Financial insiders use the phrase "the bear case always sounds smarter" to warn against being overly clever about pessimistic market forecasts. Anyone can imagine disasters that could cause huge sell-offs but history has shown that over time, the path of least resistance for markets is higher.
I keep repeating "bear case always sounds smarter" to myself because I'm sorely tempted to adopt a really, really negative outlook for equity markets. Helpfully, the strategist I trust most remains bullish.
The bear case for North American equities can be succinctly summarized. Equities are expensive (even with reference to very low bond yields) at a time when earnings growth is negative and global economic growth expectations are being continually ratcheted lower.
Furthermore, current stock values are supported by 2017 profit expectations that experts believe are overly optimistic. Merrill Lynch quantitative strategist Savita Subramanian wrote that the consensus earnings growth for 2017, at just under 14 per cent, are double her estimates.
Richard Bernstein, who held Ms. Subramanian's position at Merrill Lynch in the 1990s before founding Richard Bernstein Advisors LLC, remains very bullish on equity markets despite all of these factors. And, since I've described Mr. Bernstein numerous times as "the best strategist working," his view carries extra weight.
Mr. Bernstein recognizes that equity valuations are high but believes this is normal for the middle of a market cycle. He projects an "earnings-driven bull market" where price-to-earnings ratios normalize not by stock prices going lower, but by earnings growth accelerating quickly.
"We repositioned our portfolios earlier this year to accentuate cyclical sectors because our proprietary research strongly suggested that profits [in the fourth quarter of 2015] would be the trough of the profits cycle … it is conceivable to us that S&P 500 reported GAAP profits toward the end of 2016 or early-2017 could be growing about 20 per cent."
The accompanying first chart, below, shows that year-over-year profit growth for the S&P 500, while still in negative territory, has been stable and may have bottomed.
Where does that leave investors? We have a deteriorating economic and profit environment, expensive equities, but the potential for an inflection point leading to a lucrative upswing in stock values.
Investors have no choice but to ride it out, not go to cash or significantly reduce portfolio risk despite the unsettling market backdrop. To do so would be an attempt to time the market, which has been shown to be impossible to do successfully on a consistent basis. Going to cash would also result in an investor missing Mr. Bernstein's profit rally if and when it occurs.
There is also the danger of extrapolation. As discussed, the current economic and earnings trends are increasing investing risk. But investors should not extrapolate – assume that the current downward slide in profits and growth will continue forever – because they will be poorly positioned when things change, and they always do.
So, I'm not going to go bearish. Nervous and diversified, prepared for volatility, yes, but not bearish. The negative outlook might sound smarter, but it's usually the optimists that make more money in markets.