Richard Bernstein: “This Time Isn’t Different” by Richard Bernstein, Richard Bernstein Advisors
H/T Jesse Livermore
“If you say this time is different and you are bullish, then people think you are foolish. But, if you say this time is different and you are bearish, then people think you are very insightful.” – Anonymous
At RBA, our work on cycles has rarely identified a period which was truly unique. We study cycles all around the world, and profit fundamentals typically drive stocks. The exceptions have subsequently proven to be financial bubbles like the technology bubble in the late-1990s or the housing bubble during the mid- 2000s. We invest by the rule that “it’s not different this time”.
We search for gaps between perception and reality when investor expectations differ from the objective reality of the cycle. Some of our best success stories have originated by identifying such gaps. Our avoidance of emerging markets and MLPs and our enthusiasm for the US consumer are recent examples when our disciplined investment strategy led to one-of-a-kind portfolios.
Our recent views have been similarly out of consensus. The profits cycle seems to be in the process of forming a trough and the Federal Reserve may be more cautious when raising rates than investors expect. That combination is not at all unusual (it’s normally called an earnings-driven stock market), and we think it may be the fuel behind the next leg of the bull market.
The Federal Reserve is a lagging indicator
RBA spends considerable time determining whether indicators are leading, lagging, or coincident. However, as investors, we don’t really care whether indicators lead or lag the economy. Rather, we care whether they lead or lag the financial markets.
With that in mind, investors may be paying too much attention to the Federal Reserve. Of course, the Fed is hugely important for the economy and the markets, but it is critical to remember that the Fed is actually a lagging indicator. We expect that to be the case throughout this cycle as well Since the Fed began to target the Fed Funds rate in the early-1980s, the Fed has never led the markets either when raising rates or lowering rates (Chart 1). The chart marks the peaks and troughs in the Fed Funds Rate and the 3-month T-bill rate. There have been a couple of instances when one could argue that the Fed’s moves were coincident with the markets’, but the Fed typically lags the markets. Sometimes, the lag is as long as a year or more.
The Fed’s recent guidance seems to be following the historical norm. The uncertainty surrounding the US and global economies is preventing the Fed from being the leading indicator that some would like them to be. Recent comments indicate that the Fed may prefer lagging. If the Federal Reserve tightens monetary policy too early or too quickly, then they feel they may put the global economy at risk. However, if they tighten too late or too slowly, they feel they can always react to inflation and increase the pace and magnitude of rate increases.
The current Fed’s perceived risk and return seems similar to those of past Fed regimes. With the exception perhaps of the Volker Fed, the Federal Reserve has historically responded to economic conditions rather than set them. The current Federal Reserve’s “data dependency” is really nothing new.
The profits cycle appears to have troughed
Profits cycles, rather than economic cycles, are central to our positioning because history shows well that financial markets generally react more to profits cycles than they do to economic cycles. Accordingly, our outlook for corporate profits is more important than is our outlook for the overall economy.
Our forecast for corporate profits suggests that the profits cycle is in the process of troughing. Chart 2 highlights our expectations for the profits cycle over the next year or so. It appears to us that 4Q15 earnings season was probably the weakest of the cycle, and that the profits cycle will gradually improve through 2016. Although we don’t expect the absolute level of profits to trough, history suggests that the improvement in the profits cycle could initiate leadership changes with the stock markets.
Nothing unique going on: it’s still interest rates and profits
The combination of the Federal Reserve’s hesitancy to tighten monetary policy and the profits cycle’s potential trough indicates two things to us: 1) this cycle isn’t different and 2) the odds are the bull market continues. Of course, if one wanted to posit that the Fed will be aggressive and the trough in the profits cycle is several quarters away, then we’d be very wrong because that would be a terrible environment for equities (i.e., the Fed tightening into a deepening profits recession). However, that combination would be highly unusual relative to history, and we think it is an unlikely outcome.
This cycle isn’t unique. It’s still all about interest rates and profits. If you’d like a deeper understanding about how RBA incorporates these ideas into our portfolios, please contact your RBA product specialist. http://www.rbadvisors.com/images/pdfs/PortfolioSpecialist_Map.pdf