Motley Fool Money - What Really Drives Stocks Higher?

Episode Date: November 27, 2022

Shoppers may need to switch from steak to bologna, but they still need to eat. That’s just one reason for investors to watch consumer staples if you’re concerned about a recession. Richard Bernstein is the CEO and Chief Investment Officer of Richard Bernstein Advisors. Before that he was the Chief Investment Strategist at Merrill Lynch. Motley Fool Senior Analyst John Rotonti caught up with Bernstein to discuss:  - How growth stories can change through time.  - Sectors showing the power of compounding dividends.  - If a “Fed Put” still exists.  Members of any Motley Fool service can watch the full interview here: https://www.fool.com/premium/live/video/4056/coverage/2022/11/16/interview-richard-bernstein-ceo-cio-richard-bernst/  Host: John Rotonti Guest: Richard Bernstein Producer: Ricky Mulvey  Engineers: Heather Horton, Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

Hi everyone, I'm Charlie Cox. Join us on Disney Plus as we talk with the cast and crew of Marvel Television's Daredevil Born Again. What haven't you gotten to do as Daredevil? Being the Avengers. Charlie and Vincent came to play. I get emotional when I think about it. One of the great finale of any episode we've ever done. We are going to play Truth or Daredevil.

What? Oh, boy. Fantastic. You guys go hard, man. Daredevil Born Again, official podcast Tuesdays, and stream Season 2 of Marvel Television's Daredevil Born Again on Disney Plus. So you've got this weird kind of 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, the other eight sectors, that probably offer reasonable value. And 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. 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. Botley Fool's senior analyst John Ratante caught up with him to talk about the basic ways to build wealth through compounding dividends, and the sectors that are showing strengths at a time when liquidity is tightening up. Just one quick note, this conversation was recorded on November 10th

when the stock market popped after a better than expected inflation report. 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. Yeah, so, John, you know, there are, as I think all your viewers know, there are about a million in five different events and different things to worry about these days. And what we tried to say at RBA is, look, 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 foreign portfolio about what we feel certain about. So we kind of argued that when

looking at the United States, there's only two certainties out there right now. The Fed's going to be tightening. Our view is that they're going to tighten for longer and probably go higher than people think. And number two, the profits are going to decelerate. And so that's kind of the cornerstone of how our portfolios are structured right now. Now, just to follow up on it 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 are 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 kind of living in now real time. So this is not an optimistic outlook. What would you say drives stocks higher over the long term?

If you look at what drive stocks, is it sentiment? Is it something else? You know, I want to point out for those who may not be familiar with RBA, that we're not always bearish. We are not perma bearers. We started our firm in 2009 and 2010 because we thought we were entering one of the biggest bull markets of our careers. So we've gone from kind of one extreme to the other extreme. And we're not under our decimal fetal position. I don't want to make it sound like, you know, this is all hines 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? So for us, the way we structure our portfolios,

you know, we are a macro firm, right? That means in English we know nothing about Coke versus Pepsi, make no claims about trying to understand individual company fundamentals, rather we drive our portfolio performance through macro considerations, whether that be size, style, geography, asset allocation, and the multi-asset portfolio, things like that. And so everything that we do filters down into three categories. Corporate profits, liquidity, and sentiment and valuation. So corporate profits simply because equities respond to profit cycles, much more than economic cycles. You know, 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.

And so what you'll find is the cycles of growth in value, large and small, all those kind of things respond to profit cycles, not the economic cycles. Of course, the economic cycle influences corporate profits, but there's lots of things that influence corporate profits. So number one is profit cycles. We follow them all over the world. Number two is liquidity. We follow central bank liquidity.

We follow bank liquidity, bank lending standards in about 43 countries. Now, 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. And then number three, we look at sentiment and valuation. And some people question, why do you group sentiment and valuation together? Well, it's kind of been our story that you can't have an overvalued market or an overvalued asset that everybody hates. And similarly, you can't have an undervalued market or undervalued asset that everybody loves. So valuation reflects sentiment.

And so we group that all together and we look at all three together. So what we're really looking for are 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. So that's kind of what we do and that's how we look at the world. And our portfolios end up being very much our marketing line is they're like camellions, their portfolios change their color depending on the environment.

And, you know, at certain times it will be very U.S., other times it will be very emerging market-oriented, growth-oriented, value-oriented. You know, we have no bias towards any particular market segment at any particular time. You mentioned that you believe corporate profits are going to decline. How are we from a liquidity framework right now, from a liquidity standpoint? Yeah, so, you know, 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 and profitability that we had. The dollar as well is another thing that's constraining corporate profits.

Liquidity side, liquidity is drawing up. I mean, 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 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. You know, 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 sort of a corporate finance

point of view where hurdle rates, you know, expected rate of return, whether 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 at the beginning of this whole thing, China is one place where you're not seeing that, and you kind of have a chance of the Chinese economy could be a salmon swimming upstream. 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? and what does this historical comparison tell you? And do you even find that making these historical comparisons are helpful?

I think a knowledge of history, of financial market history, not just in the U.S. around the world, I think it's critical. I think the, you know, reading history of markets, I think is very, very important because what you find is people believe that every cycle is something new, right? We've never seen this before. Well, it's kind of rare you've never seen something before, and it's just that people don't go back and look at history. And so 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 was started with supply chain disruptions and turned into a full-scale wage and price spiral.

I think that's kind of 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's some similarities to then, and the health of central bank is trying to react to that. At the same time, that comes at, I would say, a period where we could look at, say, the 99-2000 technology bubble. It's like two things are coming together at the same time. And I think that's from just a plain historical perspective, I think that it's very interesting how we got here and how people's expectations and attitudes towards the U.S. stock market have changed so dramatically in 10 or 15 years, right? 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. I mean, what an immense change in sentiment from 10 or 12 years ago. I will not invest in the United States, so I want the riskiest stocks. So this is all going on at a point in time where monetary policy is changing very, very dramatically. And it sets up kind of an interesting 80s versus 2000 type environment. Perfect segue. So we discussed of your three sort of lenses that you look at the world, the macro world, you've got corporate profitability, you've got liquidity, and then you had sentiment in valuation. So let's move on to sentiment and valuation. How do you think the U.S. stock market is value today? And what is your take on investor?

sentiment? So I think, you know, the stock market, despite what we've seen in terms of the bare market of correction, whatever word one wants to use, that we've experienced, the market's still pretty expensive. Obviously, not as expensive as it was, but still pretty expensive. And so 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 P-Buddy, for those of you who might remember that firm, that proposed what they called the Rule of 19. And the Rule of 19, which is now more accurately, probably the Rule of 21,

said that the trailing PE 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 to higher multiples, and there was a tradeoff. And they proposed that it was using the modern day, it would be about 21. It sounds a little silly to pick a number like that, but it's, 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. Okay. So inflation came out today. It's, I think, 7.7. So let's round and make it eight for the sake of discussion, which would argue that 21 minus 8 means the PE multiple and the S&B should be 13. And the PE 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, you know, whether it's technology, communications, and consumer discretionary. Those are still about 40 plus percent of the S&P, if I'm not mistaken. And those three sectors tend to command higher multiples. So you've got this weird kind of 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, the other eight sectors that probably offer reasonable value. And 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. But if you go away from those three sectors, you know, I think you're going to find valuations are more conservative, and the menu of opportunities is monsters. Another perfect segue into my next question. So how are your portfolios positioned going into 2023?

Yeah. So, you know, when you just think, again, let's simplify a little bit. If you think about profits you sell in the Fed tightening, not a real good combination, we're seeing volatility. What works in that environment? Well, it's kind of some of the stuff that has been. been working, consumer staples, health care, utilities. You know, there's a very sophisticated economic principle that says that no matter what goes on, we also eat. And we may switch from

state to belowity, mind you, but we're still going to eat. And so what becomes important in periods like this are necessities rather than designers. And I think that's important. And 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 weaner dogs in the metaverse. And that kind of gets to some of this stuff. What is your recession checklist telling you? Are we in a recession? And if not, does it look like a recession is likely in the next year or so? Right. So it's kind of interesting. You know, the recession became good cocktail party chatter.

Are we in a recession? Are we not in good political challenge? Of course, you know, like 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 and 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. And the last couple employment data that came out said that the demand for labor actually got stronger. How'd you like to be J. Powell? And you raise interest rates 400 basis points and the demand for labor goes up, not down. I mean, could you, you know, he must be banging his head against the wall. So what we need is a recession that's going to clear that out.

Well, we've had, as everybody knows, a couple 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 a recession. But even if we were, it's clearly not alleviating the labor market pressures. So, you know, look, the politicians have a grand all 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. And the reason I say that is that companies are still hiring. We saw that in the Joltz report that came out the other day. Labor demand is still very strong. That's because their earnings are still very strong. Companies still higher when earnings are up five or 10 or 15 or 20 percent. when earnings are down five or 10 or 15 to 20 percent, 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 this much, but it may damper economic growth quite a bit. And that's probably a maybe second half, 23 type of event. The CIOs of Bridgewater, which is the largest hedge fund in the world,

recently wrote that they are seeing the, quote, strongest near-term stag-flationary signal in 100 years, end quote. And that could lead to, quote, instability and volatility over the coming decade, end quote. 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? 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 their points well-taking, right? I mean, inflation itself can hurt growth. And that's something that people have to think about. Look, long-term inflation expectations and long-term inflation forecasts range between two and three percent.

And that makes a lot of sense because long-term inflation in the United States has been two and a half percent. So of course, the forecast center on that long-term two and a half percent. So 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 three percent 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 to just manifest itself like tomorrow while a sudden we wake up and there's no inflation. The stag part, I would say, is a little bit harder. And the reason I say there's 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 stay inflation in that. And we have to differentiate that out from something that's more secular. I think from a secular point of view, I think there will be growth. It's not 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, you know, Rich Bernstein making a forecast. This is hundreds and hundreds of analysts making forecasts for 100 and hundreds of stocks. And if you build that bottom-up long-term projected secular growth forecast out there, you'll actually find the number one sector for long-term growth right now is actually the energy sector. It's not technology. And in fact, the energy sector's long-term growth rate is twice that of the tech sector. So, you know, no, I know everybody just said, well, that can't be right, right?

I get that. But why do we trust the forecast from tech analysts, and we don't trust the forecast from energy analysts. You know, I get to see anything that points out that energy analysts are innately stupid, and tech analysts are innately bright. So why can we just accept the data for what it is? And the data says the number one 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, you know, a pretty good performing sector in that environment. 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?

Yes, so it's interesting. I've been joking a lot recently saying that, you know, everybody says they're a long-term investor until you get a bare market. It's like Mike Tyson, everybody's got a plan until they get punched in the mouth. And so, but let's assume that people really are long-term investors. And if that's true, you know, my argument has been that there are relatively basic ways to build wealth through time. Right. And some of them, it's like people just ignore it. 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. I mean, it's an amazing thing. I love that. I'm a dividend growth investor, so you're speaking my love language right now. I mean, this is, this is like, you know, 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. There's something sexy or something going on. I mean, I don't, so I would say number one is keep it simple. Number two is, stick to a plan, right? Everybody's got financial plan, not just to say everybody,

a lot of people have financial plans. Those financial plans are easy to abide by when tons are good. They're really made for when times are bad. Every financial plan should have on the front of it, like, you know, break glass, pull out in case of bare 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, right? And so I think one has to realize the financial plan is not really there for the bull markets. It's there for the bear markets. And so number two is stick to the plant. You know, it's like you got this plant, stick to it. And it's made to be the counterbalance to your motions. And so stick with that.

And number three is, I would say, keep in mind that long-term stories are never popular at the beginning. And so 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 that was geared to a certain economic environment. The economic environment changes and you get a changing of the guard. And the changing of the guard, we call volatility because the old leadership underperforms 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 8th. And so I think if you're a long-term investor, the story shouldn't be like, I found the 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 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. Does the Fed putt still exist, in your opinion? So a good piece of trivia for you, the grain spam poe, which was the original put, was not coined by me, but somebody in my department at Maryland Lynch. It was a derivative strategist who actually said, the market's acting like there's a put option here. And he kind of, he never got credit for it, but he was the guy who actually came up with the term. And I think it was very easy for there to be a Fed put when inflation was 2%. Right. And, you know, 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, I mean, my attitude, I'm saying this tongue in cheek, not really. They were bored, right? And I'm not saying that real. But, you know, inflation is 2%. There's not a lot of fighting to be done. You're not hearing anything about climate change today from the Fed. Inflation's 7 to 8 percent.

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. And if the major banks are in good shape and inflation's 8%, there's no FedExam. 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 interest 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.