I maintain my previous claim that Richard Bernstein, former Merrill Lynch chief quantitative strategist and founder of his own research firm, is the best strategist working. His recent major calls – notably that developed markets would outperform emerging markets and that U.S. small caps would rally – have been tremendous of late, even though they sounded crazy at the time.
I also worked at the same firm for a number of years and was able to follow his research through entire market cycles – not just the buy recommendation but also the sell. As a means to gauge the skill of a strategist, the importance of following them through full cycles can't be overstated.
So when Mr. Bernstein writes a report called "Equity Bubble? No," I pay close attention.
Mr. Bernstein's view is that the U.S. market displays only one of the five characteristics of an equity bubble, namely available liquidity. The others – increased leverage, democratization (your barber asking for stock tips), increased turnover, record new issue activity – are not apparent.
There are those who point at record margin debt as a sign of leverage, but this fear is misplaced on two fronts. One, as a percentage of total market cap, margin debt is nowhere near exorbitant. Two, as Ritholtz Wealth Management's Josh Brown notes, "You know what else is at record highs? Short interest."
The discussion of high beta versus low beta stocks in Mr. Bernstein's report interested me most. He writes, "It seems to us that a necessary condition for an equity bubble is the overvaluation of the stocks most sensitive to the overall stock market's movement. It seems very unrealistic that high beta stocks could be selling at historically conservative valuations if there really was an equity bubble underway."
In other words, it is defensive sectors that have rich valuations. This is a clear sign that overall stock prices and market sentiment have not gotten too far ahead of themselves.
Mr. Bernstein is not a raging bull and finds current valuations at the high end of the normal range. To him, this suggests decent but not high potential returns for equities.
But, he also describes the current state of equity markets as "a normal mid-cycle rally" which suggests there's much more to come for U.S. investments.
Scott Barlow