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Excess Returns
The Opportunity No One Sees | Richard Bernstein on Finding Value in a Narrow Market
01:02:24
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- [00:01]
A
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B
Hablas Espanol Spriest du dzoitsch.
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A
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B
If you're buying an S and P index fund right now and you have a time horizon more than you know the next commercial break. Let's assume you're, you know, you, you're really investing for, you know, 1, 3, 5, 10 years. I think you can be very disappointed. For the first time in a long time, we are actually importing inflation, meaning that import prices are rising faster. The core import prices. So let's take out energy and food. Core import prices are rising faster than the core cpi. So that means we're now importing inflation. If you can't afford to buy gasoline, you can't afford to buy bread, you can't afford to buy groceries. You don't care about growth in 15 or 20 years. You care about being able to buy groceries and gasoline today. I think there's a bunch of stuff out there that is just like screaming for investors to look at them. And investors just don't care.
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C
You're watching Excess Returns, the channel that makes complex investing ideas simple enough to actually use, where better questions lead to better decisions. I'm Matt Ziegler. Justin Carbono is here with me as co host, we've got the global head of macro and custom strategies at Janice Henderson Investors, Richard Bernstein. Welcome back to Excess Returns.
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B
Thank you. Thanks guys. Thanks for having me.
- [02:17]
C
So you wrote a really happy note. Quick thoughts on war Early March. You made the point that war rarely, if ever is disinflationary, which it's obvious, you know, you're shooting at stuff, you're blowing stuff up. It tends to, tends to cause prices to go up with them. But now, two months into this Iran conflict, has the market played out with inflation expecting expectations, as expected?
- [02:41]
B
So yes and no. I mean, it's, it's kind of interesting. I think that, you know, overall, I think one would have to say inflation expectations are up. Right. And from a consumer point of view, that's simply the price of gasoline. And we know, we know the price of gasoline is up and up pretty dramatically. And that drives a lot of consumer expectations. It drives consumer confidence. You know, it's kind of a very powerful variable, probably because the signs are up every day and we drive by them and we fill up our car and you're hitting. It's like in your face as opposed to going to the supermarket where it's getting harder and harder to find prices on goods. But be that as a may, I think that, yes, I think that that hasn't affected that. And I think we're starting at, see, we're starting to see it go through into import prices. Import prices are now, are now up. And import prices, when you have a big trade deficit, tend to work their way into the cpi because we just don't make stuff. And for the first time in a long time, we are actually importing inflation, meaning that import prices are rising faster. The core import prices. So let's take out energy and food. Core import prices are rising faster than the core cpi. So that means we're now importing inflation. We did that during the pandemic and after the pandemic with all the supply chain disruptions, and we seem to be doing it again now. So. So I think, you know, look, is it hitting headline cpi? We could argue that. Yes or no. But. But is it hitting the economy? I think it's starting to. Yeah.
- [04:18]
C
Compare this in contrast, because I really love this point. You compared the 70s inflation shock to 60s guns and butter. So maybe define both of those things. Sure. Spoiler alert. Some people might not be old enough or have read the history books for Guns and Butter, but everybody's heard about the 70s oil shock. So walks through this.
- [04:37]
B
So. So let's start with the 70s and work our way backwards in time. I'll age myself. We'll do Mr. Peabody's Wayback Machine if I don't know how.
- [04:46]
C
Well, thank you for Rocky and Bullwinkle.
- [04:49]
B
Thank you. Yeah, yeah, exactly. So, but anyhow, the 1970s. So in the 1970s, you had two oil shocks and you had immense demand destruction. Completely changed, you know, the way people acted and everything else. And that was largely because gasoline as a percent of wages went up very, very dramatically. And so people had to make choices. And the oil shock worked very much like the Fed tightening interest rates. It slowed down the economy pretty dramatically. Our contention is it's not going to be as dramatic this time because oil prices, a percent of wages is still very, very low. And I think it's gone up, of course, with the war, but it's still very, very low. So that doesn't mean that we can't see a recession from curtailed supply of goods. That's already happening. And you know, you're seeing on the, you know, certain transportation sectors are starting to have problems and certain countries are having problems where the reserves aren't adequate enough for emergencies and things like that. But to say the US consumer is going to fall over and play dead, I think is very, very overdramatic, very hyperbolic. Because gasoline is percent of wages. Now, that doesn't mean it won't annoy them. And you're seeing gasoline's effect in consumer confidence. That's of course going to happen. But the question is, is it changing their behavior? I'm not sure it is quite yet. So we don't think this is quite the 1970s. Rather, it looks to us much more like the 1960s and the 1960s were a period. This second half of the 1960s were called the Guns and Butter period. What does that mean? So it was a period where it was widely thought that we could have a major buildup in defense spending, obviously related to the Vietnam War and the buildup to the Vietnam War. At the same time, we could have massive social programs, Lyndon Johnson's Great Society, that we could have both spending on guns, spending on butter. The social side of this, you could spend on guns and butter. It would do nothing to the budget deficit and it would do nothing to inflation and inflation expectations. At the same time, you also had an accommodative Fed. So in retrospect, hindsight's always 20 20, I understand, but in retrospect, we know that that was the beginning of the inflationary spiral and what really began to fuel inflation was that kind of miscalculation that this would have no, no impact. Well, today we're not getting the exact same thing. I'm not trying to, you know, but, but we're definitely getting a buildup on the gun side. The guns is definitely Happening, you know, the, the Defense Department last week, I think it was maybe the week before, put in for a one and a half trillion dollar budget for defense spending. The first trillion dollar plus budget for the defense spending in the history of the United States, excuse me, up about 42% over what was actually spent or what is being spent right now or so. So a huge buildup in, in defense that is there. So I think the gun side is, is very, very similar. The butter side's a little bit different, you know, perhaps. And again, I'm not arguing whether these are right or wrong policies. That is not, that is not my day job. I am not here to opine on politics. I'm just telling you this is kind of what's going on here, guys. And so what you've got is you've got a lot of social programs that were actually kind of invented, if you will, or initiated during the Great Society period of the 1960s are actually being cut back or eliminated now, which is, which is kind of interesting historical context as well. But we are getting the one big beautiful bill, that tax cut. Now, the president, occasionally prone to hyperbolic speech. The President has said that this is the biggest tax cut in history. Not quite sure that's true. By our reckoning, it's number six. Still massive, by the way, and still fits the story. So the butter side of this is more in terms of tax cuts and the effect that that will have on aggregate demand as opposed to spending. And there is still a lot of spending going on, but not as much, but we are getting this big tax cut. So the butter side is, is constructed a little bit different. But nonetheless, the consensus is that this should have no. Well, the consensus in Washington is that this should have no effect on inflation, no effect on the budget deficit. And by the way, we might actually get an accommodated Fed, much like we had the 1960s as well. So we think there's more similarities to the 1960s than there are necessarily to the 1970s.
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C
So what does that do to the trajectory of these things? So not just what the consensus expectations are, how do you interpret the. Both on the inflation side and the deficit side context?
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B
So I think, you know, Matt, you know, I, throughout my career, my colleagues here at RBA now, Janice Henderson, but at all of us, we kind of don't try to pinpoint forecast. People say, well, is inflation going to be 4.2%? I don't have a clue. Rather what we do is we approach it as an over under and we say, okay, here's consensus. Are we going to be higher than consensus or lower than consensus. And I think as an investor, that's actually important thing. It's not so much what your pinpoint forecast is, but is your pinpoint forecast higher or lower than what everybody else thinks? That's really more important. And so, given my previous comments, you can guess, and I'm going to say we're taking the over. We think the budget deficit will probably be likely be bigger than people think over the next several years. We think that inflation will likely be higher over the next several years. Now, let me define that a little bit, because people say, oh, inflation's going to be higher. You know, is inflation going to be 8%, 9%? You know how things are these days. Everybody kind of goes off the deep end pretty fast. And the way I describe to people is, look, the Fed is still using a 2% inflation target. That's probably pretty antiquated. And that maybe if they were to modernize that target, they'd be talking about three to three and a half. If you want to get excited, say maybe four. But if you still think that the proper inflation target is 2, it says to us the Fed's going to have an awful lot of inflation fighting to do to get to that 2%. And I don't think, especially with the new Fed chair, I don't think they have the gumption for that kind of battle. I don't think they want to do that politically. I don't think they want to do it economically. So I think we should be talking about a 3 to 3 and a half or 3 to 4% inflation target rather than the 2% that they're using right now.
- [11:50]
C
You say it's antiquated. And I think I'm hearing that statement a lot lately. And I'm also channeling it to the conversation of this rule's only kind of been there since 2012. It's barely a teenager in age that to me says there is precedent for the Fed updating this and they could go there. What do you think the likelihood is? How would you think about it?
- [12:15]
B
I think politically they will not do it. I think they're going to stick to that 2% flip. I've said this for a long time, by the way. This is nothing new. They will stick to that 2% inflation target much longer than is appropriate, because by the time they change the target, it will be widely accepted. Not just kind of a weird saying like outcast people, but I think it'll be widely accepted that 2% is the wrong number. And then they'll give in. Because I think politically, whether Democrats, Republicans, whatever, I don't think any administration wants to stomach changing that inflation target.
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C
All right, I'm taking us back to wars for a second. You had pointed out in the piece as well that rather than having one giant war, we could have lots of smaller conflicts, right? Same.
- [13:04]
B
I think. I, I think that's kind of what's happening. I, I hope that's. Look, I, I hope that when we talk war, we're talking about that. I hope we don't see like World War III or something. But I think, you know, part of deglobalization and part of what we've talked about in the past, the three of us have talked about in the past, is our overriding thing of deglobalization. And with deglobalization comes more skirmishes and wars and things like that. And I think that's happening, you know, whether you look at Ukraine. Ukraine, Russia, if you look at what's going on now in Iran, if you look at what's going on in Lebanon, you look at what's going on in Gaza, you look what's going on in Latin America, you look at what's going on in Africa. These are smaller skirmishes that are happening in a lot of different places. I'm hopeful that that's what continues and it doesn't break out into something bigger. I'm not a good enough geopolitical expert to tell you whether that's going to happen or not, but I think there's this kind of notion out there that because these are smaller, we won't see a big defense buildup. And so far the numbers are telling you that's just, just not true. I mean, we already know, and, and this is nothing original to me that, that, you know, the, the stock of arms in the United States is being depleted much more rapidly than people thought, and we don't really have the infrastructure to reproduce that in any great time. So that, that, you know, even the notion of skirmishes, I think, is going to, is going to lend to more defense spending than people think.
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C
And it certainly feels like that would be the case on the most global of stages here. Right. Because now it's defense spending all over the world.
- [14:39]
B
Oh, yeah, absolutely. Absolutely. I think, I think defense spending is one of the biggest, you know, not just the United States, but in Europe, certainly, and in Asia, it's happening. In Africa, it's happening. I think defense spending is one of the primary symptoms, I would argue, of this deglobalization. Right when everybody's kind of singing Kumbaya and holding hands together, they're not fighting around the world and I don't think where any of us are singing Kubaya
- [15:05]
C
anymore, how do we think about then inflation sort of at the global level, knowing there's that push. So not just in the U.S. how do we think about it around the whole world?
- [15:14]
B
So that's actually, Matt, that is a very, very tough question to answer secularly. I mean, in the near term everybody's going to feel more inflation simply because the supply chain disruptions that we all know about resulting from the war and the other things, longer term it's very difficult because I think again, not, not being political here and not saying this is right or wrong in any way, but I think if the United States turns out to be more isolationist than people expect and the rest of the world doesn't, so the rest of the world sings Kumbaya and we're by ourselves. The more you would think that's going to happen, the more you would think inflation would be stronger here, higher here, and not necessarily as high outside the United States because they will continue trading. Now if you think this whole thing breaks down, then it's a global phenomenon and you just bet higher around the world. But I think for a multi year timeframe, that's a little bit difficult right now because I think the geopolitics are, I don't know how anybody could forecast it right now, to be honest with you. I don't know.
- [16:22]
D
Let's pivot this to like asset classes and markets a little bit. So one of the things that you wrote about is in the 60s, guns and butter period, you know, cash was a very good performing asset class. How do you think of cash in today's environment? And is that like a viable, you know, option for someone? I guess.
- [16:44]
B
Yeah. Yeah. So, so Justin, it's like, it's, it's like heresy to talk about cash, right? I mean like we're, we're always supposed to say you shouldn't hold cash. But what actually worked pretty well in the, in this period of the 60s, the guns and butter period was cash. Cash actually did quite well. And. Excuse me, what the general theme though is shorter duration assets, shorter duration equities, shorter duration fixed income. Obviously cash being the ultimate short duration fixed income. And the reason why is when you get more inflation than people expect or people are forecasting, what ends up happening is cash flow needs today start overwhelming long term growth. Right? So if you think about the, the perfect example, I can give you today of how that's happening is if, if you look at college endowments and colleges and universities and their operating budgets right now, what's happening is their costs, our near term costs are going up very rapidly right now. Cost of energy is going up, cost of labor is going up, cost of healthcare is going up. And they can't just pass it along. You can't just raise tuition willy nilly to go along with that. So their near term costs are going up and they need to finance those near term costs. And so a larger proportion of their budgets are coming out of their endowments. The problem is they've all invested in illiquid longer duration alternatives. And so they have an asset liability match right now. So their assets are all longer duration tied up. They can't, they can't call them right away and their liability stream has gotten very short and very fast. Right. And, and so they've got this asset liability mismatch. So cash or dividends or short duration fixed income is not so bad because you're starting to throw off a lot of cash now that you need to meet your obligations. Right. And I think it's something that when everybody talks about the endowment model and the alternative space and things like that, nobody ever thought of this because they didn't think there would ever be inflation. But as I'm sure you all know, certain colleges and universities are either merging or going out of business now because of their operating difficulties in what's going on. So, so I think that's short. It's I, I say cash to get everybody's attention. But realistically think about shorter duration investments and shortening the duration of both your equity and your fixed income portfolios.
- [19:23]
D
I have a junior in high school who's starting to look at colleges and universities. So now I'm really worried about this tuition. The other, another piece that you kind of wrote and you were kind of highlighting the NASDAQ's trailing returns, this is a piece back in January that you kind of pointed out that historically it was in the top, I think, quartile of returns on a trailing three year basis. And it kind of was along the same level of what happened in the tech bubble. But what you also kind of were pointing out here is that usually after those types of periods where something like the NASDAQ has seen such strong returns, you know, oftentimes there's like this broadening out that can happen in the market. So just talk to that a little bit.
- [20:09]
B
Yeah, I think we're, we're kind of in A very similar environment, at least financially relative to that, to that tech bubble of the, of the early 2000s and you know, narrow leadership, kind of uniform idea about what growth is all about and everything else. And of course back then it was, it was the Internet. Today it's AI. And so first, let me preface this for one second by saying I think people have a very tough time differentiating between an economic story and investment story. The economic story. Will AI change the economy? Of course it will. Of course it will. Why, why would any. And it may change the economy in ways we could never imagine right now. Right? I, I'm pretty sure that's going to happen. But we're not here for economic stories, we're here for investment stories. And you know, investing is your, your longer term return on investment is generally predicated by the scarcity of capital. Are you the only person, you know, kind of providing capital? I used to joke all the time about being the one banker in a town with a thousand borrowers. Oh, fantastic. You know, you're going to set the interest rate on every single loan. And, and longer term themes are, are really a function of that, the scarcity of capital. Well, I think it's very hard to argue that anything related to AI right now is stars for capital. Right? They're all being inundated with capital. I mean, if the three of us got together, got a couple of engineers together, you know, and called ourselves like, you know, Matt, Justin and Rich AI, we could probably get funding. Right? And that's kind of silly when you think about it, you know, but we probably could. And you know, case in point, I don't want to name names, but I, I'm pretty sure a shoe company just, just saved themselves from bankruptcy by saying that they, all of a sudden they were an AI company. I mean, so I'm not that far off in saying Matt and Justin and Rich AI. You know, we're not that far off. And, and, and so that tells you that the long term rates of return are probably going to be lower than people think, despite the fact that the economic story comes to fruition. I think that that is definitely what happened after the Internet. I mean, if you bought NASDAQ at the peak of the bubble In March of 2000, you did not break even for 14 years. Right? That's unbelievable. And, and there were a couple of companies that just recently made new highs for the first time since, since 2000. 26 years later, you know, some big name companies just hit highs in the last couple of weeks. And, and so I Think we're in a very similar environment today where it's inconceivable to people that some of these big companies won't provide huge returns over the next 5, 10, 15 years. Meanwhile, what ends up happening is that because this one theme, the uniform theme, sucked in so much capital, the rest of the economy becomes capital starved. And because it becomes capital starved, that's where the investment opportunities are. And so when you see bubbles or speculative periods start to deflate, you see the rest of the economy start to do much better. And the rest of the stock market rather start to do much better because everybody's starting to realize, oh, well, like, you know, we gave too much money to this side of the economy, but look at the potential over here. And so everybody starts moving in that direction and the stocks do very well. And I think that's what we're looking at again.
- [23:40]
D
And I think that plays into the point that you made that, you know, 90% of the S&P 500 is sort of in the value and kind of quality category at this point. And just because of how concentrated the market has gotten.
- [23:55]
B
Right? Yeah, yeah. I mean, there's. There are all kinds of growth opportunities outside the AI sector. I mean, you know, it's kind of funny that, you know, you think about AI, you think about Mag7, you think about the narrowing in the market. I could understand that that narrowing of the market would make perfect economic sense if, say, the Mag 7 just to pick on them for a second. If the Mag 7 were unique, if they were the only companies growing. I get it. Sure. Let's. Let's go. But they haven't been. There's been lots of companies both in the United States and outside the United States that have been growing as fast, if not faster, and nobody cares. And so if you can get 15% growth at 15 times earnings, or you can get 15% growth at 30 times earnings as a comparative shopper, in any other market, economic market you could think of, product market, whatever, you'd be buying the 15% growth for 15 times earnings. That's not what people have been doing. They've been paying 15, 15% growth, 30 times earnings. Oh, that's not. 40 times earnings. 50 times. They don't care. And they're ignoring that. There's all these bargains out there where you can get 15% growth for, you know, half to a third of the valuation. If, if I could sell you a Maserati for the price of Volkswagen, I think you guys would, would do that. I think you'd buy that from me. But somehow in the stock market, people don't think that's important.
- [25:20]
D
It is. Do you have any sense or opinion on, do you think passive flows are to some extent contributing factor to this trend or what are your thoughts?
- [25:32]
B
I'm not sure I would say it's passive per se because just buying a passive index, you're buying everything in proportion. Right. And if there was a monster flow into passive, the more illiquid end of that passive index should actually outperform technically. I mean, it doesn't really work that way. But you just think about very simple context. The illiquid portion should outperform. I think what might be doing it though is not only people trading individual stocks, which I think at most of the major platforms their, their trading of individual stocks has gone up pretty dramatically. But the advent of, of this broad offering of ETFs that tried to take advantage of AI or technology or something like that, I think that has definitely played a role. So I don't think it's necessarily buying S and p index type ETFs that's doing it, but you know, it could be buying technology ETFs. Sure, absolutely. And they could be passive as well, by the way. Right. I mean, they don't have to be active ETFs.
- [26:41]
D
From a sector perspective, like where are you seeing, you know, opportunities where there's, you know, let's say growth at a reasonable price.
- [26:51]
B
Yeah. So I, I could be cute for a second. I will be cute for a second. And I'll say, I'll say everything except tech and consumer discretionary and communications. We think virtually everything else is fair game. No, that's, that's obviously kind of cute, but, but it's not that far off. And I think that it, it shows the breadth of opportunities across all these various sectors. Right now in our portfolios, Our portfolios are not really sector oriented right now. I mean, we are underweight tech and we are underweight consumer discretion, we are underweight communications, but we haven't picked like another sector. Rather, what we tried to do is emphasize two themes in the portfolio number one is dividends that I mentioned before. We have a huge dividend presence in our portfolios right now. And again, if you think there's going to be more inflation rather than less dividends become very important. Shorter duration equities, they become very important. And then number two, theme number two, which I realize the war has thrown a monkey wrench into this for the time being is non US Stocks. Because non US Stocks in many cases get you the dividend yield, they get you the cheaper valuation and increasingly they are showing competitive growth. So you kind of get those are the two kind of themes as opposed to saying we like energy or we like consumer staples or something like that. And that's just the way we manage money. Sometimes we're very sector oriented, sometimes we're kind of more factor or geographic located oriented rather in our portfolio. Sometimes we're size oriented. It's just where we think we're going to get the biggest bang for the buck.
- [28:35]
D
So just shake out that dividend idea a little bit more like the importance of dividends in a higher inflationary environment. Because I feel like dividend investing or focusing on stocks that are paying a dividend has kind of lost its luster in this regime that we're in. So just, I think that's worth like elaborating on a little bit.
- [28:56]
B
Right. So, so the first thing, the first thing, Justin, I, I, I just want to point out is that the compounding of dividends is one of the easiest ways to build wealth over the long term. I've never understood why people don't like to do this on a consistent basis. And here's, here's my statement that I think probably most of your, your listeners aren't aware of. 25 years now, the last 25 years, the s and P Dividend Aristocrat Index is neck and neck with nasdaq. Right. I mean that is astounding to me. The, you know, if you think about, on a risk adjusted basis, it's well ahead, just amazingly well ahead. And it shows you the power of compounding dividends. So that's number one. Number two is there are times where people gravitate towards dividends and there's times where they avoid them. And right now we're kind of in an avoiding era because it's too boring, right? If you're, if you're trading cryptocurrencies and you're trading mag7, you don't care a lick about dividends, right? That's just not in your DNA. And right now investors, that's their DNA, they don't want compounding of dividends. They want oomph, they want risk, they want their, there's no level that kind of, that kind of satisfies them. And so if you, but if you go back to the beginning of this bull market, which I would argue was 2009, 10, 11, 12, you'll find that all people wanted were dividends. The story back then was that everybody wanted large cap, high quality, dividend paying companies, that that was the core of everybody's portfolio. And didn't you understand that, that because it was a reaction to what people had seen during the global financial crisis, like, oh, my equities are too risky. I don't want risk, I want dividends. And so they lowered the beta, if you will, the market sensitivity of their portfolio. They lowered the beta of their portfolio to about 0.75. In other words, 1 being the same market sensitivity as the market overall. 0.75 is less than market sensitivity. And that's because of the dividends. Well, today that 0.75 is at 1.3. As I said, they don't care a lick about dividends. Which says to us that there's gotta be an opportunity there. Right. Fifteen years ago, we're trying to get people to accept beta. Their beta was 0.75 less than market exposure. We're saying we're at the beginning of a bull market. You gotta have more beta in your portfolio. People don't want to do that. No, we just want high quality dividend paying stocks and that's it. Now we're at the other extreme. So we have this big dividend. Okay, so why does it work in an inflationary environment? There's many ways to say this, but I'll, I'll kind of repeat what I said before. When you get more inflation than people expect, they need more cash return upfront to pay their near term expenses. Right? It's all great to talk about investing for the future, but if you can't buy gasoline, if you can't afford to buy gasoline, you can't afford to buy bread, you can't afford to buy groceries. You don't care about growth in 15 or 20 years. You care about being able to buy groceries and gasoline today. And so that near term cash flow becomes more and more important. I can assure you I won't use the word guarantee because that's a no, no word to use. I can assure you that if we get a boatload more inflation than people think, I don't know, this is not our forecast, but let's just, let's play with this for a second. A boatload more inflation than people think. I would bet you things like cryptocurrencies do really, really badly. Because cryptocurrency, you're betting on something happening out there in the future and meanwhile you can't afford to buy gasoline and bread. You, you're not going to care a lick about what's going to happen in 15 years. You're going to care what's going to happen in 15 days and everybody's mindset will change. Now that's not our baseline forecast. I'm not trying to put fear in everybody's heart, but I think it shows you the need to do that. Again. Think of what I said earlier about colleges and universities right now where their costs are going up dramatically, but yet they're all in these super long duration alts that aren't paying anything. By the way, that may mean that in the next five years or so there's a huge opportunity in the secondary alts market because they may have to all puke their alts. Right. And you may be able to buy good, good investments at, you know, 50 cents on the dollar or something. But that's, we're not there yet. I'm not saying that's going to happen but, but I think that's the way you should be thinking right now is if there is more inflation than people think, the need for near term cash will be greater than people think. Let's not put in absolutes, but it'd be more than people think.
- [33:52]
C
What do you think from the corporation standpoint, from their side of it? Because obviously investors might have some portfolio preference for dividends to receive cash, whatever else. Would we see that change also take place in the boardroom? Would we see that be communicated out?
- [34:09]
B
It's, you know, if their input costs are going up, which it's likely they would be. Yeah, they stop thinking about, you know, investing for 5, 10, 15, 20 years. And if the Fed is raising rates to combat inflation, let's assume for a second they do. Right. Let's take out the whole today discussion. Let's just say there is more inflation, the Fed is raising rates, so the risk free rate in the economy starts going up. Right now in classic business school type stuff, they tell you about a hurdle rate. And the hurdle rate is when you begin to accept projects for longer term investment. Well, if the hurdle rate is 0, let's say that everything gets passed right. Every cockamamie idea is invested in because there's no competition from the hurdle rate. Hurdle rate's 5%. You start becoming a little more circumspect than what you're investing in. The hurdle rates, 10% or 20% like it was in 1980, nothing gets done because no project can clear 20% hurdle rate. And so the economy starts shutting down and that's, you know, we're not there. And I'm not trying to say we're going there either, but, but to Answer your question, Matt, that, that, you know, as interest rates start going up, the marginal capital investment that a corporation is going to make is, becomes more circumspect.
- [35:35]
C
It is really interesting in the context that you laid out, because we know in the gfc, in that drawdown, we saw what companies were rewarded and it was the high free cash flow companies that, you know, you wanted high quality, you wanted high free cash flow, you wanted that as cheap as possible, hence that lowering of beta. And then we saw a corporate strategy shift to accommodate for that. It's interesting to think about this now at an other extreme all these years later, where that strategy could shift yet again in response to what portfolio preference is, aside from shoe companies putting AI in their names. Like this is the next step of that, I guess.
- [36:11]
B
Right, right. And the other thing that I really don't understand that investors generally don't seem to recognize is that a lot of these major companies are completely restructuring, financially restructuring. And so people are telling me they're dirt cheap, but the financial restructuring that they've gone to to make themselves very asset dependent, in some cases, negative free cash flow, now that deserves a lower valuation. But it doesn't seem like anybody's accounting for that, that everything is just going to be great for growth. Great for growth. Great for growth. I don't think we've ever seen a time in history where a sector, you know, whether it be railroads or Internet or whatever, has gone wild with investment and the return on investment has paid off in, in the near term. I don't think it's ever happened.
- [37:03]
D
Rich, where do you think we stand or where are we in terms of the profit cycle? I know, I think this week, either this weekend, next week is a very big week for earnings with, you know, some major companies reporting. And it seems like the consensus is, you know, earnings are strong, they're hanging in there,
- [37:21]
C
they're, they're good.
- [37:22]
D
And that's kind of what the market seems to be reacting to. But just where in the, like a longer term cycle do you think we are in this profit?
- [37:29]
B
No, we're, we're, it's, it's not the trough of a profit cycle. I mean, the profit cycle in the United States is kind of leveled out and it's still at a, it's kind of doing this, but it's doing this at a pretty high rate of growth. Roughly about take or leave, you know, roughly 15% earnings growth, which is, which is not so bad. And around the world what you're seeing is profit cycles are starting to slowly move towards that 15% as well. So you're absolutely right. And I've said to people a lot of times that we're not bearish. You know, I mean like if you don't like the Mag 7, automatically everybody says oh, you're so bearish. Which I don't get. I really don't understand that at all. You know, you like 493 stocks, you don't like seven and you're bear. I just don't get that. But, but so profits are actually pretty healthy. And that's part of our story about why the market should be broadening. You know, one of the major investment banks came out this morning, I believe, talking about Mid Cap and small cap profits growth actually becoming equal to the profits growth in the s and P500. It's, it's really pretty interesting to see their, their analysis and everything. So I, I would argue you're absolutely right, Justin, that the profits growth is very healthy, especially in the United States. No problem there. What's weird though is that as this reporting period has started to manifest and we've had these good numbers, the market leadership has gotten narrower. I don't get that. I don't get if everybody's telling me that earnings are so great and I believe it too. It's not like they're just telling me I believe it too. If earnings are so great, we should have a broadening market. What you're telling me, not you, what the consensus is saying is that, that more and more companies are putting up better and better growth, but yet we have to invest in the max seven. I don't get that. That makes no sense to me at all.
- [39:15]
C
What do you, what do you think about that in terms of the concentration of earnings? Because one of the counters we've heard about the, the other 493 and the catch up later this year and how they can offset this is that the
- [39:26]
B
data that I saw today was based on the median company of Mid Cap and small cap. And, and the median company is actually like growing. It's, it's actually, you can, you can see it accelerating earnings, which would mean the growth rates are going up.
- [39:41]
C
Yeah. Even if the size and the contribution is story.
- [39:44]
B
I mean look, you know people, inflation does help earnings. You know, we got to remember that the pricing power, you know, the, you know, profitability is a function of how much stuff you sell and what's your price per unit and, and, or what's your margin per unit, I should say. And you know, to some extent pricing power is A good part of that.
- [40:06]
C
What about, let's, let's talk non us a little bit again too because I think it relates, it relates to this topic and I'm back to that global inflation because global inflation probably moves GDP a little bit. So with the conflict it sort of seems, and I think, I think Ben Hunt was the first one to frame it this way. It was basically look at your net importers versus your net exporters and your net exporters, they go into one basket. And this was his argument for saying why the non US trade might be not dead, but dead for a little while at least. What do you think about that logic? How do you think about international.
- [40:42]
B
There is, there is something to that. I mean, you know, I think when I started my comments about, about non US I said I realized that the war puts a monkey wrench into, into this theme but let's ignore that for the second. Okay, so now we're not going to ignore it. I get it. And, and no, there's, there's something to that. I think not only does it make it, it can make certain countries, if this war continues, certain countries are going to have a very tough time. You're already seeing that in some of the smaller emerging economies where they don't have adequate petroleum reserves and things like that. And so the, the, the supply chain disruptions in energy are really starting to affect some of those countries quite a bit. And so yeah, and there may be, if this goes on longer, you know, the, in the, there's kind of a traditional way that you separate out say emerging markets where you start looking at energy producers versus energy consumers. Right. So, and I'm not advocating plus or minus for either of these, but I'm just going to say, you know, Brazil and Mexico are kind of energy producers, you know, Japan, not an emerging market, I get it. But Japan and you know, India are energy consumers. And, and so it may be that you want, if this goes on longer, you might want producers, not consumers, things like that. I think so far, you know, we're not, we're not an event driven firm. So far our fundamental data is holding pretty tough for the, for just emerging markets, ex China, that kind of group. And so we're still there. We solve a, an overweight to that group. But this goes on much longer. I think you're going to start seeing more difficulties and as I said in some of the more marginal emerging markets, you're seeing it already.
- [42:37]
D
Rich, I wanted to ask you, when you see companies like SpaceX, you know that coming to the market this year you have OpenAI likely probably going public. Like how do you, I mean, and correct me if I'm wrong here, you're not like, you know, doing stock picking per se in your strategies. But, but if you were to try to assess these opportunities from an investment standpoint, like what types of things would you be, I guess, looking at. So I guess I am asking at like a company level, not those companies in particular, but just in general, like how do you go about, you've been in the markets for a long time. How do you separate what is an actual great opportunity from that narrative driven, totally speculative type of investing?
- [43:26]
B
Right.
- [43:27]
D
So there's a fine line there, I think so.
- [43:29]
B
One of the things that when we started our firm many years ago, and of course, you know, we're a macro firm, so as you said, we don't, we don't trade individual stocks, but not everybody understood that. And so every now and then I would get a call from, from an I, you know, a syndicate desk, you know, with such and such an offer about. And my standard line was when you can't sell a deal, call me back, right, because it means that there's like no interest, I'm going to get a better valuation. The odds are on my return on investment are going to be higher. Of course, that was a little bit silly because if they can't do a deal, it doesn't get done because nobody wants to do a deal cheaply unless there's a distressed situation. And so I think, and there's lots of academic studies that support that, right, that show that a consistent buying of IPOs is not a very good strategy because you tend to buy at a very expensive valuation. And that tends to be, tends to be true. How do you actually go about assessing whether, is whether it's a good investment or not? Well, first I, I should point out, and I'm, I'm sure you guys know this. You know, a lot of buyers are hedge funds and a lot of the buyers are going to try and flip them. You know, although, although they say, oh, we're never going to flip, we're in for long term. Most of them end up flipping. And, and so for them it's a question of how much near term momentum is this really going to generate and how, how oversubscribed is it going to be and things like that. And they can tell, you know, pretty much from that type of information whether they have a chance to make a very near term gain, especially they're buying it on leverage. Right? You buy it on leverage you get a near term gain. Wow, boom. You got, you got a monster gain in very short period of time. And there's, there's, you're not in for the long term, so you're not going to have a lot of risk. But for an average investor, I think it depends on, and I'm stuttering here, and I understand I'm stuttering, it depends a little bit on what your goal is here. Right. If you're a momentum investor, you're not a flipper, I get that. But you really just, you want the near term, you want the one quarter, you want the two quarter price momentum in an ipo. And that's really probably it. If you're an actual investor, if you're like a value guy, I don't think anything you're going to find right now is going to be enticing to you. I'd be shocked by that right now. But I think the reality is the higher the valuation, the shorter your time horizon as a trader should be. That's kind of the way, that's kind of the rule of thumb I would use. Again, we're a macro firm, so take that with the proper grain of salt.
- [46:16]
C
How do you think about, to the degree you want to comment on this, if not, we understand too the SpaceX inclusion in the index level. How do you think about some of these? Because you invest in these vehicles. You invest and think about the world through these indices.
- [46:30]
B
Yeah. So, you know, there's always been issues like this that pop up with big IPOs. The first one that I remember. Oh, when was it? Whenever, whenever, when did Microsoft come public? Like 1990. Something. I don't even remember anymore, something like that. But I mean, for a long time Microsoft was not in the s and P500. It was like this monster company was not in the S and P. And I think S and P took a little stick for, for that happening. And, and you know, these days one of the most important things for an index provider is to make sure that their index is relevant. Right. And if you're not, if you don't have the hottest stuff, you risk not being relevant. And I think we gotta remember that the index community, and I'm not placing this blame on any one company or anything like that, don't misunderstand the point. But the index community has changed a little bit in that there's a lot of indices, indices have grown like mushrooms. They're all over the place. And my firm's as guilty as any other firm in developing indices as well. But they're everywhere. And because of that, the, the last thing a major index provider wants is for their index to be irrelevant. How do you become irrelevant? You don't have the hot stuff. You don't have the hot stuff. You're not going to have ipo. So my guess is that it's reflective of the competition. It's symptomatic of the competition in the index world that you're not going to get a situation like several decades ago when Microsoft was not included in the S and P an extended period of time. I don't think that could happen today.
- [48:10]
C
I don't want to draw a direct parallel to it, but I want to just bring this up again. You mentioned tech serial underperformance from early 2000s through the period beyond the financial crisis. And I'm curious, as we start to see this again, the S and P is becoming a bit lopsided. One might say could we have another lost decade? What would the makings of that look like?
- [48:35]
B
Yeah, I think, I think we could. I, I've actually said many times, I think, I think we are heading for another lost decade simply because the index construction, you know, you get a small number of companies dominating the index, which is what happened during the tech bubble. And so, you know, you ended up with a lost decade where for 10 years the s and P gave you a marginal negative return on an annualized basis. But if you invest in other things, you did fabulously well over that time period. If you invested in energy, mid caps and small caps, emerging markets, there were lots of things to invest in. But if you bought the S and P index fund, you did really badly. And you know, Jack Bogle, one of the founders of Vanguard was, was one of my heroes when I was younger. I mean, I hate to say this, an active manager, but I really, I really think that Jack was, was a genius. And I spoke to him a couple of times. It's not like we had a relationship. I don't want to over a couple of chance meetings. And both times I tried to ask him, a couple of times I tried to ask him, you never talk about one decks to buy and win. And his response was always, well, just buy an index for the long term and hang on. And I always thought that was a very unsatisfying answer because if you buy an index at the wrong time, it can take you long term to break even. You know, as I said, you know, you bought NASDAQ, you didn't break even for 14 years. Right. In the 1980s, if you had bought small Caps at the peak of the small cap market in 1983, I think it took you like 17 years to be neutral to the S&P 500. I mean that's the long term to me, 17 years, I mean that's crazy. And, and so I think what index to buy in one is a very important concept. And in our firm we call that pactive trademark term. By the way guys, do not try to steal that because it's the active use of even passive investments that if you're investing passively, you are making an active decision as to what you're in, what index you've chosen. And so I would argue there is no true passive investing unless you're buying all the stocks in the world. But even that is you're, you're going to be geared towards large caps and things like that as well that you, you know, you're always, even as a passive investor, you're making a decision about what's going to work in the future. And so I, I actually think that there's, there's alpha to be made over longer time periods by kind of buying indexes where people are not paying attention to them.
- [51:10]
D
Are there any other asset classes that you know could be useful in a portfolio? Like I'm thinking maybe commodities, gold. How do you view those non equity types of asset classes?
- [51:22]
B
So, so let's, let's talk about them a little bit separately. Gold. We, I, we generally not always, I don't want to overstate my case. We generally carry a small proportion of gold in our portfolios and we do that, I like to call it the spare tire in the portfolio. And the analogy is that you know, like why do we carry spare tires in our cars? Because you can't predict when you're going to get a flat. So it's always with you. And I hate doing that because I'm always afraid now I've cursed myself, I'm going to get a flat tire. But be that as it may, that's why we carry it. And so gold historically has a reasonable correlation to uncertainty and by definition you cannot predict uncertainty. So we carry a little bit of gold in the portfolio as our spare tire against the unforeseen. And we tend not to play around with it too much. I mean, you know, when gold was really ripping, we trimmed it back a little bit because it got above what we felt comfortable with. But generally we'll hold about 3 to 5% in our multi asset portfolio. So gold, we don't try to trade gold. And that's what I'M trying to say, I think it's, it can be a very tough game to try and trade gold. And I think, you know, if you're doing gold miners or you're doing silver or some high beta version of gold, I mean that's even harder. I, I, you know, that's, to me it's a warning sign when people start asking me about silver because silver is just a high beta version of gold. So gold isn't good enough anymore. We need silver and we want more risk. And so, so we don't try to trade it nor, nor are we gold bugs. You know, we don't suggest that people buy gold coins and bury them in their backyard or anything like that. I think that's a bit extreme too. But having a little bit of gold just as a, you know, relatively structural allocation is probably, probably worthwhile. Commodities, Commodities I think are pretty interesting. You know, real assets in general are pretty interesting, if you believe my story for our portfolios is actually quite difficult to do. And the reason I say that is that, you know, we, we invest primarily using ETFs and people think all exchange traded products are ETFs. Not so. In fact, a lot of commodity exchange traded products are not exchange traded funds and they carry K1s with them. And so some platforms where we have our portfolios won't allow us to buy commodity related ETPs, exchange rated products. Sorry, won't allow us to do that. And on the ones that do, we try to avoid it. Because I don't think there's anything that makes a financial advisor happier than having to explain K1s to their clients. So you know, so we tried to avoid that, but we do make up for it generally with material stocks and energy stocks and things like that. And I think, you know, for, for an equity investor, you can still play that kind of stuff without going into, you know, lumber.
- [54:23]
C
I'll clarify the financial advisor point. Nothing makes a financial advisor more upset than getting a K1 for like 82 cents. Yeah. Or a tiny net operating loss.
- [54:33]
B
Exactly.
- [54:34]
C
Yeah, yeah. Get a K1 for something worth it. If you get a K1 in the first place. When you look around the world right now, when you look at markets, when you look at the economy, what, what's the most optimistic thing you see right now?
- [54:48]
B
Oh, I think, I think the most optimistic, I think there's a bunch of stuff out there that is just like screaming for investors to look at them and investors just don't care. So we've discussed this many times, guys. I still think Small and mid cap industrial companies are like the best investment, long term investment theme out there. It is basically what is left of the US industrial base. That's the way to think about it, right? I mean we all know that we don't have much of an industrial base in the United States. I mean manufacturing construction is down year on year, manufacturing employment is down. I mean it's not like this historic. It's not like we're spending a lot of money the private or public, public sectors, you know, reinvigorating the industrial base in the United States. This is something everybody knows has to happen and nobody is providing capital. And so it's what's left. And talk about a scarcity of capital. I still think this is a great story. So that would be, that's, I think that is a screaming type thing where the companies are just screaming at people, invest in us, invest in us and nobody cares. I don't get it. So there's that, that's number one. Number two, I think if, you know, getting back to Justin's question before, investors are woefully underweight pro inflation assets, whether that's material stocks, energy stocks, commodities, short duration equities, you know, this whole thing, I think that that's another screaming story. And the third would be something about international. Now hear me out on this one. You know, non US stocks are 35 to 40% of the global equity market. My former colleague Michael Hartnett, who is the chief strategist at Merrill lynch, has pointed out that in the Merrill lynch private client system, non US stocks comprise about 6% of their equity holdings. 6% versus 35 to 40. Okay. So I was giving a speech the other day and somebody decided to be really snarky and, and the guy basically said, my word's not his. He basically said, well Weisenheimer, if you're so smart, what is the optimal allocation to non US Stocks? Okay. And I was equally snarky going back. I said not zero. Why are we worried what the optimal, optimal allocation is? People have nothing. And so if it's nothing and it goes to 5% of the portfolio and you think about that throughout the entire United States and everything else that would happen. I mean think about what that would do to non US Stocks. It'd be huge. It would be absolutely huge. So I think that we get too caught up in, you know, are you underweight or overweight? And sometimes we just don't think that equal weight is 35 to 40% non US and people have like 5 to 10. I mean if it goes to 12, it's going to be wonderful. And I don't. So I think, I think those are kind of three things that I'd be, I'd be looking at right now.
- [58:03]
C
And that flow story in that reallocation, it's such a powerful thing. It's like once in a while you'll hear people talk about it from the other end. It's, oh, some pension fund in some corner of Europe is trimming its U.S. equity position and that's why the NASDAQ went down today or something. And it works on the other direction too, though, and possibly even more profoundly.
- [58:23]
B
Right. And you know, when during the tech bubble in 2000, this was 99 or 2000, I can't remember exactly when I did this. I Simply said if 5% came out of the tech sector and you made the assumption that all of it went into the Russell 2000, how much that 5%, what would it drive the Russell 2000? Like 25, 30%, something like that? This was years ago. But I, I think, you know, it does take a lot of that flow to change the story. And, and you know, from my perspective, it doesn't mean you have, you have to sell all your growth. If you like the Mag 7, hold the Mag 7, right. That's not, I don't, you know, that's not my, my beef, my beef is that nobody wants to hold everything else. That's my beef.
- [59:07]
C
All right, one more question for you. Anything keeping you up, up at night, anything that worries you in the face of that optimism.
- [59:13]
B
So the only thing that's keeping me up at night right now, which is very apropos because I was up last night, is to have a 15 year old dog, a 15 year old dog who now cannot sleep through the night for various reasons. So, so that was actually my night last night. That was a lot of fun. But no more. Seriously, what keeps me up at night, what keeps me up at night continues to. Has been and continues to be that, that we do. I'm going to speak hyperbolically here for a second because when you're up at 3 in the morning, you tend to think hyperbolically, that we get more and more speculation that does irreparable damage to the US Economy. And what I mean by that is if you think about Wall street, you think about Washington right now, everybody is focused on speculative assets. They are not focused on the dire need that I said before about rebuilding the industrial base in the United States. Washington's more interested in cryptocurrency legislation than they are in providing tax incentives for investment in the industrial sector. I don't get this. And to me that's the thing that keeps me up is that for some reason we know that we don't like if you saw 60 Minutes a few weeks ago, that this whole story about how in the United states we build three ships a year and Korea builds like 300. I don't know what the number was, but it was like a multiple. What we do. Well, how come everybody doesn't say like we need to build more ships and let's, let's, let's, let's provide the tax incentives to rebuild the shipbuilding industry and let's know. It's, they're more worried about cryptocurrencies and 401ks. I mean to me this is like crazy. And this is both sides of the aisle. If you look at the legislation that's going on, this is not Democrat or Republican comment that keeps me up at night because I think we are losing ground competitively to many parts of the world. I mean it came out the other day that Vietnam is going to have high speed rail before the United States. And what does everybody say? Oh yeah, in California, they've just been screwing this up forever. No, wrong answer. You should say, my God, that's horrible. Why isn't the government stepping in and building high speed rail so that we can be industrially competitive with the rest of the world. Like California screwed up. Everybody knows that. But that's not the right answer. The right answer is we should be doing it. How can Vietnam have it before we do? This is crazy. And, and so that's what keeps me up at night.
- [61:42]
C
All right, and just confirming your dog's name. Not Mr. Peabody.
- [61:46]
B
No, no, Benny. All right, Benny is that he's a 15 year old Jack Russell who is if you know Jack Russell's, you know, they're very strong willed to begin with. You should have a 15 year old jack Russell who can't quite hold it anymore. It just nothing more pleasurable in life.
- [62:05]
C
All right, Our collective hearts going out to Betty and your state of sleep. But our best of Betty Rich people want to follow you online, they want to bug you on the Internet. Where should we send them?
- [62:17]
B
Right, we're still@rbadvisors.com you can follow us on Twitter @RB Advisors. And we tend to tweet multiple times on a good day, multiple times a day, but definitely, you know, five to ten times a week and people can pick up little tidbits, especially if you happen to be a financial advisor. Those little tidbits give you things to talk about with your clients. You know, things like that. It's, it's, it's really pretty helpful. So you know we're out there and
- [62:46]
C
always good for those conversation starters.
- [62:48]
B
Yeah. Well, thanks guys.
- [62:50]
C
Which absolute pleasure. Thank you for joining us. You're watching Excess Returns Like Comment, subscribe all the things below and we are out.
- [62:57]
D
Thank you for tuning in to this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess returns network@excessreturnspod.com if you have any feedback or questions, you can contact us@excessreturnspodmail.com no information on this podcast
- [63:17]
C
should be construed as investment advice. Securities discussed in the podcast may be holdings of the firms of the host.
- [63:25]
B
Some follow the noise Bloomberg follows the money because behind every headline is a bottom line. Whether it's the funds fueling AI or crypto's trillion dollar swings, there's a money side to every story. And when you see the money side, you understand what others miss. Get the money side of the story. Subscribe now@bloomberg.com
- [63:51]
C
for their clients.