Former Merrill Lynch chief investment strategist Richard Bernstein believes that the U.S. equity markets are in the early stages of a bull market that could surpass the greatest bull market of his lifetime, the 1982-1999 market. Speaking at the Fiduciary Gatekeepers Investment Research Managers conference in Boston this morning, Bernstein, who was named top investment strategist by Institutional Investor 10 times, outlined his contrarian scenario in detail.
Bull markets are often conceived in periods of widespread fear. Bernstein recalled that from 1982 through 1987 the issues spooking investors bore an eery similarity to the present moment.
Chief concerns in the early 1980s included shrinking corporate profit margins, entitlements and Federal budget deficits, which were setting all-time records. A runaway Fed under Paul Volcker was raising interest rates to unprecedented levels and acting completely on its own will. Even if its objective, squashing inflation, was very different from that of today's Fed, its controversial behavior was not very different. In 1985 and 1986, everyone fretted about a "growth recession" when GDP expanded at an anemic rate fluctuating between 0% and 2%.
Today, federal and state debt dominates the national conversation. Yet Bernstein noted that total debt, including household, corporate and other private debt, is falling at the fastest rate in history. "I just discovered this last week," Bernstein said, admitting he was shocked.
Total U.S. debt has fallen from 350% to 320% of GDP in the last few years and Bernstein surmises that it is one reason why the dollar has remained strong.
With the S&P 500 up more than 100% from its March 2009 low of 666, many people are asking if the bull market is over. Bernstein cited the absence of three classic bear market signals-yield curve inversion, extreme overenthusiastic sentiment, and lofty valuation-as evidence the bull market is young. He guesses that "we are in the third inning."
Wall Street remains as bearish as it ever was. Today, retail investors believe they have to buy everything that performed well in the last decade-gold, emerging markets, emerging markets debt, REITs and hedge funds. All these asset classes boomed in the so-called lost decade between 2000 and 2008 at the same time as the credit bubble was inflating.
Institutions continue to allocate major parts of their portfolios to hedge funds and private equity. Even though they can't keep up with stocks, institutions are "paying 2 and 20" to chase the last decade's returns.
In 2002, everyone was asking "when to get back into tech stocks," Bernstein said. "It's hard to argue stocks are overvalued when the 10-year Treasury yields 1.7%."
As for emerging markets, Bernstein noted the S&P 500 was up 30% in the 18 months while the Shanghai market was off 9%. That trend is now almost five years old.
The U.S. is starting to benefit from the rest of the world's woes. "It's not a coincidence that housing and construction are starting to rebound," he observed. "The U.S. is the smartest kid in summer school."
Other regions are still mired in much earlier stages of the deleveraging process. The debt cycle that started in America is now pervading Europe and default and delinquency rates are beginning to rise in Brazil and other emerging nations. Interestingly, the housing bubble in the developed world artificially stimulated demand for emerging market exports like bedding, towels and carpets.
Ironically, the fastest projected growth rates in the world can be found in small-cap U.S. stocks represented by the Russell 2000. Bernstein like small-cap U.S. banks with no international exposure.
He admits that he is concerned with political gridlock. "The fiscal cliff is a real risk. I have no faith in Washington but the situation isn't that hard to solve," he said. "Spending as a percentage of GDP is at an all-time high, and tax revenues are at all-time low."
For those who are wigged out about inflation, Bernstein thinks there are better alternatives to TIPS. Those alternatives include small-cap stocks which boomed during the hyperinflation of the late 1970s, junk bonds and junk munis. Simply put, inflation devalues debt and makes it easier to pay down.