options. At the peak in the year 2000, that was about $6 worth of earnings that came from simply not expensing something that is an expense.

GIBBS: So we're still too high on these valuations as well as earnings. Now, the baby boomers, the demographics.

ARNOTT: Demographics is the factor that has me the most worried. Here we're looking at a situation in which 10 to 20 years from now we'll have more people than ever before selling assets to fund their retirement needs to a proportionally smaller population as a fraction of the economy than ever before. That's not good for asset values.

The flip side of that is that we'll have more people than ever before buying goods and services from a smaller proportion of the population still working and still producing those goods and services than ever before, which creates an inflation risk that could kick in five to 10 years from now.

GIBBS: All right. Enough of the doom and gloom. There are some things that you like.

ARNOTT: There sure are.

GIBBS: Your best bets are emerging market debt, surprising despite the fact that Argentina has defaulted. You like the inflation indexed bonds, the TIPS. You're also saying commodities are an opportunity as well as commercial real estate. Tick them off for us.

ARNOTT: Sure. Firstly, we do like stocks better than bonds right now on a short-term, tactical basis, and I think that's worth noting. One can believe that we're in a secular bear market, and in a secular bear market you can have small bull markets in the midst of a secular bear market, and I think that's what we're experiencing right now. But if you compare stocks with alternative investments, alternative investments are more interesting still. Emerging markets debt yields 8 to 10 percent, historically has a default rate of less than 2 percent. That's very encouraging.

We're looking at TIPS yields of 2.7%. That's low by historical standards. They were launched at closer to 4 percent yields. But why on earth would an investor require fully 2.7% from something that's backed by the full faith and credit of the U.S. government?

GIBBS: Either outright or in mutual funds, TIPS are still attractive?

ARNOTT: TIPS I think are still attractive. I think their natural yield is below 2 percent, which means a bull market in TIPS. Also commercial real estate not so much residential real estate. That's expensive. But commercial real estate is still priced to provide attractive yields.

GIBBS: And very quickly we've got about 30 seconds left you still do say that we could see a short-term pop in stocks, and you've got three that look rather attractive.

ARNOTT: Sure. If we're looking for interesting stocks, M&T Bank Corporation, Dell, Boyd Gaming. These are three companies in very different industries, each of which I think is attractive for a variety of reasons.

GIBBS: Rob Arnott, fascinating discussion. Thanks very much for joining us.

ARNOTT: Thank you very much.