Human beings do something really well.  They buy what they wish they would have bought and they are spectacular at it.

The last time we had a record amount of money move to passive was in March 2000.  Back then only 10% of the market was passive and today it is close to 40%.

These strategies (passive) must buy regardless of valuations.  This causes valuations to get to extremes.  When things go over the cliff, they go down that much faster.  I think that’s the big risk today.

Current valuations are at the second highest level in history.

Mark Yusko, Morningstar Chicago ETF Conference

Last week, I promised I’d share some of my Morningstar conference notes.  So let’s start there today.  I hope that you find my notes helpful.  I believe we investors should always be putting together a shopping list of best ideas so that we are in a position to act when the getting is good.  To that end, I believe you will find some ideas below to start thinking about (if you haven’t already).

Personally, I walked away from the Best Ideas panel with a few ideas that I may include in my own portfolios.  The China and India theme keeps bumping me on the head.  I hope you enjoy this week’s post.

Included in this week’s On My Radar:

  • Morningstar Best Ideas: Richard Bernstein, Mark Yusko and John West
  • Charts That Matter
  • Trade Signals – Sentiment Better, Risk On Remains

Morningstar Best Ideas: Richard Bernstein (Richard Bernstein Advisors), Mark Yusko (former UNC Endowment CIO and Founder, Morgan Creek Capital Management) and John West (Research Affiliates)

There is a lot of information to present so I’m going to present it in two parts over this week and next.  And there were a number of very good ideas.  The dialog was great.  Following are my shared notes.

Best Ideas Panel – Part 1

Mark Yusko:

  • Human beings do something really well. They buy what they wish they would have bought and they are spectacular at it.
  • The last time we had a record amount of money move to passive was in March 2000.
  • Back then only 10% of the market was passive and today it is close to 40%. These strategies must buy regardless of valuations.  This causes valuations to get to extremes.
  • When things go over the cliff, they go down that much faster. I think that’s the big risk today.
  • Current valuations are at the second highest level in history.

Richard Bernstein:

  • It is not March 2000 for the equity market, it is March of 2000 for the fixed income market.
  • We are very close to something happening in the fixed income market. Why do I say that?  Inflation expectations, while not rising dramatically, troughed last February.
  • We are in a period where people are rushing into fixed income. And for the first time in a number of years, money growth is rising.
  • We know that the consensus is always wrong. Look, the individual investor has never gotten it right.
  • Pension funds are overweight bonds for the first time in God knows how long. Why do we now believe they’ve got it rig when inflation has troughed and money growth is beginning to expand?
  • People are so worried about the equity market but what they are really missing is the March of 2000 in the bond market.
  • The fact that inflation seems to have troughed and nobody seems to be aware of it is a worrisome factor.

John West:

  • I like to think of the world in two ways: do we have equity markets bullish or bearish and do we have inflation expectations rising or falling.
  • Most of the time in the last 30 years we’ve had falling inflation expectations and an equity bull market. However, that isn’t the only investment environment we are going to see in our investment lifetime.
  • We can see bear markets that come with bits of inflation or we could have reflationary bear markets. Stocks and bonds are wonderful diversifiers against each other until you get periods of rising substantial inflation.
  • Where are we today? Inflation expectations have fallen from 2 ½% to 1.2%. Now they are picking up again but they are still 40% lower than they were three years ago.
  • Certain types of assets respond well to changes in inflation expectations. What we call strategic third pillar assets.
  • A 25 or 50 bps change in inflation expectations could move these assets up 15% or 20%. Outside of TIPS, most inflation assets are particularly cheap.
  • Especially some of the backdoor hedging asset credit categories like bank loan, high yield, certainly EM. They are priced to deliver a real return of 4% over the next ten years vs. a 60/40 priced to give you about 1% over the coming ten years.

Bernstein:

  • The line several years ago was we are going to inflate away the debt. If you believe that, you want to buy all the companies that have all the debt.  (Bernstein is not sure he believes this but if you do…)
  • I do believe inflation is going to come back but maybe it goes from 1% to 2% or maybe 3%.

Yusko:

  • Outlook for US stocks: Demographics is destiny!
  • When you have a lot of people under age 25, you have high inflation and low productivity.
  • When you have a lot of people between 45 and 65, you have high productivity and you have rising stock prices.
  • When you have a lot of people between 65 and 85, you have declining productivity and low stock prices.
  • Harry Dent wrote a book on this in 1993. He said in 2008 to 2023 we will have a 15 year period where bonds will outperform stocks.
  • Since 2008 bonds have outperformed stocks.
  • Since 2000 the return on U.S. equities is 3.50% compounded per year for 16 years. There is a technical term for that… that sucks.
  • Bonds have been almost double that. EM has been almost double that.
  • In 2000, as Warren Buffett wrote, valuations were stupid. They were… they were crazy.
  • We have gone through this period now where everybody is saying, “Wow, the last five years have been great.”   Because the previous 12 months were really crappy.  2008 was really bad.

Yusko: So, what do we do from here?

  • Look, there are four risks we can take as investors:
  1. We can take the risk free rate. That is now 0%.  We can take credit risk.  We can buy a bond.  You get 2% above risk free long term.  You know the return over the next ten years.  It is 2%.  We know this.  It is 100% correlated to the yield. (Note: If inflation is at 2%, the real return after inflation is 0%).

Yusko told a story about an advisor he met recently.  He asked him why he was throwing so much money into bonds.  The advisor said because he needs to make 7 ½% for his client.  But you are going to make 2% Yusko told him.  But my client needs to make 7 ½%!  But you’re going to make 2%.

The advisor said, “No, no, no, over the last ten years I’ve made 7 ½%.”  Yusko answered, “But ten years ago the yield was 7 ½% and 20 years ago it was 11% and 30 years

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