Bernstein: High Valuations No Reason to Stray

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I'm here at the Morningstar Investment Conference, and I'm joined today by Bill Bernstein. He is an author and he is an investment advisor.

Bill, thank you so much for being here.

Bill Bernstein: Once again, pleasure to be here, Christine.

Benz: I know. It seems like we do these interviews frequently. We appreciate it.

Let's start with the current market environment. I think a lot of investors have been kind of looking at the market. Bond yields certainly aren't enticing. Cash yields are close to nothing. And equity valuations are not cheap either. So, investors naturally are concerned about what they should do next, wonder what they should do next. You spend a fair amount of time thinking about asset allocation. What's your best counsel to them?

Bernstein: Well, I think you simply need to stay the course. First and foremost, you have to have a strategy. You have to have a policy allocation and you should by and large stick to that. If you're going to deviate from it, it shouldn't be by very much and it should only be in response to very large changes in valuation and of course, in the opposite direction from those.

Benz: So, let's talk about where we are currently in the context of market history over very long time periods. It does seem that we have been in this situation before. Let's talk about what tends to happen after market environments like the current one.

Bernstein: Well, it's said that the four most dangerous words and the four most expensive ones in the English language are "this time it's different." So, if there really is something different now, if say, we were sitting at perhaps the tail end or perhaps at the beginning of an even longer period of extended market valuations, the market has never had valuations this high for this long, so, maybe this is to borrow a fairly awful phrase, a new normal. It used to be you would see cheap valuations, single-digit, 10, 11, 12 P/E multiples maybe for periods of years and years at a time. We're still seeing those occasionally, but they don't last for five or 10 years. They last for five or 10 weeks now when they occur.

So, that suggests that returns going forward are going to be in general fairly low. And on top of that, of course, you have the situation with bonds where you have the central bank intervention which is producing financial repression, essentially zero to negative real yields at most horizons. And that maybe not be something which is long lasting. Eventually, the banks are going to have to--the central banks are going to have to unwind that and we'll see higher yields.

Benz: So, if there may be at some point some sort of market correction that would bring equity valuations down to a more attractive level, does that argue for maybe holding a little bit more cash than I otherwise would, so that I'm at least somewhat liquid and in a position to take advantage of periodic opportunities?

Bernstein: I think that you certainly should be holding more cash than you did, say, five or six years ago in the wake of the '08-'09 crash. And again, we're not talking very big changes because that's generally not a good idea. But if you were 60-40 six or seven years ago, maybe you should be 55-45 now, or not.

Benz: How about foreign equity valuations? Do you find that they are a little more attractive today or not really?

Bernstein: Yeah, I do find foreign equity valuations more attractive. You're seeing dividend yields in the range of 4% and 5%. It's not hard to find those, particularly in emerging markets. Of course, there is a good reason for those. Stocks don't get cheap without a good reason.

Benz: Alternatives? I know some investors have held out alternatives depending on whatever type, long-short or market-neutral or managed futures, as a potential place to park money in the current environment of low bond yields and not cheap equity valuations. What's your take on alternatives?

Bernstein: They are a compensation scheme, not an asset class.

Benz: Because of their high fees that completely erodes their return advantage?

Bernstein: Yeah. And after all, what is an alternative? It's some combination of stocks, bonds, cash, and commodities. Where is the juice in that? I don't get it.

Benz: When I'm thinking about putting together a portfolio, should it just be plain vanilla stocks, plain vanilla bonds and call it a day? Is there any category that you think is interesting as a diversifier for those two?

Bernstein: Anytime that anyone tells you that 60-40 is dead or that any long-standing well-established investment strategy is dead, that's usually the time to stick with it.

Benz: But 60-40 isn't the right allocation for everyone certainly?

Bernstein: Correct.

Benz: Younger investors should potentially have more?

Bernstein: Theoretically, yes.

Benz: I know in your book though you suggested that perhaps younger investors start out with lower equity allocations than 95% or 100% just to make sure that they are comfortable with equities before they go in fully.

Bernstein: Yeah. If I've learned one thing in the past 10 or 15 years is that it's nonsensical to talk about the riskiness of stocks without talking about the investor who is investing in them. So, if the investor is a young saver, they want volatility, they want low return. Stocks really aren't all that risky for a young investor. On the other hand, if the person is in the deccumulating phase, they retire, they have no more savings then stocks can be Three Mile Island-toxic, particularly if they have a high burn rate.

Benz: Bill, thank you so much for being here. Always great to hear your insights.

Bernstein: My pleasure.