“The bull market has a ways to run and investors are missing out if they favor defensive positioning, as many are doing,” said Richard Bernstein, chief executive officer and chief investment officer, Richard Bernstein Advisors LLC.
“We are not even close to a recession,” Bernstein explained in a session at IMCA’s 2017 Investment Advisor Forum recently. He likened the record inflows into bonds in summer 2016 “at the worst possible moment” to the flood into equities at the height of the tech bubble in March 2000.
When bond market inflows peaked last summer, overall market duration was at its longest, meaning that fixed income investments were maximally vulnerable to interest-rate changes. But inflation expectations, both in the United States and globally, had bottomed out six months earlier, providing a signal that interest rates were headed up, and thus bond prices were likely to fall.
Meanwhile, there are many indications that the bull market is likely to persist and investors should be favoring cyclical rather than defensive investments. As inflation expectations have returned, yield curves have steepened and very few remain inverted (a strong sign of an impending downturn).
In addition to a pickup in inflation expectations, leading economic indicators in the United States and many other economies signaled strengthening. “The economic indicators of three out of four major global economies were stronger in November 2016 than they had been in the previous three months,” Bernstein noted. “The fact that the Russian stock market rose 32 percent since the U.S. election is a further signal of an improving global economy, because the Russian economy is based on commodities, for which demand increases with global growth.”
“While many look at gross domestic product growth as an indicator of where the stock market is headed, they should be looking at profit growth instead,” added Bernstein. “Here too, the signs are overwhelmingly positive for equities.”
“Profit growth in the United States hit bottom in December 2015 and profits began a resurgence at the beginning of 2016. As a profit recovery progresses, the markets rotate such that cyclicals begin to outperform defensive sectors, which is exactly what has happened.”
As of year-end 2015, municipal bonds, real estate investment trusts, and treasuries were among the top performers, while Standard & Poor’s (S&P) high beta, the Russell 2000, and emerging market equities were among the worst performers. At the end of 2016, the rankings had basically flipped, with S&P 500 high beta, the Russell 2000, high-yield corporates, and emerging market equities outperforming and treasuries and munis underperforming.
Sector performance showed a similar pattern. In 2015, energy and materials underperformed, as is typical during the profit recession, and health care, staples, and consumer discretionary outperformed, but in 2016, energy, materials, and financials were the top performers while health care and consumer discretionary and staples fell to the bottom.
Given this scenario, Richard Bernstein Advisors portfolios are significantly overweight in global small caps and global cyclicals (energy, financials, materials, and technology) and underweight in defensive sectors (health care, consumer staples, utilities, and telecom). In fixed income investments, they are significantly underweight duration.
Bernstein stressed that while the profit recovery was clearly underway before Donald Trump was elected president, his election is likely to further contribute to growth.
“The president is talking pro-growth and your clients are pro-income. They’re making a monstrous bet that he’s going to be completely unsuccessful,” Bernstein said. “I’m not sure you want to buy that.”
Bernstein issued one caveat for his assessment of the investment landscape: “If the dollar appreciates significantly, ignore everything I said.”