Rich Bernstein, Merrill Lynch's newly minted chief U.S. strategist, cut his recommended equity weighting to 50% Monday from 60%, worrying that the stock market has strayed back into speculative territory. Shares slipped.
But maybe Bernstein's got it wrong. Not because he isn't a nice guy or because he isn't smart -- nothing could be further from the truth -- but because Merrill's U.S. strategists have had a bit of a losing streak lately.
In the late 1990s, the firm's strategist was the bearish Chuck Clough, who shuffled away in early 2000 -- right before his call on stocks turned correct. Merrill then hired Panglossian pundit Christine Callies, who was rarely right. Bernstein, who as Merrill's chief quantitative strategist had often disagreed with Clough and had always disagreed with Callies, stepped to the plate in December. Now, the question is: Is three a charm?
"If I were wrong," says Bernstein, meaning the market keeps going up, "it could be it's just a liquidity-driven bubble. Or it could mean this time is different. I'm not sure I'm comfortable with either of those options."
Stock valuations are incredibly stretched, says Bernstein. Based on reported earnings (rather than the funky pro forma ones many companies like to use these days), the trailing
price-to-earnings ratio on the benchmark
is extremely high -- 40.8 at the end of last week, according to Standard & Poor's.
Compared with Merrill Lynch company analysts' long-term expectations for earnings to grow by 14.7% a year, the P/E-to-growth, or
PEG, rate is at its highest point ever in the 21-year history of Bernstein's data. He notes that in the past whenever this PEG rate has hit extremes, troubled times for stocks have followed.
Bernstein goes on to say that Wall Street's characterization of his equity weighting cut as bearish says a lot about the kind of market environment we're in.
"It's interesting that it comes off as being so incredibly bearish," he says. "I think of it as being conservative. There are very few people out there that say one should be conservative in this environment."
The Squared Circle
Bernstein's equity weighting is, along with J.P. Morgan equity strategist Doug Cliggott's, the lowest on the Street. As it turns out, Bernstein has developed a sentiment indicator based on strategists' equity allocations, and notwithstanding his inclusion in it (yes,
Mr. Heisenberg, we understand that could be a problem), it shows that bullishness has continued to reign on Wall Street even in the face of steep losses.
Toil and Trouble?
Source: Thomson Financial/First Call
Bernstein believes that this downturn has been unique in that nobody "fought the
Fed," reckoning that the reason the old maxim worked in the past was that there were always investors around who thought lower interest rates wouldn't get the economy on its feet, and that fighting the Fed would be a good idea. Since everybody kept on believing economic revival was right around the corner, valuations never came down as when the economy hit the skids in the past. In the trough of the last recession, for example, the S&P's forward P/E (based on analyst estimates, according to Thomson Financial/First Call) fell to 10.5. In contrast, the S&P's forward P/E has mainly stayed above 20 since the recession started in March, dropping below that level only briefly in September.
In fact, a forward P/E of 20 on the S&P has pretty much been rock bottom for valuations since early 1998. Perhaps there is some actual sense to Bernstein's quip about how maybe "this time is different." There have been times in the past when the market valuation framework actually has changed. In the late 1950s, for instance, companies began investing more in growth and paying less in dividends, basically ruining the dividend-based valuation models that a lot of people were using. As it happens, the late 1950s were the last time the
fed funds target rate was as low as it is now.
"You've got your lowest interest rates in 40 years, so what's your historic benchmark?" asks Jeff Matthews, head of the Connecticut hedge fund Ram Partners. "I'm a low P/E guy. I don't own any stocks that you could consider indicative of this market. But I'm not going to say, 'Look at the multiple on the
-- this is stupid.' "
Or one could also argue that with the Baby Boom generation hitting their peak period of earnings, and of investing, the valuation framework for stocks has been permanently altered. Because everybody needs to invest for retirement, stocks have become the prescription drug that everybody needs to take -- never mind the price.
But the problem with both these scenarios is that, while maybe they're true, there's no good way right now to differentiate whether there's been a valuation-regime change or if stocks have simply gotten incredibly pricey.
"Our work will probably never suggest overweighting stocks during a bubble or bubblelike environment," Bernstein cautioned in a note Monday morning. "Thus, similar to what happened during 1999 and early 2000, if liquidity growth accelerates and our fundamental forecasters do not turn, then our overall strategy might end up being inappropriate."
Nor would his work suggest overweighting stocks if for some reason the market's valuation framework suddenly shifted higher. But even if Bernstein ends up being, in hindsight, just as wrong as his predecessors were, he would say that buying something you can no longer price is a dangerous thing to do.