Tue, 9 Jul 2013
Investors' real-return expectations are too high for foreign stocks and too low for U.S. stocks, especially for small- and mid-cap names, says Richard Bernstein, CEO of Richard Bernstein Advisors.
Kevin McDevitt: Hi. I am Kevin McDevitt for Morningstar. We're here at the Morningstar Conference with Rich Bernstein from Richard Bernstein Advisors.
Rich, thanks for joining us.
Rich Bernstein: Thanks, Kevin.
McDevitt: Rich, you've got a number of very interesting contrarian perspectives on the market. We want to explore a few of those with you.
McDevitt: The first one I want to get into is the fact that you are actually long Treasuries, which is very rare these days; most managers tend to be pretty short in terms of duration.
Bernstein: That's right.
McDevitt: And in your mind that's more of a way of hedging an equity portfolio. Why are long Treasuries so attractive? Also, do you think that the benefits of Treasuries as a hedge are likely to persist over time?
Bernstein: First, let me just say one thing. We're not necessarily always in long Treasuries. We adjust the risk of the portfolio. We move along the curve depending on how much equity exposure we're taking. But that being said, our duration [a measure of interest-rate sensitivity] is longer than our benchmark in all our portfolios. And as you said, it's to kind of balance out that equity risk.
What we found, really now coming up on six to seven years, is the only major asset class that has a negative correlation to virtually every other asset class has been Treasuries. And I don't really have a view on whether rates are going up or rates are going down. I just know that if I am going to try and lower the volatility of a portfolio, I have to have something that's negatively correlated to all the other asset classes. I have to basically protect against being wrong, and that's what diversification is all about.
McDevitt: And looking back historically, has that correlation changed over time? Have the dynamics of it have changed?
Bernstein: Very much so, very much so. In the 1980s and the '90s, Treasuries were positively correlated with equities. Treasury returns were positively correlated with equity returns. And therefore, you couldn't diversify a portfolio. You're using traditional stock/bond/cash diversification. That's why you have the whole rise of the alternative asset class because stocks and bonds were positively correlated.
In last six or seven years, stock returns and Treasury returns have been negatively correlated. And so if that's the case, what that argues is that traditional asset allocation is working again. As you might guess, I'm not a big fan of alternatives because of that because I think they're expensive and I don't think they necessarily provide you that negative correlation that Treasuries do right now.
McDevitt: Well, let's maybe look at that. A lot of people believe that if they look at the landscape and look at the kind of the major asset classes, nothing really looks cheap. And a lot of people are still wondering these days, can you still achieve decent real returns with a traditional asset mix?
Bernstein: I think you can. I actually would argue that I think the U.S. equities are reasonably valued. I'm not going to say they were as cheap as they were three or four years ago, but I really do think they are very reasonably valued. I think a lot of people don't realize that some of the best growth stories in the world right now are in the United States. For instance, U.S. small-cap stocks have projected earnings growth right now that's twice the projected earnings-growth rate of the emerging markets. I don't think people realize that.
So, generally, I think when people say that the U.S. stock market is expensive, they're not looking at the growth prospects that come with that market, as well. At the same time I think, they're overestimating the growth prospects around the world. So, I think, maybe in total, you may not get great real returns, but where I think people are making a mistake right now is I think their expectations for real returns are too high outside the United States and too low in the United States.
McDevitt: Let's talk more about kind of the small-/mid-cap thesis and kind of the prospects for growth there. It seems like one of the planks of that argument is a strong dollar: The dollar will continue to strengthen in the years to come. That'll benefit the small-/mid-cap companies primarily. But it seems though that in terms of valuations, relative valuations, small and mid-caps are actually fairly expensive relative to large caps. Talk about that dynamic a little bit.
Bernstein: Yes. In the United States, I think there has been a big change in the way bull markets progress over the last, say, 10 or 15 years versus what we saw from 1980 to 2000. 1980 to 2000, you had mostly P/E-driven stock markets and so you began a bull market with P/Es very, very low.
Post 2000, what's happened is bull markets have generally begun with higher P/Es, and the P/Es have shrunk as the cycle has matured because you had a more cyclical rebound in earnings. In other words, they are more earnings-driven markets after 2000, and more interest rate-driven markets prior to 2000.
If that's correct, and some people will not agree with that, but if that's correct, what it argues is that the reason that you are seeing such high valuations on small-/mid-cap stocks in the United States is because the market is beginning to anticipate that earnings growth coming. And therefore, the time to sell more cyclical, lower-quality, smaller-cap stocks will be when the P/Es are very low. In other words, that will be peak earnings.
So, if you think more in terms of an earnings-driven market versus a P/E-driven market, you can see why we're so bullish on small-/mid-cap stocks and not put off by the valuations.
McDevit: Just to clarify, you're not expecting to see more P/E multiple expansion from here. It's going to be really earnings growth.
Bernstein: Correct. I think, actually, in the near term right now the volatility you're seeing in the U.S. stock market is very much related to that issue, into the fears that people have that interest rates are going to go up. But yet they're not seeing the earnings growth yet to offset the negative effects of rising rates. That actually happens in every cycle by the way; that's not unique to this cycle. But that's where we are right now, in that tug-of-war between improving fundamentals and rising rates.
McDevitt: Going back to the Treasury argument, you feel like if we had rising rates that basically what you are losing on the Treasury side, you're going to make up for in the equity side, or at least equities will not do as badly as Treasuries?
Bernstein: We actually think you are going to do well in equities through time here. Remember, I started by saying that we adjust the risk of that fixed-income portfolio. I mean, from what the environment that we foresee, we're not sitting out in 30-year zeroes or something, where we might of have been several years ago.
We've shortened the duration because we are more bullish. We do think the economy is going to do better than people think. We do think profits will do better than people think. It would be unrealistic to expect 30-year zero-coupon bonds to outperform in an environment of accelerating profits sort of cycle. So, we have shifted that in, but we don't know. We may play with the duration, but we may not play with the allocation of how much we're giving to bonds.
McDevitt: Great. Rich, thank you very much.
Bernstein: Sure. My pleasure.
McDevitt: Thank you for watching.