Richard Bernstein is CEO and chief investment officer of Richard Bernstein Advisors. Before that, he was chief investment strategist at Merrill Lynch.
Motley Fool senior analyst John Rotonti recently talked with Bernstein about topics including:
- How companies' growth stories can change over time.
- Sectors that show the power of compounding dividends.
- If a "Fed put" still exists.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
This video was recorded on Nov. 27, 2022.
Richard Bernstein: You've got this weird imbalance within the U.S. stock market. We've got three sectors that are probably very expensive still. But then there's this other group of everything else in the other eight sectors that probably offer reasonable value. The way I've described it to people is, I actually think the menu of opportunities in the global equities markets right now is huge. I think it's just monstrous. It's just not in the three sectors -- U.S. tech, U.S. communications, and U.S. consumer discretionary -- the three sectors that everybody loves.
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Chris Hill: I'm Chris Hill, and that's Richard Bernstein, CEO and chief investment officer of Richard Bernstein Advisors, a firm with more than $13 billion in assets under management. Before starting his own firm, Bernstein was the chief investment strategist at Merrill Lynch. Motley Fool Senior Analyst John Rotonti caught up with him to talk about the basic ways to build wealth through compounding dividends, and the sectors that are showing strength at a time when liquidity is tightening up.
Just one quick note. This conversation was recorded on Nov. 10, when the stock market popped after a better-than-expected inflation report.
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John Rotonti: Let's start with your current macro view of the world and what you think that means for the U.S. stock market going forward.
Richard Bernstein: John, as I think all your viewers know, there are about a million and five different events and different things to worry about these days. What we try to say at RBA is, there's always going to be a lot of uncertainty. There's nothing we can do about that, but let's try to invest for what we feel more certain about, and form a portfolio by we feel certain about. We argue that when looking at the United States, there's only two certainties out there right now. The Fed is going to be tightening. Our view is that they're going to tighten for longer and probably go higher than people think. And No. 2, that profits are going to decelerate. That's the cornerstone of how our portfolios are structured right now.
Now, just to follow up on that for one second, that doesn't sound like a good combination: Fed tightening, profits decelerating. And one's intuition is correct. The volatility that we're seeing in the marketplace is exactly what history suggests should happen when you get the combination of the Fed tightening and profits decelerating. So we're living it now, in real time.
John Rotonti: This is not an optimistic outlook. What would you say drives stocks higher over the long term? If you look at what drives stocks, is it sentiment? Is it something else?
Richard Bernstein: I want to point out, for those who may not be familiar with RBA, that we're not always bearish. We are not permabears. We started our firm in 2009 and 2010 because we thought we were entering one of the biggest bull markets of our careers. We've gone from one extreme to the other extreme, and we're not under our desks in a fetal position. I don't want to make it sound like this is "all hands on deck," bear market type stuff. But I think there's times to be aggressive and there's times to calm down. I think right now we think it's time to calm down a little bit.
So what do we look at? For us, the way we structure our portfolios, we are a macro firm. That means in English, we know nothing about Coke versus Pepsi. We make no claims about trying to understand individual company fundamentals.
Rather, we drive our portfolio performance through macro considerations, whether that'd be size, style, geography, asset allocation in the multi-asset portfolio -- things like that. Everything that we do filters down into three categories: corporate profits; liquidity; and sentiment and valuation.
Corporate profits simply because equities respond to profit cycles much more than economic cycles. When you own equities, you own companies. And when you own a company, you should worry about the profitability of the company that you own. So what you'll find is the cycles of growth and value, large and small, all those things respond to profit cycles, not to economics cycles.
Of course, the economic cycle influences corporate profits, but there's lots of things that influence corporate profits. So No. 1 is profit cycles. We follow them all over the world.
No. 2 is liquidity. We follow central bank liquidity. We follow bank liquidity, bank lending standards in about 43 countries. Obviously, the 43rd country doesn't give you as much information as the United States, but it's still worthwhile to look at them, if not individually, then certainly in aggregate.
Then No. 3, we look at sentiment and valuation. Some people question: Why do you group sentiment and valuation together? Well, it's been our story that you can have an overvalued market or an overvalued asset that everybody hates. Similarly, you can have an undervalued market or undervalued asset that everybody loves. So valuation reflects sentiment.
We group that all together and we look at all three together. What we're really looking for is situations where fundamentals are improving, liquidity is improving, and everybody hates it -- or vice versa, fundamentals are deteriorating, liquidity is drawing up and everybody loves it. That's what we want to avoid. That's what we do and that's how we look at the world. Our portfolios end up being very much like ... our marketing line is they're like chameleons. The portfolios change their color depending on the environment. At certain times, it'll be very U.S., other times it will be very emerging market oriented, growth oriented, value oriented. We have no bias toward any particular market segment at any particular time.
John Rotonti: You mentioned that you believe corporate profits are going to decline. How are we from a liquidity framework right now, from a liquidity standpoint?
Richard Bernstein: Corporate profits, I think everybody knows are starting to come under pressure, whether it be from very tough comparisons, whether it be input costs and labor costs going up, or simply hard comparisons versus the post-pandemic surge in profitability that we had. The dollar, as well, is another thing that's constraining corporate profits. Liquidity side -- liquidity is drawing up. There's no other way to say it, whether investors realize that or not -- liquidity is drawing up. Whether you look at the Fed, you look at any major central bank, or you even look at the secondary and tertiary central banks around the world. The vast majority of them are trying to mop up liquidity.
They are making lending standards harder. They are raising interest rates. So whether you want to think of it from the point of view of traditional liquidity, or whether you want to think of it in a corporate finance point of view or hurdle rate, expected rate of return, or the "risk-free rate of return," if you will, or hurdle rate -- they're all going up, which makes investing in riskier assets less attractive. And you're seeing that all around the world right now.
Interestingly, one exception to that -- and not to get people angry with me at the beginning of this whole thing: China is one place where you're not seeing that, and you have a chance that the Chinese economy could be a salmon swimming upstream here.
John Rotonti: Is there a historical period that you think is a good comparison to today's market environment of high inflation, Fed tightening, rising interest rates, geopolitical tensions, possibly slowing GDP growth? What does this historical comparison tell you? Do you even find that making these historical comparisons are helpful?
Richard Bernstein: I think a knowledge of history, of financial market history, not just the U.S. for the whole world, I think is critical. I think reading the history of markets I think is very important because what you find is people believe that every cycle is something new: "It's never happened, we've never seen this before." Well, it's kind of rare you've never seen something before. It's just that people don't go back and look at history.
To your question more specifically, I would say right now is a combination of two different periods. One period would be late '70s, early '80s, where inflation started with supply chain disruptions and turned into a full-scale wage-and-price spiral. I think that's happening now where we started with supply chain disruptions, and now the labor market makes up over 75% of inflation, according to a recent academic study.
So there are some similarities to then and how the central bank is trying to react to that. At the same time that comes in, I'd say, a period where we could look at, say, the 1999-2000 technology bubble. It's like two things are coming together at the same time. From just a plain historical perspective, I think it's very interesting how we got here and how people's expectations and attitudes toward the U.S. stock market have changed so dramatically in 10 or 15 years.
If you think about it, 10 years ago, nobody wanted to invest in the United States, emerging markets were all the rage. And now they're talking about meme stocks. What are the immense change in sentiment from 10 or 12 years ago -- I will not invest in the United States, so I want the riskiest stocks. This is all going on at a point in time where monetary policy is changing very dramatically. It sets up an interesting '80s versus 2000 type environment.
John Rotonti: Perfect segue. We discussed, of your three lenses that you look at the world, the macro world. You've got corporate profitability, you've got liquidity, and then you had sentiment and valuation. Let's move on to sentiment and valuation. How do you think the U.S. stock market is valued today? And what is your take on investor sentiment?
Richard Bernstein: I think the stock market, despite what we've seen in terms of the bear market or correction, whatever word one wants to use, that we've experienced, the market is still pretty expensive. Obviously not as expensive as it was, but still pretty expensive. What I say to people is, there's an old rule of thumb, which is going to sound ridiculously silly, but it's not that far off from what the math actually says it is. When I started the industry in the early '80s, there were people at Kidder, Peabody -- for those of you who might remember that firm -- that they proposed what they call the Rule of 19. And the Rule of 19 -- which is now more accurately probably the Rule of 21 -- said that the trailing P/E on the S&P plus the inflation rate, the CPI, you take those two numbers together, it should equal 21.
Now you'd say, what they're basically saying was that there's a trade-off, if you will, between higher inflation and lower multiples, or lower inflation and higher multiples. And there was a trade-off. And ... using the modern day, it would be about 21. It sounds a little silly to pick a number like that, but as I said, it's not that far off from, if you do the math and you actually look at it in detail, not that far off.
So let's say the rule of 21. Inflation came out today. It's, I think 7.7%. Let's round and make it 8% for the sake of discussion, which would argue that 21 minus 8 means the P/E multiple on the S&P should be 13. The P/E multiple, I think is about 16 or 17. So it says that we're still an overvalued market.
Now, one thing that I think is interesting within that, is that one has to admit that three sectors have dominated the S&P 500, whether it's technology, communications, and consumer discretionary. Those are still about 40%-plus of the S&P, if I'm not mistaken. Those three sectors tend to command higher multiples. So you've got this weird imbalance within the U.S. stock market, where we've got three sectors that are probably very expensive still. But then there's this other group of everything else -- the other eight sectors -- that probably offer reasonable value. The way I've described it to people is, I actually think the menu of opportunities in the global equities markets right now is huge. I think it's just monstrous. It's just not in the three sectors -- U.S. tech, U.S. communications, and U.S. consumer discretionary -- the three sectors that everybody loves. If you go away from those three sectors, I think you're going to find valuations are more conservative and the menu of opportunities is monstrous.
John Rotonti: Another perfect segue into my next question. How are your portfolios positioned going into 2023?
Richard Bernstein: We just think, again, let's simplify a little bit. If you think about profits decelerating and the Fed tightening, not a real good combination. We're seeing volatility. What works in that environment? Well, it's some of the stuff that has been working: consumer staples, healthcare, utilities. There's a very sophisticated economic principle that says that no matter what goes on, we also eat. We may switch from steak to baloney, mind you, but we're still going to eat. What becomes important in periods like this are necessities rather than designers. I think that's important. I think if we do have higher secular inflation than people think, I think the necessities are going to be very, very important as a longer-term secular theme as well. I joked very often I said that I strongly doubt the future of the U.S. economy is cute wiener dogs in the metaverse. That gets to some of this stuff.
John Rotonti: What is your recession checklist telling you? Are we in a recession? If not, does it look like a recession is likely in the next year or so?
Richard Bernstein: It's interesting the recession became good cocktail party chatter. Are we in a recession? Are we not? Good political chatter, of course: "We're in a recession." "No, we're not."
From an investment point of view, my attitude so far has been: Who cares? This really doesn't have a lot of relevance to your portfolio or my portfolio right now. Because what we really need is a recession that is deep enough to alleviate the labor market pressures, because that's where the inflation is right now -- it's in the labor market. We have an historically tight labor market. The last couple of employment data [reports] that came out said that the demand for labor actually got stronger. How'd you like to be Jay Powell, and you raise interest rates 400 basis points, and the demand for labor goes up, not down? He must be banging his head against the wall.
So what we need is a recession that's going to clear that out. We've had, as everybody knows, a couple of quarters of negative GDP. Current GDP is actually positive. The Atlanta Fed came out the other day and said their latest forecast for GDP now is up to 4%. So we're probably not in recession, but even if we were, it's clearly not alleviating the labor market pressure. Look, the politicians can have a grand old day with it, we can talk about it over a drink. But for our investment portfolios, I just don't think we're there yet. Now, will we get one? Yeah, I think we will, but I think, oddly enough, -- and this doesn't always happen -- my guess (emphasizing the word "guess") is that a profits recession is going to lead an economic recession.
Often it's the other way around, but I think it's going to happen. The reason I say that is that companies are still hiring. We saw that in the JOLTS [Job Openings and Labor Turnover Survey] report that came out the other day. Labor demand is still very strong. That's because their earnings are still very strong. Companies still hire when earnings are up 5% or 10% or 15% or 20%. When earnings are down 5% or 10% or 15% to 20%, you lay people off. You don't hire people. So a profits recession may come to the aid of the Fed. The Fed may not have to tighten as much, but it may damper economic growth quite a bit. That's probably a maybe second-half '23 type event.
John Rotonti: The CIOs of Bridgewater, which is the largest hedge fund in the world, recently wrote that they are seeing the "strongest near-term stagflationary signal in 100 years," and that could lead to "instability and volatility over the coming decade end." What do you think are the odds we enter a prolonged stagflationary environment? And how do you think investors should be positioned for possible stagflation?
Richard Bernstein: Yeah. I'm not sure I would go quite to the extent that they are on the "stag" part. The "-flation" part, I think I agree, but the point's well taken. Inflation itself can hurt growth and that's something that people have to think about. Look, long-term inflation expectations and the long-term inflation forecast, the range is between 2% and 3%. And that makes a lot of sense because long-term inflation in the United States has been 2.5%. Of course, the forecast centered on that long-term 2.5%. To say that inflation is going to be higher than people think for an extended period of time, it's not a "hair on fire" forecast. All you're really saying is that inflation is going to be 3% or more for an extended period of time.
And I would agree with that. I think that's going to happen. I think the genie is out of the bottle. I think it's going to be very hard to tame that. I think it's going to be a long time before we see the Fed's target of 2% inflation. I just don't think that it's reality to expect it to just "manifest itself" -- like tomorrow, we wake up and there's no inflation. The "stag" part I would say is a little bit harder. The reason I say that is one has to remember that every cycle has a period of stagflation simply because inflation is a lagging indicator. So the economy begins to slow first, inflation hasn't slowed yet, so you always get this period of stagflation in them.
We have to differentiate that out from something that's more secular. From a secular point of view, I think there will be growth. It's just not going to be in the sectors that people think it's going to be. For instance, if you look at bottom-up earnings estimates for long-term growth -- so this is not Rich Bernstein making a forecast. This is hundreds and hundreds of analysts making forecasts for hundreds and hundreds of stocks. If you build that bottom-up, long-term projected secular growth forecast out there, you'll actually find the No. 1 sector for long-term growth right now is actually the energy sector. It's not technology.
In effect, the energy sector's long-term growth rate is twice that of the tech sector. I know everybody just said, "Oh, well that can't be right." I get that. But why do we trust the forecasts from tech analysts, and we don't trust the forecasts from energy analysts? I've yet to see anything to point out that energy analysts are innately stupid and tech analysts are innately bright. So why can't we just accept the data for what it is, and the data says the No. 1 sector for long-term growth is energy? Well, if you think that maybe we're going to be in a longer-term secular stagflation environment, energy would be a pretty good performing sector in that environment.
John Rotonti: For investors that have a long-term horizon, five to 10 years, what strategic principles would you share with them? What investing and portfolio management strategies do you think lead to long-term investing success?
Richard Bernstein: Yes. It's interesting. I've been joking a lot recently, saying that everybody says they are a long-term investor until you get a bear market. It's Like Mike Tyson [said]: "Everybody's got a plan until they get punched in the mouth."
But let's assume that people really are long-term investors. If that's true, my argument has been that there are relatively basic ways to build wealth through time. Some of them, it's like people just ignore them, and I don't understand why. My favorite, which I've used for many, many years is that since Nasdaq's inception in 1971, utility stocks have outperformed Nasdaq. Shows the power of compounding dividends through time. That's absolutely true. It's an amazing thing.
John Rotonti: I love that. I'm a dividend growth investor, so you're speaking my love language right now.
Richard Bernstein: It's one of the easiest ways to build wealth is the compounding of dividends, and nobody wants to do it. There's always a better way to grow wealth, or something sexier, or something going on. I would say No. 1 is, keep it simple.
No. 2 is stick to a plan. A lot of people have financial plans. Those financial plans are easy to abide by when times are good. They're really made for when times are bad. Every financial plan should have on the front of it like, "break glass, pull out in case of bear market." That's really what the financial plan is for, is to tell you to stick to what you said you were going to do when times are bad and you're highly emotional.
I think one has to realize the financial plan is not really there for the bull markets, it's there for the bear markets. So Number 2 is stick to the plan. It's like, you got this plan -- stick to it. It's made to be the counterbalance to your emotions. Stick with that.
No. 3 is, I would say, keep in mind that long-term stories are never popular at the beginning. The way to think about this is, when I was at Merrill, we used to counsel all the time that periods of volatility always signal a change in leadership. In fact, what happens is the economic environment changes. There was some old leadership in the market. It was geared to a certain economic environment. Then that economic environment changes and you get a changing of the guard and the changing of the guard, we call volatility because the old leadership under-performs and some new leadership starts to emerge but investors always want to go back to the old leadership.
They don't want to embrace the new leadership. They want to go back to the old leadership. So they sit there and they wait for the old stuff to come back, and then they finally appreciate the new leadership in like the eighth inning. I think if you're a long-term investor, the story shouldn't be like, "I found a great story." It should be a realization that "Yeah, there are growth stories and growth stories change through time." They don't change for a week or a month or a quarter. They change for years. And that we should be very open, and should be very dispassionate about where those long-term stories are, and, as I said before, accept the data for what it is, and be very dispassionate, not cling to the old stories.
John Rotonti: Does the "Fed put" still exist, in your opinion?
Richard Bernstein: The "Greenspan put" which was the original put, was not coined by me, but by somebody in my department at Merrill Lynch. It was a derivatives strategist who actually said "the market is acting like there's a put option here." He never got credit for it, but he was the guy who actually came up with the term.
I think it was very easy for there to be a Fed put when inflation was 2%. Some people have said to me, "Why did the Fed go off and start talking about climate change and all these things that have nothing to do...?" Well, my attitude, I'm saying this tongue and cheek, not really -- they were bored. I'm not saying that really. But inflation is 2%, there's not a lot of fighting to be done, so you go off ... you're not hearing anything about climate change today from the Fed. Inflation's 7% to 8%. The Fed is prime focused on defeating inflation here. I don't think they could care less what happens in the stock market so long as it doesn't create a financial calamity. However, one has to remember, everybody has told me that the major banks are in the best financial shape they have ever been at this point in the cycle. I don't think the Fed cares about cryptocurrency speculators. I don't think the Fed cares about small private debt companies, or anything like that. The Fed cares about the major banks.
John Rotonti: Sure.
Richard Bernstein: If the major banks are in good shape and inflation is 8%, there's no Fed put.
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Chris Hill: If you're a member of any Motley Fool service, you can watch the entire interview with Richard Bernstein. Just click the link in the episode notes. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.
