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Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful. For you, Morningstar, where data speaks.
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If there's one lesson that we've learned about capitalism and private enterprise, it's this. The system seeks to maximize outputs per unit of inputs, and we haven't seen that. There is no effort, apparently, to optimize.
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Hello, and welcome to the Barron Streetwise podcast. I'm Jack Howe and the voice you just heard is Brad Conger. He's the Chief Investment Officer at Hurdle Company. It manages $29 billion for institutions and wealthy families. Brad's going to talk with us about the stock market and something called the equity risk premium and whether valuations are too high and how all that AI spending factors in. That's next. We have a question from Federico. Yes, you, Federico. This episode is about you, you might say. Let me read your email. I am a listener and had two questions I would love to get your take on. First, I've been riding the AI infrastructure trade, but what if one of the big MAG7 players develops a much more efficient model that is something that uses far less compute or gets to that point through a major breakthrough? What would that mean for AI infrastructure stocks? I think that's on a lot of our minds right now. Second, you write, semis are booming, but they are also a cyclical sector. Should investors try to time the top or is it better just to stay in for the long run? Thank you very much. Would love to hear your thoughts. Well, you're going to hear them. I mean, a couple of mine, but mostly you're going to hear brats. I had some things to say on this subject. Booming spending for memory and chips a couple of weeks ago on this podcast. In a moment you'll hear Brad talk about just the possibility you raise. What are these companies that are spending all this money and who would like to earn decent returns in their money and who at some point down the road might be paying more careful attention to their costs? What if they suddenly figure out a way to build magnificent AI tools using a lot less spending? I think we could all agree that might be bad for the stock market. It fits in with what Brad will have to say about how expensive the stock market is to begin with. Okay, let me say just two quick things before we get started. One is that I'll be away for a few days and so I'm recording this ahead of time. I mention that because, let's say there's, I don't know, like an Aerial invasion of panda bears and they begin robbing the nation's biggest banks. And it destabilizes the financial system. Listeners might be thinking, I hear what you're saying about the equity risk premium, but what about the pandas? Chances are we'll get to the pandas next week if that happens. And the second thing is about the equity risk premium. That is a highfalutin piece of Wall street fanciness and I specialize in those. I speak the language of the Wall street jungle and I can translate it for the rest of society. I'm kind of like Tarzan, only not as good a shape and I'm kind of afraid of heights other than that, just like Tarzan. The equity risk premium is a cornerstone of modern finance. It answers the question how much return over and above what I can get on a risk free investment am I demanding to be compensated for dealing with the chaos of the stock market? It's often one of those things that is fancier than it is useful for everyday investors. I'm going to walk you through it, so if you hear it come up, you'll know what it means. And also, I guess, what it doesn't mean. Start with Goonies. And yes, I do mean the 1985 Steven Spielberg adventure. If I have mentioned it before, I'm not even sorry. To tell you the truth, there's a scene early on in which Mikey from his porch opens the front gate for Chunk. Chunk is a terrible nickname for a kid, but this was the mid-1980s, it was not an especially sensitive era. And by the way, as Chunk grew up in real life, he slimmed down and became a highly successful entertainment lawyer. Good for him. I mentioned Chunk only to say that in this scene in the film where Mikey opens the gate for Chunk, he uses a device that employs, in this order, a bowling ball, a bucket, a balloon, a chicken, a football and a sprinkler. This of course, is an example of what's called a Rube Goldberg machine. It's an overly complex mechanism that performs a simple task. And to me, the equity risk premium is a lot like that Goonies gate opener, only maybe not as reliable. To calculate it, you, you start with the expected return of the stock market and you subtract a risk free rate. Let's say you expect the stock market to return 10% a year. So 10% expected return for the market minus the 4% risk free rate, that gives you a 6% equity risk premium. That's how much investors are demanding to stay in stocks. There's just one problem with that you cannot bake a certainty pie if your ingredients include, I don't know, berries. And in this case, we can't truly know the equity risk premium unless we know what the market will return. And if we knew that, we wouldn't be fiddling with theoreticals about whether we're being compensated enough. You see what I'm saying? It's kind of an overly mathy treatment of the subject that can give a false sense of confidence. So I think investors should view the equity risk premium, let's just call it the erp, shall we? Investors should view the ERP as just a loose framework for judging the relative appeal of stocks versus safe bonds. The idea is that the more you can make in safe bonds, the less attractive the stock market is by comparison. Okay? So if you ever want to use the ERP for yourself, you're going to have to do the best job you can for expected returns. And I can give you a few options. One is to use historical average returns. I don't think that's a very good idea because it doesn't say anything about whether stocks are likely to do better or worse than average from here based on how expensive they are. Now, I've seen ERPs that are based on surveys of expected returns. I don't recommend you survey your friends. They'll think you're weird. The Federal Reserve uses its own method, and I think it's maybe the best of these. It benefits from clarity and consistency. Twice a year the Federal Reserve publishes the Financial Stability Report, sizes up risks to the financial system. It comes out each May and November, and this being May, we have a fresh one to calculate it the Fed way. And this might be hard to picture, so if it is, just let the words wash over you. I'll come to you with an end result in just a moment. You basically start with the earnings yield of the stock market. That's a year's worth of projected earnings divided by the market's price. If you're fractionally inclined right now you might be thinking, wait a second, earnings over price. Didn't you just take the price to earnings ratio and flip it upside down? Why, yes, I did. But don't forget to express it as a percentage. I did that for the s and P500 recently and I got 4.7% for the earnings yield. From that, we're just going to subtract the real 10 year treasury yield. By real, I don't mean the one that's not fake. Real on Wall street means after inflation. There's a special kind of treasury called tips, which is adjusted for inflation, which will give you that figure. And the 10 year one recently yielded about 2%. So if you take our 4.7% earnings yield and you subtract that 2%, you get 2.7% and that's your equity risk premium. That's how much extra you're getting for staying in stocks. And that number has historically been a heck of a lot higher. The Fed notes in its latest report that the ERP has, quote, moved up a touch, but remains, quote, near a 20 year low. And the only reason it's moved up a touch is because the earnings have been so stupendous and that's linked directly to AI spending. There's been so much money spent on chips and such that we've got a blowout forecast for earnings for this year. Think of the ERP as something that works kind of opposite to saying the stock market is expensive. If you hear the ERP mentioned in investing conversations, you kind of have to think upside down from how you think about P E ratios. A low P E ratio means this thing is cheap. Maybe it's attractive. A low ERP means investors aren't being rewarded a lot right now for staying in stocks. Maybe that's a risk. Maybe it's time to reduce your stock exposure. Again, I'd be highly disinclined to make changes to your long term investment strategy based on a mathy theoretical model. You're asking why didn't you just say the stock market looks a little bit expensive instead of walking us through the Goonies and the Equity Risk Premium? Well, the Goonies part was totally unnecessary. I did that for the love of the podcasting game. The Equity Risk Premium explainer was because it's going to come up in the conversation with Brad, and also because I like my listeners to be able to lord these things over their friends in conversation. Next time everyone's trying to sound smart about stocks, just tell them the returns have been great, but you're worried that the 20 year low on the Equity Risk premium could signal complacency. Then climb onto your high investing horse and admire the view. If any of them responds with something about the capital asset pricing model, you're in too deep. Fake a sneezing attack and get out of there. I see no reason that investors should flee stocks, but I have been a little bit worried about what I've called Buy the dip Itis. I think I've used that phrase in this podcast probably more times than I've mentioned Goonies, although it might Be close by. The dip itis is the notion that investors just don't seem that concerned about events that come up that could affect inflation, interest rates, corporate profits, the economy, you name it. And maybe investors are right to feel that way. We have this war in Iran that has blocked the flow of oil. It's raised the price of oil and of gasoline. We're seeing that when we fill our cars. But the US Economy has become more energy efficient over the years. The US Is also a big producer of oil. And when you put those together, what it means is that the profit increase that we're seeing for companies that are in the energy business that outweighs the economic impact of the pain being felt by consumers. I'm not saying it's more important. It's not. I'm just saying it gets a higher weighting in the numbers. And what really gets a high weighting now, as we've said, is all this spending on artificial intelligence that's covering up all kinds of weak spots for the economy. So we never really saw a profound market drop in relation to the Iran war. Lately, I feel like it's been that way in response to a lot of different events, from COVID to tariffs. And I saw an investment report from Brad Conger. He's the chief investment officer at Hurdle and Company. The report is titled the Dog that Didn't Bark. And in it, Brad argues that these repeated shocks have conditioned investors to treat bad news as temporary. And that complacency, according to Brad, is showing up in the equity risk premium, which is much lower than it has been on average. And he calls that a potential warning sign for future stock returns. I'm having trouble deciding whether I'm gloomy or upbeat about the stock market, so I reached out to Brad to hear more about his view. Let's get to part of that conversation now.
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It's a little bit of a thought experiment because we've, you know, we've now had, like I said, four episodes where bad news arrived and it didn't cause any damage to portfolios. So the natural question if you're an investor is why do I even worry about those events? And it seems like people are almost buying them before they happen, knowing that they're going to happen. In other words, like, okay, Covid was the first one, then the Ukraine war, then the Silicon Valley, almost bank run, which people forget that there was a weekend there where we lost two top 20 banks. And there was a real worry that on Monday, following those insolvencies, it would spread. And in the Event. There was sort of a bailout or an extension of the deposit guarantee. And then Liberation day. And then more recently, the tariffs.
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Liberation Day. The start of the tariffs.
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The tariffs, yeah. Now you could say, look, these were all events that actually eventuated to the positive, meaning, you know, there's always a risk of a bad outcome. And we. We got sort of a concern about a bad outcome. And then it broke. Broke to the positive. In other words, Covid looked pretty dark, but then there was $6 trillion of stimulus.
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I mean, it didn't look pretty dark like they shut down Disney World. The NBA wasn't having games, people got sent home from work, people were hoarding toilet paper and so forth. It looked like the zombie apocalypse for a while there. And then in hindsight, we look and we say, oh, well, maybe we overreacted in some parts or so for. Or we got it together eventually. But yet it looked pretty grim for a while there.
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My thought experiment is it's rather rational for investors to actually price out the equity risk premium because it seems like bad things happen and then the consequences are pretty mild or very transient. I actually believe that what we're seeing is more about incredible euphoria or optimism than it is extinction of the risk premium.
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I've been calling it buy the dip itis like, it feels like investors have buy the dip itis no matter what the problem is, they have learned from recent experience that the market always bounces. Not just that the market always comes back eventually, but the market always bounces right back ferociously. And you should buy the dip immediately. If there's a crisis today, you should buy the dip yesterday. That's the way investors seem to be behaving.
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It's sort of like the boy who cried wolf. Like, when the wolf really does show up and the boy cries and the villagers are, you know, accustomed to the. The lie, they don't come and you really get eaten alive. So you know that that is the downside of the buy. The buy the dip itis.
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I think let me push back on this idea for the benefit of, you know, people out there who are skeptical or what. I'm going to try to anticipate what they might be saying. They might be saying, well, Brad, yeah, there are problems. Like, you know, right now there might be concerns, but the AI revolution is a reason why you want to be involved in this market. No matter what the other issues are, no matter what the price, you have to be in this market. The. How about that?
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Yeah, that's certainly one objection now to that. I would say that was also true in 99, 2000. By the way, the last time we saw the ERP, the equity risk premium actually go to zero because the equity earnings yield was about 3 and bond real bond yields were about 3. Meaning you know, the 10 year treasury was 6 in 2000 and, and inflation was about 3. So we actually had an ERP of 3.
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The equity risk premium refers to the return that investors expect above and beyond what a risk free return is paying. So maybe you take like the 10 year treasury yield. It's the amount over that that they expect to get from their stocks. And, and you can figure that out based on how stocks are priced, I guess. I mean, is that like roughly how do you go about doing that? What do you look at?
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That's exactly right. So there is a very simple definition which the Federal Reserve uses for the financial stability report, which is the equity earnings yield, which is the inverse of the P. So if today's 20, 20 over 1, 1 over 20 is 5%, the earnings yield is 5% and the real 10 year bond yield today is say 2 something, right? 220 and then you get $520,000 less $220,000 and you get a 3.
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You're saying basically investors are, they're not getting much return over what they could be getting if they just bought safe bonds, 10 year treasuries, what have you. Is that what you're seeing now?
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That's right. To your argument, which is the, you know, the AI. How do I participate in the AI without being in the equity market? Is that it's the growth rate, right. So I would assume a growth rate of earnings in line with nominal GDP over long, long periods of time. It's really impossible for the constituents of the S and P to outgrow the U.S. economy. Now right now earnings are up 20% this quarter, year over year, right. They're forecast to be up 18% for the full year, 26 year over year.
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This is earnings. I forget the difference between Nirvana and Valhalla, but this is one of them. For earnings. This is earnings paradise. It could hardly be better.
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Exactly. And listen, the parallel is the Internet was also a fundamental productivity generating technology, compressing time and distance, improving access to information. We also got an equity risk premium of zero. I guess the bottom line is people can be so excited about growth that they make bad assumptions. The question is always, is this time different? And I think a lot of your, you know, your listeners would say, yeah, this time is different. This is a, you know, a paradigm Shift that we've never seen before. The singularity. Right.
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If it, if it's, if this is going to go wrong, how does it go wrong? What does that look like? Like an episode like this. If this is excess and if investors have got it wrong, the market is too expensive and they're being too complacent and things are about to go kablooey, what is, what does that kablooey look like? I've been told I say the word kablooey too much. I. But it has been at least, I feel like it's been at least eight or ten episodes since I've used a kablooi. So I feel entitled to a few on this one. Go ahead.
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Here's what could go wrong. In my opinion. What we've seen today is all about maximizing inputs. In other words, every generation of frontier model costs 10 times the one before. If ChatGPT costs 10 million, GPT4 will cost a billion. If there's one lesson that we've learned about capitalism and private enterprise, it's this. The system seeks to maximize outputs per unit of inputs and we haven't seen that. There is no effort apparently to optimize.
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I guess according to what you're saying, we, we don't need as much infrastructure spending or we don't need spending. We don't need to be growing it at this pace.
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Certainly, yeah, maybe 720 billion of CapEx in this year, a trillion next year, maybe it's too much and maybe some of that get stranded and that's ugly. And you know, the parallel to the Internet or the.com era is we laid a lot of fiber that was never used or it wasn't activated for a long time. And that's what really kills an economy is when you've malinvested a trillion dollars and somebody, somebody here being the debt holders, have to eat it.
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Thank you, Brad. I gotta tell you, malinvesting a trillion dollars sounds like a bad thing. And people eating it. The eating of the malinvested trillion, that sounds worse. What I want to know is what we as investors do about it. We're going to hear about that next after this quick break. Data is everywhere. But is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks. Foreign. This is a little part of the podcast I like to call welcome Backsies. Trademark pending. We're hearing from Brad Conger. He's the chief investment officer at Hurdle and Company hurdle. And company is one of the oldest and most prominent of what some people call an outsourced chief Investment office or ocio. I'm pretty sure that makes Brad the CIO of an ocio. He's been talking with us about some of his concerns about the stock market. I want to know what we should do about it. Let's get back to that conversation. But Brad, what do I do about this? Suppose I find your argument on this persuasive and. Or the concerns that you're raising persuasive. And now I'm worried because. And by the way, I've had a nice juicy run up in my stock portfolio. So like, you know, back when, when times weren't as good, I used to check it every six months. But lately I, I check it three times a day because the numbers I see make me happy.
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They're always changing. You just got richer.
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But what do I do? Because I want to do something to protect my gains, but I also don't want to miss out if the market keeps running up. So what should I do here as an investor that's different from what I have been doing?
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So there's two things you can do. One is you can dampen the volatility of portfolio. So if you have an allocation to semiconductors or managers that are overwhelmingly in the hottest sector, you can curtail that a little bit. I think that's a reasonable. And by the way, what do you do with that money rather than go to cash, you buy the S and P. And the sense is, listen, if this is the singularity and this is an incredible productivity improvement, well, a lot of companies that are currently sort of not in vogue will actually see margin uplift. Because you know what's going to happen? Insurance companies are going to start processing claims with a fraction of the people at a fraction of the cost, and their margins are going to go through the roof. So edge towards the door. If the party is, if the punch ball is about to get removed, sort of, you know, get closer to the door. And one way you could do that is reducing the highest volatility in your portfolio.
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I had a friend who came to me and he said, I got this, you know, in my portfolio. It's doing really well. But I got this one thing in there that's just killing me right now. Can you take a look? And I looked. He had exactly two things. An S&P 500 fund and just a plain vanilla bond, one fund. I said, well, yeah, it's not killing you, but like, yeah, it's not doing as well as your S&P 500 fund. But I think there are a lot of people out there like that now where they've got a 60, 40 or a 70, 30 or whatever, whatever it is. And they're just, they're running with the S P500 because it's worked so well for so long. What about that kind of investor? Are they too tech heavy? Should they be doing anything? Is, are they missing crucial exposures or anything? They should be doing differently right now.
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I would never tell somebody to get out. I would say that if you were a 60, 42 years ago and you're now 75, 25, why don't you rebalance back to your 60, 40, meaning sell some S and P spy and buy some bonds. What we've done in portfolios is we've skewed a little bit towards Europe. And you know, Europe is sort of like the redheaded stepchild of global markets. It never ever works. Actually, it worked last year. But I think that owning Europe is a way to participate in the singularity without being overexposed. We own a lot of what we think of as real assets, sort of the high asset, low obsolescence category, which is REITs, real estate investment trusts in the U.S. you know, hated asset class. You know, offices is really a horrible category for a long time, but they're washed out. You know, the, the cap rates are now reasonable, like 6%, and that's before any growth. So REITs, we like home builders, again, you know, hated sector. But they're hard assets. They're not going to get disintermediated by AI.
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Anything else that I've neglected to ask you on this subject that you think is important for investors to know right now, or is there anything out there right now that you think investors are getting really wrong and that they need to be, that they need to know about?
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I think there's just an amazing
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level
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of confidence that the winners of AI today will be the winners tomorrow. And I think the lesson of, you know, 99, 2000 is that a company like Juniper Networks, which was the leader in enterprise servers, or Cisco, which was the, you know, the leading maker of network servers, could actually do well. But the second derivative of the change goes from growing at 100% a year to 70 to 50, to 40, to 10. The idea that companies actually can't grow 10 years in a row at 100%, which is what's required if you're paying, you know, 150 times sales for something that's, you know, that's sort of what you're banking on for some reason.
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I'm thinking back at, I mean, we've just seen some crazy things in the past, let's say decade, what the heck were those things even called? NFTs. Remember those things like that, you know, people, at one point people were buying like, I don't know, holographic worms or something like that on the Internet.
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We've got some in our PE portfolio. So if you want some pudgy penguins or some bored apes, we've got some for you.
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So I'm just wondering if we're better than we were at that moment, right?
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I honestly, I don't think it's crypto, I don't think it's NFTs. I actually remember there was a mania over cannabis like eight years ago and everything that was involved in distribution of cannabis or growing sort of went 10x in a period of 6 months. I think this is a real innovation, right? And I think it's going to be with us for a long time, much longer and have more applicability to the world. I just think that it's still worth taking a breath and realizing that, that the future is more uncertain than you can imagine.
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Better than the apes and cannabis. But you got to be careful about the prices. I appreciate, Brad, you taking the time to share your view with us.
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Good to chat. Thanks a lot.
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Take care. Thank you, Brad. And thanks to all of you for listening. And I want to thank Chunk and Tarzan, pudgy penguins, everyone who pitched in. And I especially want to thank Federico for your question. I hope we answered it head on or at least dinged it on the way by. If you have a question that you'd like played and answered on the podcast, you can send it in. It could be in a future episode. Just use the voice memo app on your phone, send it to Jack. How that's h o u g h@barrons.com you can subscribe to the podcast on Apple. Podcast, podcasts, Spotify, wherever you listen. If you listen on Apple, you can write us a review. Thanks and see you next week. Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.