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After the Bubble, How Capitalism Will Survive
Monday September 29, 3:09 pm ET
By Lawrence C. Strauss
RICHARD BERNSTEIN, CHIEF INVESTMENT STRATEGIST at Merrill Lynch, is no stranger to the bear camp. A longtime bull in the mid-1990s, he switched his outlook in 1998 -- too early, initially, but eventually right on the mark. In the 2000s, he has remained bearish, concerned about the effects of low interest rates during much of this decade. Bernstein, 49, who has been with Merrill for nearly 20 years, admits that he missed the boat in 2003, when the Standard & Poor's 500 gained 28.6%. He remains cautious on equities, favoring bonds, especially Treasuries, and cash.
For a look at what all of the recent tumult in the financial markets means to investors, Barron's caught up with Bernstein at Merrill's New York headquarters. Merrill itself is in the middle of the action, of course, having just agreed to be acquired by Bank of America.
Barron's: What are your thoughts on all of the recent upheaval, including the U.S. Treasury Department's attempt to buy illiquid securities from financial institutions, and its impact on the market?
Bernstein: There is an awful lot of turmoil, but it's not the end of capitalism as we know it. This is the natural downside to the credit bubble. For a long time, people would not admit there was a bubble. Then they thought the bubble was healthy.
This is the natural downfall we saw with technology stocks, and what we are seeing in financial stocks is the same thing.
You've been bearish for some time. Was that based in part on the excesses you saw in the credit markets?
It is a little bit more than that. People forget that we were raging bulls back in the '90s, when people really weren't so bullish. I can remember Alan Greenspan's "irrational exuberance" speech was in December of '96, and it really wasn't related to technology stocks; it was related to other stocks in the economy. But we became increasingly cautious as monetary policy got looser and looser. The idea that you could remove risk from the marketplace really made people speculate. What the credit bubble did was to expand that speculation to a broader range of asset classes. So our caution was based on the notion that there was too much money chasing too few ideas.
When you talk to clients, what are they most concerned about?
Inflation -- that's the No. 1 question, whether it is the private-client side of the business or global markets or the media. Everybody is asking about inflation. Everybody is sure that we are printing money, that the United States has quickly become an Argentina, that the dollar is going down and that inflation is going up.
And your view?
I just don't think that's the right approach. That scenario could happen. If the economy quickly turns, yes, we have a big problem on our hands. But if the economy continues to slow and credit creation continues to contract, it's going to be very hard to get sustained inflation.
I think prices are going to respond to the slower global economy. I believe the global economy will be weaker than people think. You always have to make a bet, stronger or weaker. I've been arguing that you should err on the weaker side. If that's true, then demand for commodities, demand for everything, goes down and some inflation subsides.
More than anything else, remember that inflation is a lagging indicator and credit is a leading indicator. There's not a lot of credit being issued these days.
You wrote in a recent note that the government was taking "a very Japanese approach to solving [the] credit crisis."
In Japan, they kept trying to maintain the status quo, and they kept the excess-lending capacity in the system alive. So their credit crisis dragged on for years.
The critical component to ending a credit crisis is quickly getting rid of excess capacity. In most cycles, the boom and the bust is in the industrial sector. We build too many factories. We end up with too much inventory, and then profitability comes down, and what happens? You start closing all the factories, removing excess capacity and inventory.
It is in the financial sector this time where we have tremendous excess capacity.
So, we think the financial sector is going through massive consolidation; the number of companies will shrink dramatically over the next several years. My attitude has been that the government should facilitate that process. My fear has been that what the government is trying to do is treat everything as a one-off situation and, therefore, trying to maintain the status quo for everybody else.
Treasury Secretary Paulson's proposal [to have the government buy illiquid assets from financial firms] may be the first step in terms of getting a government entity involved -- or at least admitting that there is a systemic problem. But the question still is, "Is the plan facilitating consolidation, or keeping the status quo?" That may come out in the details.
How attractive do equities look?
We have been -- and remain -- underweight in equities. Our benchmark allocation for equities is 60%, but we are at 50%. We are overweight in bonds, which has a weighting of 45%. We don't have a lot of cash, about 5%.
What would make you turn more bullish on equities?
We are looking for sentiment and valuation to improve, and we are looking for analysts' estimate revisions to actually capitulate.
So earnings estimates are not going down as much as you expected?
No, not at all. Relative to history, you would never know there was an economic slowdown going on in terms of analysts' revisions. That is largely because investors over all have not come to grips with the relationship between the credit crisis and the knock-on effects on the real economy: The next thing to look for is more defaults.
We are also watching jobless claims, which have been rising. Employment is very, very critical to the future of the economy.
Within the equity market, we are overweighting all kinds of defensive areas. Consumer staples and health care are the two dominant themes that we have right now from our sector-strategy group.
Why those sectors in particular?
One obvious reason is that they are defensive. No matter what goes on, we all still eat -- that kind of story. These sectors also have very stable cash flows and, surprisingly, when the dollar appreciates, they tend to do quite well.
Why is that?
Because when the dollar appreciates, it usually means the world is slowing. And if the world is slowing, you don't want to have economic sensitivity in your portfolio. For example, pharmaceutical companies have a lot of foreign exposure and people think of them as being very dollar sensitive. What people forget is another issue, notably economic sensitivity. And so the stocks that really underperform when you go into a global slowdown are foreign-exposed companies with economic sensitivity, like materials and energy -- not pharmaceuticals.
Could you talk a little more about stock valuations and your concerns there.
We have never had the combination of 5.5% inflation and about a 25 multiple on the S&P's trailing earnings. When we talk about a 25 multiple on the S&P, nobody can believe that it's actually the trailing earnings. And then people say, "Well, if that's true, it's only the financial stocks." Well, it's not. It's much more broad-based.
The market is just legitimately expensive, and we are so hesitant to use forward earnings, because analysts haven't revised their estimates downward. So to say the market is selling at 13, 14, 15 times forward earnings is a meaningless statement.
What's ahead for the economy, and how much more pain will there be?
That's a hard question to answer, but investors who are looking for a sharp V-shaped recovery are going to be quite disappointed. I don't see that happening. That's because we are going through Phase I of this process, which is the deflation of the credit bubble. Phase II is the knock-on effects on the real economy, and we're just beginning to see that.
The S&P 500 was trading at around 1200 late last week. Where do you see it going over the next year?
Surprisingly, our models still show a return of about 6% for the S&P over the next 12 months. We have about seven different models that we use to come up with that 6%. What is very interesting is that in the last two or three months, the dispersion of forecasts for these models has gotten incredibly dramatic and has been skewed downward.
So the 6% forecast is the median, not the average, which is about minus-18. We have always used the median to try to remove some of the volatility. But we've never seen that gap before between the mean and the median.
Moving to bonds, what's your view of that asset class?
Let's start with the Treasuries, which have outperformed stocks in the last 10 years.
If these were semiconductor stocks, everybody would be piling into them. It is just amazing that we have an asset class that is outperforming and everybody still hates it. The No. 1 issue right now with Treasuries is probably inflation. But you need credit creation to get inflation; printing money, which is what everybody is scared of, does not create inflation by itself, especially when the velocity of money [or the frequency it is spent] or credit creation is going down. When the global economy starts to reaccelerate, credit creation begins to pick up and, therefore, the velocity of money begins to pick up, and then central bankers are going to have their hands full. But for right now, I don't think people should worry about inflation.
So we are still very big fans of Treasuries. We are big fans of higher-quality bonds. But one of our constant themes has been that credit spreads are widening, whether it's emerging-market debt or corporates or munis. The market will continue to differentiate between really high-quality assets and lesser-quality assets.
What do you see happening to hedge funds in the wake of all this turmoil?
I expect there will be tremendous consolidation there, as well. Hedge funds are coming under tremendous pressure.
What should investors be looking at?
Instead of looking back longingly at what did work and saying it has got to come back, investors should focus on what are going to be the new growth stories.
Sectors like health care?
It is going to be very, very mundane and boring stuff compared to what we have seen in recent years. A credit bubble makes a lot of things look sexy. So we are going to go through a period of mundane investing -- staples, health care, developed markets over emerging markets, high-quality bonds instead of low-quality and emerging-market bonds. And the dollar will appreciate relative to a lot of other currencies.
Thanks, Rich.
After the Bubble, How Capitalism Will Survive
Monday September 29, 3:09 pm ET
By Lawrence C. Strauss
RICHARD BERNSTEIN, CHIEF INVESTMENT STRATEGIST at Merrill Lynch, is no stranger to the bear camp. A longtime bull in the mid-1990s, he switched his outlook in 1998 -- too early, initially, but eventually right on the mark. In the 2000s, he has remained bearish, concerned about the effects of low interest rates during much of this decade. Bernstein, 49, who has been with Merrill for nearly 20 years, admits that he missed the boat in 2003, when the Standard & Poor's 500 gained 28.6%. He remains cautious on equities, favoring bonds, especially Treasuries, and cash.
For a look at what all of the recent tumult in the financial markets means to investors, Barron's caught up with Bernstein at Merrill's New York headquarters. Merrill itself is in the middle of the action, of course, having just agreed to be acquired by Bank of America.
Barron's: What are your thoughts on all of the recent upheaval, including the U.S. Treasury Department's attempt to buy illiquid securities from financial institutions, and its impact on the market?
Bernstein: There is an awful lot of turmoil, but it's not the end of capitalism as we know it. This is the natural downside to the credit bubble. For a long time, people would not admit there was a bubble. Then they thought the bubble was healthy.
This is the natural downfall we saw with technology stocks, and what we are seeing in financial stocks is the same thing.
You've been bearish for some time. Was that based in part on the excesses you saw in the credit markets?
It is a little bit more than that. People forget that we were raging bulls back in the '90s, when people really weren't so bullish. I can remember Alan Greenspan's "irrational exuberance" speech was in December of '96, and it really wasn't related to technology stocks; it was related to other stocks in the economy. But we became increasingly cautious as monetary policy got looser and looser. The idea that you could remove risk from the marketplace really made people speculate. What the credit bubble did was to expand that speculation to a broader range of asset classes. So our caution was based on the notion that there was too much money chasing too few ideas.
When you talk to clients, what are they most concerned about?
Inflation -- that's the No. 1 question, whether it is the private-client side of the business or global markets or the media. Everybody is asking about inflation. Everybody is sure that we are printing money, that the United States has quickly become an Argentina, that the dollar is going down and that inflation is going up.
And your view?
I just don't think that's the right approach. That scenario could happen. If the economy quickly turns, yes, we have a big problem on our hands. But if the economy continues to slow and credit creation continues to contract, it's going to be very hard to get sustained inflation.
I think prices are going to respond to the slower global economy. I believe the global economy will be weaker than people think. You always have to make a bet, stronger or weaker. I've been arguing that you should err on the weaker side. If that's true, then demand for commodities, demand for everything, goes down and some inflation subsides.
More than anything else, remember that inflation is a lagging indicator and credit is a leading indicator. There's not a lot of credit being issued these days.
You wrote in a recent note that the government was taking "a very Japanese approach to solving [the] credit crisis."
In Japan, they kept trying to maintain the status quo, and they kept the excess-lending capacity in the system alive. So their credit crisis dragged on for years.
The critical component to ending a credit crisis is quickly getting rid of excess capacity. In most cycles, the boom and the bust is in the industrial sector. We build too many factories. We end up with too much inventory, and then profitability comes down, and what happens? You start closing all the factories, removing excess capacity and inventory.
It is in the financial sector this time where we have tremendous excess capacity.
So, we think the financial sector is going through massive consolidation; the number of companies will shrink dramatically over the next several years. My attitude has been that the government should facilitate that process. My fear has been that what the government is trying to do is treat everything as a one-off situation and, therefore, trying to maintain the status quo for everybody else.
Treasury Secretary Paulson's proposal [to have the government buy illiquid assets from financial firms] may be the first step in terms of getting a government entity involved -- or at least admitting that there is a systemic problem. But the question still is, "Is the plan facilitating consolidation, or keeping the status quo?" That may come out in the details.
How attractive do equities look?
We have been -- and remain -- underweight in equities. Our benchmark allocation for equities is 60%, but we are at 50%. We are overweight in bonds, which has a weighting of 45%. We don't have a lot of cash, about 5%.
What would make you turn more bullish on equities?
We are looking for sentiment and valuation to improve, and we are looking for analysts' estimate revisions to actually capitulate.
So earnings estimates are not going down as much as you expected?
No, not at all. Relative to history, you would never know there was an economic slowdown going on in terms of analysts' revisions. That is largely because investors over all have not come to grips with the relationship between the credit crisis and the knock-on effects on the real economy: The next thing to look for is more defaults.
We are also watching jobless claims, which have been rising. Employment is very, very critical to the future of the economy.
Within the equity market, we are overweighting all kinds of defensive areas. Consumer staples and health care are the two dominant themes that we have right now from our sector-strategy group.
Why those sectors in particular?
One obvious reason is that they are defensive. No matter what goes on, we all still eat -- that kind of story. These sectors also have very stable cash flows and, surprisingly, when the dollar appreciates, they tend to do quite well.
Why is that?
Because when the dollar appreciates, it usually means the world is slowing. And if the world is slowing, you don't want to have economic sensitivity in your portfolio. For example, pharmaceutical companies have a lot of foreign exposure and people think of them as being very dollar sensitive. What people forget is another issue, notably economic sensitivity. And so the stocks that really underperform when you go into a global slowdown are foreign-exposed companies with economic sensitivity, like materials and energy -- not pharmaceuticals.
Could you talk a little more about stock valuations and your concerns there.
We have never had the combination of 5.5% inflation and about a 25 multiple on the S&P's trailing earnings. When we talk about a 25 multiple on the S&P, nobody can believe that it's actually the trailing earnings. And then people say, "Well, if that's true, it's only the financial stocks." Well, it's not. It's much more broad-based.
The market is just legitimately expensive, and we are so hesitant to use forward earnings, because analysts haven't revised their estimates downward. So to say the market is selling at 13, 14, 15 times forward earnings is a meaningless statement.
What's ahead for the economy, and how much more pain will there be?
That's a hard question to answer, but investors who are looking for a sharp V-shaped recovery are going to be quite disappointed. I don't see that happening. That's because we are going through Phase I of this process, which is the deflation of the credit bubble. Phase II is the knock-on effects on the real economy, and we're just beginning to see that.
The S&P 500 was trading at around 1200 late last week. Where do you see it going over the next year?
Surprisingly, our models still show a return of about 6% for the S&P over the next 12 months. We have about seven different models that we use to come up with that 6%. What is very interesting is that in the last two or three months, the dispersion of forecasts for these models has gotten incredibly dramatic and has been skewed downward.
So the 6% forecast is the median, not the average, which is about minus-18. We have always used the median to try to remove some of the volatility. But we've never seen that gap before between the mean and the median.
Moving to bonds, what's your view of that asset class?
Let's start with the Treasuries, which have outperformed stocks in the last 10 years.
If these were semiconductor stocks, everybody would be piling into them. It is just amazing that we have an asset class that is outperforming and everybody still hates it. The No. 1 issue right now with Treasuries is probably inflation. But you need credit creation to get inflation; printing money, which is what everybody is scared of, does not create inflation by itself, especially when the velocity of money [or the frequency it is spent] or credit creation is going down. When the global economy starts to reaccelerate, credit creation begins to pick up and, therefore, the velocity of money begins to pick up, and then central bankers are going to have their hands full. But for right now, I don't think people should worry about inflation.
So we are still very big fans of Treasuries. We are big fans of higher-quality bonds. But one of our constant themes has been that credit spreads are widening, whether it's emerging-market debt or corporates or munis. The market will continue to differentiate between really high-quality assets and lesser-quality assets.
What do you see happening to hedge funds in the wake of all this turmoil?
I expect there will be tremendous consolidation there, as well. Hedge funds are coming under tremendous pressure.
What should investors be looking at?
Instead of looking back longingly at what did work and saying it has got to come back, investors should focus on what are going to be the new growth stories.
Sectors like health care?
It is going to be very, very mundane and boring stuff compared to what we have seen in recent years. A credit bubble makes a lot of things look sexy. So we are going to go through a period of mundane investing -- staples, health care, developed markets over emerging markets, high-quality bonds instead of low-quality and emerging-market bonds. And the dollar will appreciate relative to a lot of other currencies.
Thanks, Rich.
