#10 - Rich Bernstein: Market Outlook, Investment Opportunities

26:18This is what you have to remember. And that is the return on investment is always highest when capital is scarce. Translated, you want to be the one banker in a town with a thousand borrowers. Think about that for a second. If you're the one banker in a town with a thousand borrowers, you're going to make a mint, right? Because you're going to control the interest rate on every single loan. Turn it around. A thousand banks and one borrower, the borrower makes out like a bandit because the banks he'll compete away the profit margin on the loan. And so whenever you're investing, you want to think, am I in a situation?

26:54Am I the one banker in a town with a thousand borrowers? When I was in Maryland, I used to get in trouble for saying I would liken it to loan sharking. And people would get very, because loan sharks are the ultimate investment. You know, they find people need money really, really badly. And then they charge them an exorbitant rate, right? No, I'm not suggesting our industry is loan sharks. Don't misunderstand the point. But it's an economic analogy that I think is very appropriate here. in the, you know, you want to be the one banker in a town with a thousand borrowers and people forget that. Earlier, you mentioned artificial intelligence and it's obviously it has potential impact economically, inflationary wise and so on.

27:35Would you talk about your perspectives about that and how investors should think about AI? From the notion, will AI change the economy? of course it's going to. I don't know why that's even open for discussion. All major technologies have major impact on the economy. My favorite one, which we don't consider technology anymore, is the light bulb, where the light bulb turned the economy into a 24-hour economy, a massive productivity increase. You can't have a graveyard shift in the dark. You need light for that. So that was true. But I think what we have to do as investors is separate out the economic story from the investment story.

28:18We don't really care about the economic story. We care about the investment story. So again, let's go back to the technology bubble and what happened. So the technology bubble was all about the internet. And the story was the internet was going to change the economy. And it did. It changed the economy in ways that we could never have envisioned. Look at what we're doing right now, as an example. However, despite that wonderful economic story, the investment story was terrible. As I said before, if you'd invested in NASDAQ at the peak of the bubble, it took you 14 years just to break even. Terrible investment story, wonderful economic story, right?

28:56So now let's talk about AI. So is AI going to change the economy? As I said, of course it will. Why would anybody argue it's not going to? Of course it will. But that's the economic story. What about the investment story? And I think the investment story, given the hype and given the narrowness of the market and everything else, I think we are going to find that the investment story is not as good as people think. My guess is that if we come back here in five years or 10 years or 15 years, the companies that we are talking about with respect to AI are not the companies we're talking about today.

29:29Then, you know, if you go back to the tech bubble, I don't think there's a couple of companies still that people would talk about, but the majority of the big names, like people think of them as either has-beens or boring companies or, yeah, okay, they're around, you know, that type of thing. A couple of them people would say they're still leaders, but most of them you wouldn't. So I think that's going to happen today as well. Yeah, and that's certainly consistent with history. Even, you know, before the internet, you had the nifty-fifty, you have all these companies that are all of a sudden the darlings and they become overpriced relative to what is likely to transpire.

30:07And you can take any great company and make it a bad investment by just raising the price too high. Right, exactly. One concept that you've described in the past is that investors should only date cash. Cash has been king for a while. I think cash has outperformed in the stock market last two years. Do you think now is a good time to date cash? It's interesting. The number one question I get asked, Alex, is cash attractive? And the unfortunate reality is, yes, it is. And that's how monetary policy works, right? When the Fed raises rates, they do so to explicitly make cash attractive relative to other investments in the economy as they try to suck capital away from everything else in the economy.

30:56That's how they slow down the economy is by doing that. And so when people say it's cash attractive and the Fed has raised rates 525 basis points, you should say, yeah, it's attractive. However, the analogy that I've used, you know, you date cash, you never marry it. What happens inevitably is that investors fall in love with cash. They say, wow, I can get 5 % or 6 % out of cash. Why should I invest in anything? Well, we all know that over longer periods of time, cash is a miserable investment. Why? Because you're not taking part in the economy. And so the whole point of investing is to invest in profitable ventures and get returns on your assets and things like that.

31:40Well, cash, you're not taking any risk, of course, but you're not getting anything either. So as you stretch out the time horizon, what you find is that cash becomes a more inferior, more and more and more and more and more inferior investment. I say date cash, never marry it. So I think, yeah, today it's probably worth going out on a couple of dates and that sort of thing. But again, one has to remember that cash is a short-term investment, always has been, is incredibly poor long-term investment. Now, what's comparable, well, there's all kinds of things that people should be looking at. Again, think of my earlier seesaw analogy.

32:19I would argue this side of the seesaw all the way down there. If your time horizon is a year, two years, three years, this other side of the seesaw is a lot more attractive than cash. I mean, people forget that cash is the risk-free asset. If you want to take no risk, you get whatever the yield cash delivers. And for a long time, it was near zero or at zero. and all of a sudden it looks attractive relative to that history. But all these assets, price versus cash, they have to offer an expected return above cash. And when cash goes from zero to five and a quarter that quickly, assets reprice to give you a forward-looking return that's competitive with cash.

32:56And so I think looking backwards, you can misunderstand that and say, oh, cash was king, therefore, and the yield is high relative to history, it looks attractive, but that could be missing a lot of the analysis. You talked about the once-in-a-generation trade opportunity. You've written about that in the past. Would you share with us some of your historical observations and talk about potentially the next trade of a generation? It's kind of cute to divide these things up by decades, right? And of course, the markets don't start on December 31st and end on December 31st. But let's for a second assume that that's the case, that we're talking decade by decade because it's easier to talk that way.

33:44And you alluded to this before about how each decade has had different kind of characteristics to it. And I think that's true today, too. But the one that I find very interesting is the relationship within the equity market decade by decade between emerging markets and venture capital. You've really never had a decade where they both did well. Venture capital did well. Emerging markets didn't. Emerging markets did well. Venture capital didn't. And my guess, I'm not sure I know why, but my guess is that what happens is you get too much capital flowing to one asset class or the other. We overcapitalize the asset class.

34:22And the investment opportunities then become less attractive, right? Similar to a lot of things we've been talking about. So one of the things that's very interesting is that we went through the lost decade of equities, the 00s. Emerging markets significantly outperformed venture capital. Then we get to the 10s, right? Venture capital significantly outperforms emerging markets. Might say for the next 10 years that we should be looking at emerging markets relative to venture capital. And I don't think that's going out on a limb. It doesn't mean the venture capital investments are all going to start coughing up blood or anything.

34:54That's way too dramatic. But which of the two asset classes is likely to perform better? I think it really could be something like emerging markets as you're looking at the next five, 10 years, as opposed to venture capital, which is clearly being overcapitalized now. When you think about the amount of existing investments, amount of capital being raised, the AI craze, everything else that's going on, it's hard to argue, using my line from before, that you're the one banker in a town with 1 ,000 borrowers. Yeah, you're also coming off of a 20, 30, almost 40-year period where you either had falling interest rates or zero or near zero interest rates.

35:33And it's very possible that we're now in a secular change where interest rates aren't going to be falling or near zero, and it's a different environment. And that can change the math very quickly. I think that's right. You know, our head of fixed income, Mike Cantopoulos here, pointed out that from 1980 to 2020, the 10-year yield fell 75 % of the time. And, you know, we do it by month by month. It was like 75 % of the months the 10-year yield fell. Since 2020, the yield has gone up 75 % of the time. Now, Now, one could argue, wait, that's like 40 years versus four years. Yeah, I get that. I understand that.

36:14But what if it's not 75-25? What if it goes to 50-50? That would argue that the contours of valuation, the contours about the fixed income in the equity markets are going to start changing. If you think about the potential causes of that shift for that period that you just described from the early 80s until recently, inflation wasn't a concern. So anytime there was a hint of economic weakness, you could have an expectation and the Fed would respond to this by cutting rates. Now inflation is a concern. And so my guess is, is the Fed is going to be slower to cut and may keep rates higher for longer because now they have to worry about inflation as a potential tradeoff.

36:58Is your view similar? Yeah, I would go one step further and say, I think there's a possibility, not necessarily a high probability, but a possibility that the Fed may be forced to even raise rates more, depending on what happens with inflation and the strength of the economy. You know, as we were talking before, the economy is actually stronger than people think right now. One has to remember that inflation is a lagging indicator. So what we're starting to see in some of the inflation figures is they seem to be bottoming now. They're not going down anymore. That makes sense. If the economy is actually stronger than people think.

37:33You wait and wait and wait for your lagging indicators. Inflation being a lagging indicator, sure enough, there it goes. It's starting up again. That doesn't mean we're going to have 9 % and 10 % inflation, right? That we're in a very hair on fire environment where everything has to be so dramatic. But all that has to be is more inflation than people expect, more inflation than the Fed expects. That's all it takes. And that's essentially what happened in the 70s. It just kept going up and up and up. Expectations are rising, but inflation stayed ahead. A lot of people miss that. In that environment, you had nominal rates go up significantly, but real rates actually fell.

38:07Yeah. So that's a very, you know, that environment could obviously repeat. It's likely going to be different. But those are periods where both stocks and bonds can do poorly at the same time. Yep. Exactly. Absolutely. And I think that was, you know, it's the reason why people don't like inflation is that financial assets tend to do less well, real assets tend to do better. Yeah, let's talk about diversification for a second. Diversification hasn't really paid off the last couple of years. You've had a stretch where assets moved in tandem based on expectations of the Fed's next move. And then also you've had the S &P 500, the index that everybody loves, that's had this tremendous run last almost 15 years.

38:52And the more of that you own, the better you did. And the less of it you own, in other words, more diversification hasn't really panned out. How do you think about all this? We've actually suggested that today, not today, but I mean, this current period right now is a call for maximum diversification, right? We have the narrowest equity market probably in my career. I don't think we've ever seen anything where we could talk about seven stocks. And I would venture a guess, and I say this tongue in cheek, I would venture a guess that there is no sound theory of building wealth that says you should invest in only seven companies as a sound way.

39:32We all know the diversified portfolio built through time is a great way to build wealth. And so when we have this extreme concentration, we would argue it's a call for maximum diversification. Again, think of my seesaw analogy, right? This side of the seesaw has like a bazillion different ways you could invest. But then you come to the reality. And when I was at Merrill, I used to talk about this all the time. Investors are habitually under-diversified, right? We all know diversified portfolios are what you want to have. Why are people habitually under-diversified? Why are they so destroyed by bear markets?

40:07Why the psychology of all this? And the answer is because people don't really want to be diversified because diversification means holding assets that you don't particularly like, right? In other words, everybody has a view of the world. You diversify in case your view of the world is wrong. Well, if your view of the world is wrong and you're not holding those assets, you think those assets are going to be terrible. Why would I invest in those assets? Because it doesn't fit your view of the world. And so you have nothing in the portfolio at that point. You'll have nothing in the portfolio that protects you against you being wrong.

40:44And the end result is people are habitually under-diversified. And I think we're at one of those periods, again, where people become, if I can use the word, a little bit investment myopic, where they're only looking at this very short, very nearsighted view of the financial markets and missing the range of opportunities that are out there. So I actually think most portfolios, I think the data shows are really not very well diversified. There's some data that shows that individual investors are punting diversified portfolios to go trade individual stocks again. This is not good stuff. And we all know that this is not the way to build wealth through time, but it's like a siren song, right?

41:29We can't resist, and then we crash on the rocks, for those of you who enjoy Greek mythology. In my experience, the way you build wealth over time is you don't lose it. and slow and steady wins the race, but it's a hard thing to actually do in practice. And I think part of it is it's easy to have a view of what you believe the future is going to hold. And then you position for that as you described. But I think the part that's really missing is that most investors and many professionals included are overconfident in their ability to predict the future. They just don't realize that they're going to be wrong a lot.

42:05Oh, absolutely. I think we all fall into that category. Yeah. And then if you think about today's environment, for a long time, inflation wasn't really a concern. Now it's an issue. And you have volatility, not just in growth, but also in inflation. You have volatility in what the Fed's going to do. The Fed doesn't know what they're going to do. You have geopolitical risks. There's just a lot of potential risks brewing. And it feels, if you just look at that and forget the past, that it's a time to be more diversified than less diversified. One of the trends that I've observed is a big move into private credit.

42:42There's a lot of interest in that space because the yields are so high. You've spent some time talking about the importance of having a liquid fixed income portfolio this year. Would you talk about that? Sure. So I think, look, there's private credit is, it's very interesting how it came about, right? You'll notice that the major banks are all saying how sound they are right now. And the bank analysts are talking about how sound they are. And you might like regulation or not like regulation, but the reality is that the big banks are so sound right now because of all the regulation after 2008, they were prohibited from doing all these kinds of risky things.

43:17And so the major banks are very sound. However, what happened by forcing them to be so sound was that they lost market share. And they lost market share to entities that were not regulated, commonly called private debt. It is a very interesting opportunity given those dynamics. Sort of an unintended consequence of the post-2008 bank regulation was that somebody was going to take risk. Where was it going to go when it went to private debt? Now, there's nothing wrong with private debt. And I don't want anybody to think that the comments I'm about to make here are negative anyway. No, they're not.

43:53There's going to be good private debt and bad private debt, as there are good stocks and bad stocks. It should not be a shock to anybody. But the movement, people have generally used fixed income as kind of a safer, more liquid investment relative to other investments. And the move to private debt is taking you towards riskier. That's the reason why they exist, because the banks can't invest there. So by definition, the loans are riskier and they're less liquid. So what we've said is fine. That's fine. There's nothing wrong with that. But let's try to balance that out with more liquid fixed income alternatives.

44:33So what we've said is, okay, you've got this illiquid version. Let's go with uber liquid, but not lose the fixed income exposure. You can go to cash like we were talking about before, but then you're going to lose all the benefits of the fixed income market overall. Why would you want to do that? So what we've said is go illiquid, that's fine, but then go uber liquid. How do you do that? Enter stage left, fixed income ETFs. Fixed income ETFs are a major innovation in the fixed income markets. And one has to remember that one of the main purposes of the financial markets is to facilitate transactions, right?

45:11So many people on this call may have traded commodity futures like pork bellies or something like that. I'm going to guarantee nobody on this call has ever hauled around a pork belly. Commodity futures are more liquid than the underlying asset. Equities are more liquid than the assets they represent on the balance sheet. Imagine if every time you wanted to trade a stock, we'd have to bring lawyers into the room and sign contracts about the transaction that's going on and stipulate all the terms and conditions and everything else. equities are more liquid than the underlying assets on the balance sheet, and it facilitates the transaction, right?

45:47Fixed income ETFs are doing exactly that. They are bringing liquidity to a notoriously illiquid marketplace. People don't often understand the fixed income markets are still what's called dealer markets. They are not exchange markets. And dealer markets, because you put two dealers together to make a transaction, are notoriously illiquid. Fast transactions, big transactions are more difficult to make than they would be in, say, the equity market or the commodity futures market or something like that. Fixed income ETFs are bringing that liquidity to the fixed income markets. And so we've been managing our fixed income portfolios using fixed income ETFs, I don't know, 14 years, whatever it is now.

46:27And we've been doing that on purpose because we saw this innovation coming and we thought it was going to change the way fixed income money management was going to occur. Well, let's take that technological change, if you will, with what we were talking about before and the potential change that maybe we're moving from secular disinflation to some version of secular inflation, right? Let's not talk about the 1970s. That's very extreme, but not disinflation anymore. That's going to call for more active management in fixed income. You're not going to be able to buy and hold for 30 years like we did.

47:01But how do you become an active manager in an illiquid market? It's very difficult. That's the advantage of fixed income ETFs. We've been talking about diversification and the importance of diversification. One of the more diversifying markets is China. It's the second biggest economy in the world. Potentially, it could outpace the US at some point in the near future. And it is highly diversifying because it's a different economy. They have their own monetary system and more and more, it's more domestically driven. But there's heightened geopolitical risks. How does all of those considerations net out for you?

47:43Let me give you two preambles here before we go on and talk about China. Number one, everybody at RBA understands the politics. We get that. We understand it, but that's not really our job to opine on politics. Our job is to look for investment opportunities as best we can. When we have stated mandates from our investors, of course, we pay attention to the stated mandates. That could be anything from, if you remember, the sin stocks and things like that. There's all kinds of... People have always had political or religious views about what should or shouldn't be in a portfolio. When we are presented with that, of course, we adhere to those things.

48:21But If we don't, but we're not given a mandate like that, it's not our job to impose a mandate on the portfolio. Second thing I want to point out is, using the term that we were using before when we were talking about cash, I think China is a date but not a marriage. And the reason why is I think their long-term issues are reasonably well-known, but the demographics there are terrible. This is going to hinder economic growth and hinder productivity through time. And the more you want to stretch this out, the more it becomes. So in the comments I'm about to make, I'm not suggesting that China is some great long-term investment and that kind of thing.

48:58No, no, no. I think that's not worth it. We're talking about kind of a cyclical play here that maybe lasts a year. If we're lucky, we get two years out of it. So the reality is that, number one, China is dirt cheap. There are many issues surrounding China. We know them. Everybody knows them, right? You could list all the concerns one has about China. China sells about one third of the valuation of NASDAQ. I don't even know what it is versus the MAG-7. It's probably like a quarter of the MAG-7's valuation. Now, remember, NASDAQ and MAG-7 are everybody's favorite. And China is over here. So again, the seesaw analogy, I think, is very important.

49:40I would argue those concerns that everybody has are already discounted into the stock prices when you get that kind of valuation disparity. Who doesn't know about Taiwan? Who doesn't know about these? Everybody knows it's discounted to the valuations. Number two, the fundamentals in China are much better than general perception. Retail sales in China, industrial production in China, corporate profits in China are all stronger. And I say profit. Retail sales, industrial production, corporate profits, and GDP growth. That would be the other one. I'm sorry, there were four. GDP growth would be the other one.

50:15They're all stronger than in the US. And it's like, nobody knows this. Everybody thinks China's economy is imploding. It's not. It's actually stronger than the US economy right now. So there's a gap here, again, between perception and reality. And I think, as we discussed a little bit, performance will change that. I think we're starting to see a bottoming in the Chinese stock market. Jury's out, of course. But I think if we find that the Chinese stock market is somewhat counter-cyclical, and it does start appreciating here, I think we'll find that enthusiasm for China and we'll build to some extent.

50:50Not the way it used to be, right? There are political issues, there's all kinds of things going on. I get that. But as a cyclical opportunity for a year, a year and a half or something, I think it's very, very attractive. And how do you think about incorporating alternative investments in a well-diversified portfolio? We obviously don't. We're not an alternative manager. We don't have that. But I am asked the question quite often. I don't like the term alternative investments. because there's so many different branches of alternative. I mean, you've got venture capital, you've got private equity, private debt, you've got real estate, you've got commodities, you've got all these different things running around here.

51:28And to group them all is like saying, I want to invest, right? It doesn't make any sense. So I think there are areas of alternative investments that are always attractive. And I think there are areas that are probably unattractive. And so I don't think there's anything necessarily good or bad about them the same way, you know, just say, I like stocks, right? What does that mean? There's good sectors, good themes, and bad sectors and bad themes. I view alternative investments the exact same way. So I think they have a role in a portfolio, of course. Why not? I don't, you know, privates and investing on a private scale, why not?

52:06Why wouldn't you do that? But I don't think I just don't like the whole concept of alternatives. That just doesn't make any sense to me. Yeah, I suppose it's very opportunity dependent. And also, when I look at them, I think about how diversifying are they to the existing exposures that you have. So if they basically go up and down with the stock market, that's not with worse terms, that's not necessarily a great addition to a portfolio. But if it's reliably different, that can be diversifying. And if it has a decent expected return, that could be additive to a portfolio. Exactly. And it should be, you know, I've always thought that the places to invest privately are places the public market, you can't invest in the public market, right?

52:49If there's no way to invest in the public market, then you know that the privates are probably going to have pretty good returns. If it's just kind of dovetailing with what's going on in the public market, probably a little bit hyped. Well, Rich, why don't we end with one insight that you feel is unique that many have not thought of before? I think besides my buy low, sell high, which I think is so hard to do. The one thing that when I talk to individual investors that I, and I wrote a whole book about this, you know, 20 years ago or something. And it really is about, we know there are basic building blocks to building wealth and we know they work.

53:32Why don't people do them? And the example that I use in the book was a weather forecast. We all look at the five-day weather forecast, although you guys are in California, the five-day weather forecast may not change. But in the Northeast, where I am, the five-day weather forecast is kind of important. And people always look at that fifth day. And now they tease people with seven and 10-day forecasts. And we know the probability of the seven or the eight or nine or 10th day forecast is getting less and less accurate as we go out. We know that, but yet they keep that seven to 10 day forecast right at the end of the news because they know people are waiting for it.

54:12Am I going to be able to go on a picnic over the weekend? You know, that kind of thing. And I say in investing, it's the same thing. I can give you a weather forecast that'll be right 100 % of the time, but you'll laugh because it's so obvious, right? And my weather forecast is going to be cold in Minneapolis in January. I mean, of course it is, right? There's no insight of my telling you that. Well, when we come to investing, it's the exact same thing. A well-diversified portfolio held for the long term is a great way to build wealth. Why don't people do it? And the answer is there's always something out there telling them it's newer, it's better, it's quicker, you're going to make more there's always some sexy thing out there that lures people in you know like moths to the flame and and the difficult aspect of investing is not finding opportunities it's sticking to your discipline right and and that's i i tell when i speak to individual individual investor audiences i would say that is the role of the financial plan that when you get too greedy or you get too fearful there should be something on the financial plan says, you know, break glass, pull out financial plan, because it's at those extreme points that that's the role of the financial plan day to day.

55:27Like who cares? Right. Extremely fearful, extremely greedy. That's when you need the financial plan to tell you that you're going off the rails and you're going away from this very easy, well-diversified portfolio held for the long-term builds wealth. Yeah. I guess the problem is we're human and we were subject to emotions and that's probably not going to change. So, so I guess the best you can do is to be aware of that, of those blind spots, particularly at the extremes, both on the upside and the downside. And all you have to do is zoom out, see the big picture. Don't make the wrong decision at the wrong time because that will basically take you off track.

56:07And it's really as simple as that. And it's just much easier said than done. Of course. Rich, this was great. I appreciate you taking the time, sharing your insights. I enjoyed the conversation. I hope you did as well. Yeah, Alex, thanks so much for the invitation. Thanks for listening. We hope you enjoyed this episode. Please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast. If you have questions, feel free to email us at info at insightfulinvestor.org. And if you enjoyed the discussion, please subscribe to this podcast to ensure you don't miss future episodes.

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