Asset managers would be wise to boost their holdings of equities, most especially U.S. small- and mid-cap stocks, because of the bull market and “American industrial renaissance” now underway.
So said Richard Bernstein, principal of Richard Bernstein Advisors LLC and presenter of a morning general session – “Fear and Indecision: Sounds Like a Bull Market – at the Investment Management Consultants Association conference in Manhattan, New York.
Underpinning the positive outlook for U.S. equities, said Bernstein, are continuing economic growth, improvements in U.S. business and economic indicators and (counter-intuitively) investor uncertainty that the current run-up in stock valuations can be sustained beyond the near-term.
“There are tons of opportunities in equities markets now,” said Bernstein. “We’re in the middle of the biggest bull market since the great bull market of 1982, yet most people don’t realize this.”
The reason, added Bernstein, is that most investors fail to identify bull markets on the upswing. Between 1991 and year-end 2011, he noted, the average investor enjoyed less than a 2 percent return on their portfolios, a yield inferior to that of some 30-plus asset classes over the same period.
Bernstein attributed investors’ failure to identify the bull market of 1982 and the one now underway to several factors. He noted that 30 years ago, as today, people avoided equities because of fears about rising inflation, runaway federal budgets and debt, low corporate profit margins and inappropriate (too tight in the 1980s; too loose now) Fed monetary policies.
Other concerns of investors today, as during the early 1980s, Bernstein added, are fears about the negative economic impact of high oil prices; low gross domestic product growth (0-2.5 percent in both eras); anti-growth tax policies, sovereign debt crises (Europe’s currently; Latin America’s in the 1980s), and seemingly out-of-control federal entitlement programs, notably skyrocketing spending on Social Security and Medicare/Medicaid payments.
Overriding these issues, said Bernstein, is uncertainty about the future performance of equities. To the extent investor concerns (real or perceived) about the negative impact of business and economic indicators increase this uncertainty, then the “risk premium” – the return in excess of the risk-free rate of return that an investment is expected to yield – also rises. Thus, high risk premiums should make the equities markets more attractive, not less.
“Because of the tremendous uncertainty prevalent among investors, the risk premiums of U.S. equities now are huge,” said Bernstein. “That translates to historically cheap stocks and mutual funds – and hence great market opportunities.”
Bernstein added that he views the concerns now top-of-mind among investors as more imaginary than real.
He pointed out, for example, that an “American industrial renaissance” is now underway, one reflected in the rising values of U.S. small- and mid-cap stocks, because of “wage compression” (declining real wages) and rising, technology-fueled worker productivity that are making U.S. business – among them U.S. manufacturers – more competitive in world markets.
On the energy front, Bernstein observed also that energy costs for U.S. businesses and consumers are now (except in the Middle East) lower than in any another region worldwide. Low energy costs, in turn, enable businesses to keep their distribution costs down.
The American industrial renaissance, added Bernstein, is prompting many U.S. businesses to question the value of outsourcing manufacturing and services to developing countries like China and India.
“Outsourcing may now be an outdated business model, particularly in the manufacturing sector, because it doesn’t take into account all production costs,” Bernstein said. “GE finds that it’s now cheaper to manufacture many of its products in the U.S. The decision to outsource no longer hinges on low labor costs.”
Turning to monetary policy, Bernstein said the Fed is unlikely to tighten interest rates and, thereby, restrain economic growth. He pointed to an October 2012 statement by Federal Reserve Chairman Ben Bernanke, who said the Fed expects to keep short-term interest rates at “exceptionally low levels to at least 2015.”
Bernstein also discounted a view common among asset managers that the stock market is “significantly overvalued.” A comparison of U.S. 10-year Treasury yields against the Shiller cyclically-adjusted S&P 500 price-to-earnings ratio (CAPE) shows this not to be the case, he said.
Also undermining the overvaluation thesis, Bernstein said, is a “hoarding of cash” by businesses. If there were greater confidence in Wall Street, then more businesses would boost capital spending and diversify their holdings.
Calls by asset managers to dump equities from portfolios because of this perceived overvaluation is “exactly what you want to hear,” Bernstein said, because such statements only boost risk premiums and equity market opportunities.
Conversely, he added, securities professionals should take care to avoid investing too much in currently popular asset classes – alternative investments like emerging market funds, private equity, real estate investment trusts, commodities and hedge funds – because many of these asset classes now “correlate” (fluctuate in value in tandem) with equities.
The trick to appropriately diversifying an investment portfolio, he said, is not to blindly invest across asset classes, but to direct funds to only those asset classes that do not in fact correlate. And the one asset class that now meets that criterion (in relation to equities) is U.S. Treasuries.
“Alternatives became popular in prior years because equities and U.S. Treasuries were highly correlated,” Bernstein said, “But Treasuries do not now correlate with stocks. The way to mute portfolio volatility, therefore, is to hold Treasuries alongside stocks and bonds in an asset allocation.”