RICHARD BERNSTEIN: In the United States, the profit cycle is decelerating. The peak of the profit cycle was roughly about the fourth quarter of 2018.
As we go into 2020, the risk isn't that positive zero to 5% could be -05%, or maybe -5% to 10%.
Contrary to what most people believe, United States' leading indicators are rolling over, but what they're not aware of is that the leading indicators in China are about the strongest momentum of any major economy in the world.
VINCENT CATALANO: Locked into an investment methodology that just doesn't seem to do the trick, well, perhaps you can benefit from my guest today and his highly adaptive style of investing. Richard Bernstein, the CEO and Chief Investment Officer Richard Bernstein Advisors, Mr. Bernstein founded Richard Bernstein Advisors in 2009, a very propitious time to do it. The firm utilizes a unique-- and it really is unique top down approach to investing, focusing on macro trends rather than an individual stock selection.
Rich has over 35 years' experience on Wall Street, most recently, as a Chief Investment Officer at Merrill Lynch. Rich is a longtime friend. I'm delighted that he's here today. Rich, welcome.
RICHARD BERNSTEIN: Thanks, man. Thank you.
VINCENT CATALANO: Why don't we cut to the chase here in terms of market conditions and all profit cycle? That's a core element of the methodology that you use. Where are we now? Why does it matter?
RICHARD BERNSTEIN: At Richard Bernstein Advisors, we were a macro firm, but unlike other macro firms, we don't follow economic cycles, we follow profit cycles as you pointed out.
The reason why is because profits are the heart and soul of equity investing. I think people forget why it's even called equity. It's called equity because when you buy shares of a company, you become a partial owner of the company. If you're a partial owner of the company, all you care about is the profitability of the company that you own. You don't care about GDP, you care about the profitability of the company that you own.
What you'll find is, whether it's in the United States or around the world, all the things that people like to talk about, whether its growth and value, large cap and small cap, all those market segments, they revolve around the profit cycle and this goes back to work that we did in the early 1990s when I was at Merrill Lynch, and we've subsequently tested all around the world and it works. It works everywhere.
VINCENT CATALANO: It works everywhere?
RICHARD BERNSTEIN: Everywhere.
VINCENT CATALANO: Okay. Does it matter, the quality of the profits, in other words, gap versus operating earnings?
RICHARD BERNSTEIN: We prefer to use gap earnings. In fact, gap reported earnings, which are the version of earnings as opposed to operating earnings or adjusted earnings or pro-forma earnings or all the other things that investors hear about, because gap reported earnings skews the analysis most in the investor's favor. That's why companies don't like to use gap reported earnings because it can make them look bad, and they don't want to look bad. But from our perspective, you want to get all the influences of the profit cycle so you can adequately really measure profitability through time.
VINCENT CATALANO: Have you found why the profit cycle works? What I'm trying to get to is this. Talk about the market players that are there. It sounds to me a lot like the reason the profit cycle matters is because investors look at this more, so as you mentioned a moment ago. Why is that so? Why do they look at that? Why do they not look at some of the other elements that are there?
RICHARD BERNSTEIN: Well, Vinny, as you know, I used to teach in the grad school at NYU. One of the questions I used to ask the MBA students was, what's the difference between the stock market and a horse race? An MBA student should be able to answer that pretty easily and they never could, they always had a tough time.
The reason why is because we do think of the stock market exactly like a horse race. We even use the same words, I'm going to make a bet on company XYZ. You're not making a bet, you're an owner, as I said before. I think the noise that on any given day and all the issues that are going on, all the sexiness of day trading takes away the fact that profits are ultimately what you're buying in the stock market and that's ultimately the lifeblood.
VINCENT CATALANO: Where are we in the profit cycle now?
RICHARD BERNSTEIN: It depends where you are in the world. In the United States, the profit cycle is decelerating. The peak of the profit cycle was roughly about the fourth quarter of 2018.
VINCENT CATALANO: Is that the rate of change?
RICHARD BERNSTEIN: Yes.
VINCENT CATALANO: Okay.
RICHARD BERNSTEIN: In other words, the rate of change of corporate profits peaked roughly at about the fourth quarter of 2018, and that growth rate has been coming down. It's still positive, which unfortunately gives people a little bit of false security, but it is decelerating. What we've already started seeing is the rotations within the US stock market had become more defensive, which is very normal when profits decelerate. That rotation towards defensive sectors of the US market will get more intense if we actually get a negative earnings growth, meaning a profits recession. It looks like that's probably in the cards for 2020.
VINCENT CATALANO: 2020?
RICHARD BERNSTEIN: Yeah, early 2020.
VINCENT CATALANO: Okay, and for 2019, we're looking at flattish numbers for the year.
RICHARD BERNSTEIN: Correct. 2018, profits were up about 20% to 25%--
VINCENT CATALANO: Still positive but flat.
RICHARD BERNSTEIN: Right, for '18. Well, '18, it was up a lot. It was up by 20%, 25%. 2019, full year looks like it will be between zero and 5%. Up a little bit, but as we go into 2020, the risk is that that positive zero to 5% could be -05%, or maybe -5% to 10%.
VINCENT CATALANO: If I have to stay in the market, if I'm an institutional investor, and I'm compelled to stay in the market, I'm going to gravitate towards more defensive issues under those circumstances?
RICHARD BERNSTEIN: Correct. That's exactly right. You've seen that in the stock market this year, where a lot of defensive sectors, whether it be consumer staples, whether it be utilities, whether it be real estate, you've seen those sectors start to outperform pretty dramatically as profits have begun to decelerate. That's perfectly normal.
What's been the icing on the cake right now has been the uncertainty with the capricious policymaking in Washington, where it's one day on, one day off, one day on, one day off. That uncertainty works like the Fed tightening, it hinders risk taking. As we've gotten this capricious environment, we found that people have rotated even more towards these defensive sectors.
VINCENT CATALANO: That uncertainty, I want to get to that in a little bit. Do you take any market trend factors into consideration? In other words, you see the profit cycle decelerating, you know that where you want to be is going to be in those sectors that benefit from it. Do you look at market timing cools to say, "Okay, well, it looks like consumer staples now are and the trend is this and so we're going to rotate from and--" Do you do that?
RICHARD BERNSTEIN: We do, but differently from I think the way you're thinking, the way you're describing it. What we will do is we will look at the momentum in the marketplace, let's say it's very cyclical, and we'll compare that to the fundamentals, let's say the profit cycle. If we find the momentum is very much in favor of cyclicals, but the profit cycle's starting to decelerate, that presents an opportunity to us. It says that the consensus is that we want to be in cyclicals but the reality, the fundamentals are saying that you should be shifting.
Now, will we get that right from day one? Of course not, but through time, that process works pretty.
VINCENT CATALANO: Exactly. That that helps from a performance point of view, I would think, because you're selling into strength under those circumstances.
RICHARD BERNSTEIN: Absolutely. The unfortunate reality of what goes on these days is when you sell into strength, people don't say, "Oh, you're being highly constrained, you're selling into strength." They say, "No, you don't understand what's going on. You're an idiot." It's a little bit difficult to do a turning point.
VINCENT CATALANO: Exactly. You get the pressure and then the clients have to feel confident that yes, I know what I'm doing and we'll work its way through the cycle, those things. Let's look at the economic picture, to what extent do you take the economic picture into consideration beyond the profit cycle, meaning monetary policy, GDP, debt to GDP, all those elements. How do you weave that whole thing? Is that like an upstream backdrop to what you're doing?
RICHARD BERNSTEIN: There's two sides to what you said. One is immediate economic indicators, things like industrial production or something like that, where of course, we're going to try and tie that to the profit cycle. Because remember, profitability is just a function of how many units you're selling and what's your profit margin per unit, and so there's a lot of macro variables that either help you forecast the number of units that will be sold or the margin per unit, whether that be pricing power, labor costs, anything like that. We'll use that as part of trying to forecast the profits, as part of our forecasts of the profit cycle.
The other issue as you mentioned, debt to GDP and things like that, those are longer term secular issues. We do pay attention to those, but they won't affect our quarter to quarter positioning or something like that. But of course, and we've written extensively on debt to GDP in the United States and how investors don't appreciate that this has been going on for 40 years. We're all sitting here waiting for this moment of truth where all of a sudden, everybody wakes up and we're in a big problem because there's so much debt to GDP.
What people don't realize is, this has been going on now for 40 years and it's like water torture, just keeps drip, drip, drip and our secular rate of growth in the United States has been falling as our debt to GDP is going up. This is nothing new. It's been going on for a long time. It's a major issue. There are ways to fix it, whether the politicians can do that and that's whole nother story for probably another day there.
VINCENT CATALANO: You're right. Exactly, but we'll touch on a little bit of the political aspect of it in the monetary policy part in a moment. The debt super cycle as it's been cold by one firm, that that's what you're describing and we're still going on with that. It's still going on. You don't know, just like valuation, you don't know when that rubber band's going to snap and it can just keep going and going
RICHARD BERNSTEIN: Well, my argument is that they it's so much like there's a day of reckoning, which a lot of people like to talk about. It's more like a slow cancer. The way you can see this is our lack of competitiveness in the United States. Why can't the United States compete anymore? Why are we losing market share and production, and things like that? It's not an accident that this is happening, it's because more and more of our cash flow within the US economy is going to service the debt and can't be reinvested in productive assets, and it's just a slow cancer.
VINCENT CATALANO: Your friend put out a report, Charts for the Beach. One of the items, the first one on Page 1 deals with the OECD leading indicators. In the report, you reference why you like Chinese equities-- we'd get to in a second. This is one of the fundamental economic indicators that you look at, leading indicators to help inform you of the action that you want to take?
RICHARD BERNSTEIN: Absolutely. There's a lot packed into that question, Vinny. If you think about first, the notion of leading economic indicators, people take this for granted, but they forget that there are leading coincident and lagging indicators. For some reason that I've never understood, equity investors have a fascination with lagging indicators, which makes no sense to me, given that the stock market itself is a leading indicator.
What are classic lagging indicators? Well, inflation and the unemployment rate. What do people talk all about all the time? Inflation and the unemployment rate. Leading indicators are things like weekly initial jobless claims and building permits. I'm sure most people watching this have never even talked about something like building permits or something like that, and so you've got this weird thing where people look at lagging not leading indicators.
We look at leading indicators all around the world, about 40 different countries or so. We do that to try and get a grip on what is the potential for profits to turn up. What is the potential for overall the economy turn up?
What you'll find right now is contrary to what most people believe, United States' leading indicators are rolling over. I think most people know that, most people are aware of that. What they're not aware of is that the leading indicators in China are about the strongest momentum of any major economy in the world. Some people say, "Well, it's not showing up in their numbers." Of course, it's a leading indicator. The leading indicators should reflect it first before you see it in the headlines and so we think that's very important.
VINCENT CATALANO: Now, if you were-- if that makes you let's say, predisposed towards going into the Chinese issues, and back to the timing issue again. When do you decide, "Hey, we're going to increase or we're going to put a couple of positions on in that area." What becomes the next, "Okay, this says, hey, Rich this is looking pretty interesting here." Now, what's next? Do you look at profit cycle in that regard? Do you look at all the market indicators here?
RICHARD BERNSTEIN: Sure. We have a whole series of indicators that try to forecast corporate profits in China, or in the United States or in Europe, or pick whatever place you want to look at. Yes, first, you want to look at the leading indicators and see if there's a conducive-- a backdrop that's conducive to better profitability. Second thing we look at is what are our profit indicators telling us? Right now, they're beginning to bottom. They're suggesting that the next quarter or two, Chinese profitability will begin to pick up. It's already bottoming in China, whereas in the United States, it's still decelerating.
VINCENT CATALANO: Let's shift to a couple of political issues and monetary issues. One of the things that I've been pontificating on of late has to do with the Fed, and the Fed, really in effect, backstopping what has to be perceived as bad behavior. The trade war and things of that sort. Yeah, we understand the justification for it, the rationale, et cetera, and all that, how you go about doing it is an issue, which is important to explore. How do you incorporate? Do you incorporate monetary policy issues? I want to get to something with interest rates and negative rates and yield inversions.
RICHARD BERNSTEIN: Okay. One of the things we try to do, it's always very difficult, but as a firm, we try very hard to look at the geopolitical type issues as dispassionately as we possibly can. Everybody's got a side they like to come down on but if that starts influencing your investment decisions, you're going to be led astray. Think about how many people did not partake in the bull market because they thought that fiscal policy and monetary policy were inappropriate. Well, it's not for us to decide what's appropriate and what's not, it's what is.
One has to always remember that politics is about what should be, some better world, but investing is about what is. Your delta set of cards, you got to invest relative to this set of cards. What's very interesting right now with the set of political cards we've been dealt is that people, again, don't want to believe the reality of what's happening. For instance, and one of the things that we've talked a lot about to our clients, investors has been most people don't realize that monetary and fiscal policy right now are very pro-inflation.
Now, there's no consensus out there right now that's more hardcore than inflation is dead and gone, can't come back, be it monetary and fiscal policy in the United States are both very pro-inflation. Tariffs are always inflationary if they actually come in to be and they work. There's never been a situation where they're not. Monetary policy given that the unemployment rate is so low, they can't be trying to simulate employment, they're obviously trying to simulate nominal growth and inflation.
I don't think people realize that. I think if you approach this very dispassionately, that's the big issue in monetary and fiscal policy right now.
VINCENT CATALANO: From an investment point of view, you're going to look for issues that will benefit from inflation, are you not?
RICHARD BERNSTEIN: Correct. Now, it depends. Now, if some people say when I respond, I say that's correct. They say, "Oh, well, you must like commodities." Well, not necessarily, because every cycle has a period of stagflation, not 1970 stagflation, but every late cycle environment has a period of stagflation where you'll find inflation continues to go up, because it's a lagging indicator, and growth begins to slow. That's what makes late cycle environments very difficult for the Fed. Everybody's convinced the Fed is an easing cycle right now, we're not quite so sure, because of this issue with lingering inflation and they may actually be stoking inflation.
VINCENT CATALANO: The yield curve and yield inversion, in the past, it's come about when the Fed said, "Whoa, put the brakes on." This time, it looks like the bond market says, "Whoa, we're putting the brakes on." Now, to my recollection, that's like never happened before.
RICHARD BERNSTEIN: I'm not sure it has.
VINCENT CATALANO: Yeah. With that, yeah, we have a yield inversion, but it didn't come about in the usual fashion. Does it still have the same validity, do you think?
RICHARD BERNSTEIN: Well, I think there's two ways to look at this. One is, is the yield curve an indicator of looming recession and bear market? Number two, why? Why does it work? It's not just a magical thing.
Number one, that's the tough one to time. Nobody ever knows if the yield curve inverts, what's the time