Bernstein: Big Bond Investors Blew It

January 12, 2018

Richard BernsteinRichard Bernstein is chief executive officer and chief investment officer of the firm that bears his name. Richard Bernstein Advisors is known for its top-down approach that focuses on macro trends. Bernstein is one of the panelists at Inside ETFs Jan. 21-24 in Florida for the discussion “Where to Invest for the Next 3 Years.” ETF.com caught up with him for a preconference chat.

ETF.com: The topic of the round table you’re participating in is where to invest for the next three years. Would give us a rundown of what you’ll talk about in that panel?

Bernstein: My main topic that I’ve been talking a lot about in the last three or four months is that people have completely mis-assessed risk—in any number of different ways.

First of all, what they’ve completely ignored—because they’re so worried about 2008 coming back still—is the opportunity cost of not being in the equity market. In our report, we pointed out that, in the last five years, stocks have outperformed bonds by 15% per year—that’s a monstrous fee to pay for protection.

I can’t believe more people aren’t asking, how can pension funds be underfunded when we’ve had the second-longest bull market in history? The answer is, because they haven’t had a correct allocation to equities. They, like everybody else, have been scared that 2008 was going to come back. It’s not just individuals; it’s really pretty widespread.

Why are people still investing with absolute-return hedge funds during a bull market? It just doesn’t make any sense. It’s because they’re sure that 2008 is coming back. When you talk about whether it’s one year, three years, five years or 10 years, people have to be much more dispassionate about assessing perspective, expected returns and risk. It’s amazing that it’s still influencing asset allocations. That’s No. 1.

No. 2 is that people have set asset allocations, assigning very high probabilities to low-probability events. And what I mean by that is, there’s a report by one of the brokerage firms toward the end of last year that identified eight different black swans.

I thought that was hysterical. Because, No. 1, a black swan is supposed to be something you’re not supposed to be able to identify. No. 2 is they found eight of them. And No. 3 is that the whole point of the report was how to structure a portfolio given the possibility of these eight things occurring. By definition, a black swan is supposed to have something less than a 1% probability. Why in the world would you structure a portfolio for something that has less than a 1% probability of occurrence?

Recently people have asked me, “Don’t you think the risk of war in Korea is higher?” And my answer is, “Of course it is. But maybe it’s gone from 0.5% to 2 or 4%.” However, what’s the probability over the last six months or so—when people have been asking me these questions—that the Korean earnings were going to come in better than people thought? We assess that to be more like 75% probability.

Do I structure a portfolio for 1% probabilities, or do I structure a portfolio for 75% probabilities?

ETF.com: So this is something you see happening in the wider investing population?

Bernstein: Look at mutual funds and ETF funds flows, and you can see it. It’s only been very recently that equities have begun to outpace bonds. That would be No. 1—the misallocation of assets.

No. 2 for me would be that people have ignored and are ignoring and, my guess, will ignore inflation risk. Everybody says, oh, people have been waiting for inflation to come back forever and nothing is happening. That is just completely untrue. That’s bond investors trying to rationalize why they won’t buy anything but bonds.

If you look at bond returns since inflation expectations troughed—which was actually in 2016—what you’ll find is bonds have returned about 1% total, not 1% per year. And stocks have returned about 35%.

This notion that inflation is not a risk, is not affecting anything and we should ignore it, just isn’t true. The bond market has been having a lot of trouble even in the face of what people were seeing to be no threat from inflation. If you’re looking for something that could bite people in the tush, that could be it.

ETF.com: Right now you’re bullish on the market.

Bernstein: Bullish on the equity market. We have pretty close to the highest equity allocation we can have in our portfolios for equities. We have the lowest, fixed-income allocation we can have. And what fixed income we have is extraordinarily short duration.

 

ETF.com: What would reverse your bullish outlook on equities at this point?

Bernstein: There are three things for us that we always look at. We look at profits. We look at liquidity and we look at sentiment/valuation.

Profit’s still accelerating around the world, so we think that’s OK. There’s a ton and a half of liquidity out there. And we know that because the VIX [Chicago Board Option Exchange (Cboe) Volatility Index] is telling us that. Right? The VIX is really more than anything else a reflection of how much liquidity there is.

It’s hard to get volatility when there’s a lot of liquidity, because people buy on the dip. Nobody ever asks, “Why don’t people buy on the dip in a recession?” The answer is because they don’t have any liquidity to do so. So we know there’s a lot of liquidity.

And sentiment and valuation—look, it’s not March of ’09. I’m not trying to overplay my hand on this one, but we’re nowhere near extremes.

What would make us change? Well, if profits rolled over, if liquidity dried up too much and people were truly euphoric about equities, that would do it for us.

ETF.com: Do you think the tax reform package has given new life to the bull market in equities?

Bernstein: Yes. And it should. Whether it should for three years or not—getting back to the panel title—is another story.

Here’s why I say this: The short-term effect is what we call “unmitigatingly bullish” for the stock market. And the reason is that a cut in the corporate tax rate is specifically designed to aid the owners of capital. Who are the owners of capital? The shareholders. It’s called equity because you’re a partial owner of the company.

A cut in the corporate tax rate is specifically designed to help those people and to help investors. So on the surface you could say yes, this is very bullish. However, we’re a little skeptical that the secondary-, tertiary- and fourth-level effects of the tax cuts will actually come to fruition; in other words, creating jobs, building new factories, all this kind of stuff.

The reason goes back six, seven years ago, where I pointed out that, when you get a tax cut, there’s an inevitable leakage abroad. And it’s very difficult to measure. What I mean by this is, let’s say you’re a company and you’ve decided you’re going to go buy new computers. So we go and buy 25 new computers for the company.

Well, where are those computers made? They’re made in Korea, Taiwan or China. What’s happened is that some of the stimulus effects of the tax cuts has just aided Korea, Taiwan, China, someplace else. And has it really stimulated production here and job creation here? Or has it stimulated production and job creation in Korea?

Who would know? It’s very difficult to determine that. But given our trade balance, it’s a pretty fair guess that there’s going to be a fair amount of leakage.

My argument in the article that I wrote for The Financial Times was that, giving just blanket cuts would have a very muted effect on the economy longer term, would more likely just drive up the deficit because of these leakage effects.

Rather, what you should do is give tax cuts for good behavior. If you build the plant there, you get the tax cut. But you don’t get the tax cut hoping you’re going to build a plant.

Contact Heather Bell at [email protected]

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