Facing a stock market that has doubled in price over the past five years—and with memories of the last market collapse still vivid—you can’t help but wonder: Is another disaster lurking around the corner?
Holding vastly different opinions are two strategists with decades of insight and experience. Richard Bernstein, former chief investment strategist at Merrill Lynch, now an adviser to funds for Eaton Vance, is bullish. James Montier, who helps manage $117 billion at GMO — itself an adviser to two Wells Fargo funds — is bearish.
Both make strong arguments — ones that may challenge your view of today’s investing climate.
THE BULL: RICHARD BERNSTEIN
Are stocks overpriced?
The market is priced roughly at fair value. You have to look at valuations in light of inflation. Our firm uses sophisticated models for that, but a rule of thumb is that the price/earnings multiple and the inflation rate should add up to less than 20.
Inflation is now at about 1.5%. The P/E for stocks in the Standard & Poor’s 500, as we speak, is about 17, based on trailing earnings. So a little below 20, or roughly fair value.
Stocks are not cheap, but that doesn’t mean the bull market is over. Pension funds in the U.S. have their lowest equity allocations in 40 years. Wall Street strategists recommend an underweight of equities. I’ve found, over three decades, that the consensus asset allocation is a very reliable contrary indicator of where the market is headed.
A version of the P/E that carries a lot of weight now is the one championed by Yale’s Robert Shiller. By that measure, based on 10 years of earnings, P/Es are very high.
In the past, when these high Shiller P/Es signaled an overpriced market, we’ve had much higher rates of inflation than we do now.
When interest rates and inflation decrease, P/Es tend to expand. When rates or inflation rise, P/Es contract. The theory is that inflation eats away at a company’s future value, for several reasons. Earnings might rise, but inflation-adjusted earnings might not. Earnings quality tends to decline, in part because you’re simply paying off debt with cheaper dollars. And overall investor confidence tends to deteriorate. So you have to adjust for inflation, but professor Shiller doesn’t.
If you do adjust for lower inflation, it predicts normal returns — about 8% to 9% a year. We look at more than valuation, though. For example, sentiment is still attractive. We actually think you’re going to get above-average returns — say, 10% to 15% a year over the next several years.
Two years? Five years?
I think we’re halfway through one of the biggest bull markets of our careers. The stock market has been up for the same reason it always goes up in an early-cycle environment. Expectations are extremely low, monetary and fiscal policies kick in, and the economy begins to grow. That’s what happens every cycle, and it happened this cycle too.
Now we are entering a mid-cycle phase in which you get the tug of war between rising rates — a bearish sign — and unanticipated improvement in the economy — a bullish sign. Sentiment isn’t exactly ebullient, and the economy keeps improving.
But when your readership believes there’s no risk in equities, the bull market is almost over. And in the kiss of death, the yield curve inverts, meaning that long-term interest rates drop below short-term rates. In other words, people are so desperate to lock in long-term rates that they pay more for them than for short-term rates.
Watching for an inverted yield curve will keep you out of trouble. That simple little indicator suggests the bond markets are beginning to expect significantly weaker growth. Generally this occurs before the stock market begins to anticipate slower growth. And we haven’t seen it yet.
You’ve noted that a classic sign of a bubble is increased use of borrowed money to invest. Margin buying of stocks is at a record high.
Nobody knows how much of that is long — betting that stocks will rise — and how much of it is short — betting stocks will fall. In the past, when individuals played a greater role in the market, you assumed that margin was used to be levered long. Today hedge funds are a much bigger force, and my research suggests they’re relatively neutral. Some of that margin is being used for shorting. So I don’t think increased leverage is driving up prices.
What other bubble indicators do you look for?
When sentiment becomes overwhelmingly bullish to the point where people jettison diversification, that is very, very worrisome.
You see that now in highflying tech, social media, some biotech. Valuations are so out of whack with reality. You’d think that people would have learned from the hot stove.
What do you say to analysts who worry that equities are inflated by the artificial suppression of interest rates by central banks?
I get that question all the time. The point of stimulative monetary policy has always been to artificially inflate asset prices. Interest rates are lowered so that people take more risks and multiples expand. Companies get a cheaper cost of capital, which they can then use to invest.
The notion that the Fed is the only reason the stock market is up is what people claim during the early stages of every bull market. The time to worry is when the Fed inflates asset prices too much and the characteristics of a bubble emerge.
What happens if earnings — the “E” in P/E — drop to historical norms?
Profit margins are at an all-time high. There’s no doubt about that. But profit levels are also a function of sales. When margins compress, companies generally start to fight for market share. We think earnings forecasts for large-cap multinationals may be way too optimistic; we are concerned about emerging markets and the impact they could have on multinationals’ earnings. But domestic U.S. manufacturing is gaining market share. I’m not talking about 3D printing. I’m talking about ball bearings and grease. Small- and mid-caps.
I’m not a stock picker. But we believe investors should probably focus on more domestically oriented stocks and avoid emerging-market stocks as much as possible. In addition, since profit margins around the world seem likely to contract, investors should aim at market-share gainers. We like U.S. small-cap industrials. If you know the name of the company, the odds are that they have too much international exposure.
Also, I think that high-yield municipal bonds are a tremendous value play right now.
They yield more than high-yield corporates for the first time in history.
So when will you know your portfolio is overpriced — that it’s time to get out of small-cap industrials or high-yield munis?
We look at gaps between perception and reality. Over the past several years, the sentiment toward small-cap stocks, despite their superior performance, has been quite poor. But ultimately that gap between perception and reality will begin to change.
There will be more negative-earnings surprises because expectations get too high. Flows into small-cap funds will pick up. We’ll hear people talking about how cheap they are, as opposed to how expensive they are. [Laughs.] Then we’ll find other investments that look more attractive.
THE BEAR: JAMES MONTIER (cont.)
THE BEAR: JAMES MONTIER
Are stocks overpriced?
There is no doubt that the U.S. stock market is exceedingly overvalued.
What makes you so sure?
The simplest sensible benchmark is the Shiller P/E. Right now we’re looking at a broad index like the Standard & Poor’s 500 trading at something like 26, 27 times the Shiller P/E. Fair value would be 16 or 17 times historical earnings.
But bulls say the Shiller P/E doesn’t look so bad if you adjust it for interest rates or inflation.
It doesn’t make any sense to do that. The history of stock prices shows that they are good long-run inflation hedges. That’s because companies can generally raise their prices when their input costs rise, which protects their profits and dividends from inflation. And since equities are valued based on profits per share, equities are largely immune from inflation too.
Adjusting for interest rates is even more bizarre. Empirical horseraces show that valuation ratios — say, P/Es — unadjusted by current interest rates have predicted long-run returns far better than valuations adjusted by interest rates.
What if you look at P/Es based on expected earnings for the next year?
I spent nearly 23 years working at investment banks surrounded by analysts, and I have to say I think analysts probably were put on this planet to make astrologers look like they know what they’re doing.
The idea of basing a valuation on a forward earnings number is laughable. Most analysts spend all of their time being spoon-fed by company management and thinking about the next quarter’s earnings release — a horizon that is just not meaningful.
But maybe rising profits will justify higher stock prices. Maybe corporate profit margins will be higher than they used to be.
It is possible. We spend a lot of time worrying about that: What could prevent margins from falling?
[GMO co-founder] Jeremy Grantham puts it very well. For most investors, he says, “This time is different” are the four most dangerous words. But for value investors [who buy stocks they think the market has undervalued], “This time it’s never different” are the five most dangerous words. They lead to simple-minded extrapolation — an unchecked belief that the future will be like the past.
For a really good example of that, think of value managers who bought financials in 2008 because they were “cheap.” They failed to understand the dangers posed by the bursting of the credit bubble and the way in which earnings had been inflated during the housing bubble.
But profits as a percentage of gross domestic product have indeed been elevated for a sustained period. Now the data show profit ratios are not increasing anymore, and that may be the first sign that they’re beginning to peak. Looking forward, more federal budget cuts are coming, which should reduce profits.
Are we in a bubble now?
The technology bubble of ’99 was a good old-fashioned mania. People really did believe this time was different — that the dotcoms would change the way the world worked forever. I think what we are seeing today is more of a near-rational bubble.
When you have central banks around the world setting interest rates below the rates of inflation, effectively telling you that cash will earn nothing, then you tend to seek out other vehicles for investing. That distorts pricing across a wide range of assets.
I’d call it a foie gras market, in which investors are the geese being force-fed risk assets by central banks. It isn’t pleasant, but it may be the best that you can do given the alternatives that are available to you.
So what should investors do?
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Personal investment advice is not our business. But when you look at the S&P 500 at today’s valuations, our return forecast is negative 1.5% annually after inflation. Cash will earn something like minus half a percent over the next seven years.
It’s hard to find bits of the market that are actually attractive. So we look for high-quality stocks, which have three features: high profitability, stable profitability, and low leverage: the Johnson & Johnsons JOHNSON & JOHNSON
, Procter & Gambles PROCTER & GAMBLE COMPANY
, and Microsofts MICROSOFT CORP.
of the world. They’re certainly not cheap. But they are the best of the bad bunch.
And outside the U.S.?
Globally, European value stocks also probably deserve a place in a portfolio. So do some emerging markets, which is probably a brave call given the events that are unfolding around the world. In our unconstrained portfolios, we have just under 50% in equities spread among those groups, and then the rest in a combination of things like Treasury Inflation-Protected Securities and cash.
You don’t want to be fully invested or else you give up the ability to take advantage of shifts in the opportunities you face. Also, we have found that if you shift assets depending on your opportunities, you’ve greatly reduced the risk of lifetime ruin — running out of money before you die.
Does that mean timing the market? Or simply having a global portfolio and rebalancing once a year? That is, selling the asset that’s performed the best and buying the one that’s done the worst?
Rebalancing is the simplest of all valuation-based strategies and a really good start. But I think one absolutely should try to market-time based on valuation.
Ben Graham actually said that in Security Analysis [a classic investing book co-written by David Dodd and first published in 1934]. He said, “It is our view that stock-market timing cannot be done…” and that’s the bit everybody quotes. But he goes on to say “unless the time to buy is related to an attractive price level,” which I think is exactly right.
Any tips on how to market-time?
My colleague Ben Inker says you should smoothly and slowly enter and exit markets. Rather than trying to pick the top or bottom, which you’ll never do, move maybe 5% or 10% of your portfolio in or out each quarter. That’s what we’re doing.
We are slowly drawing down our equity exposure in recognition of the fact that the markets have been expensive. If they get more expensive, we may sell a little faster, and if they get less expensive, we may stop selling.
Being patient is a massively underestimated virtue when it comes to investing because there is nothing worse than sitting there watching your neighbor get rich because he’s been invested and you haven’t because you think the market’s expensive. But if you can be patient, a valuation-based framework is exactly the right way to do things.