Full Transcript: Rich Bernstein and David Rosenberg on Bubbles and Capital

Merrill Reunion on the Fed, Gold, AI Misallocation, and Looking Outside the US

Matt: You’re watching Excess Returns, a channel that makes complex investing ideas simple enough to actually use, where better questions lead to better decisions. This is an extra special show, partly because these guys used to talk together all the time, and now it so rarely happens in public. I’ve got first-hand reasons why I know how much fun this is gonna be. Honestly, feels kinda like a Blues Brothers reunion. I’m gonna let them debate who’s Jake and who’s Elwood. But I have hunches of where that could go. So let’s get into it. Richard Bernstein, welcome back to Excess Returns. Say hello, Rich.

Rich: Thanks, Matt. Great to be here. Thank you for the invitation.

Matt: And, I mean, the best Rosie since The Riveter, David Rosenberg. Welcome back to Excess Returns. How you doing today, David?

David: Thanks for inviting me on. You know, I was gonna say there’s no accounting for taste, but I appreciate it. And plus, I’m with my buddy and former colleague. We did go through a lot together.

Matt: Well, here’s to the trauma bonding. Call it what you like. Here’s to the trauma bonding. I’m ready to unpack some of this because I feel like—and this was part of the inception for this—I was new in my career at Merrill Lynch coming into the financial crisis period, and between Dave, between you talking about the economic consequences of a slowdown in housing and just how ugly that could get, which few were talking about, and Rich, between you saying, “I get it, you still have to be long, so just get out of financials, get out of the way,” letting me understand how sector rotation worked, these were both pivotal to my education as an investor and an allocator.

I wanna just start there for just a second. Rich, does that period, how much space in your head does that still occupy? Or have you just blocked out the Merrill years altogether? Nothing against Merrill. I just mean in the—

Rich: I have no... Yeah. No, it’s not like PTSD. Do you? I mean, no, no, no. Well, Matt, again, thanks for having us on. Look, I think in my career and in Dave’s career, it’s been the era of the last 20, 25, 30 years have been the era of bubbles, right? We’ve seen very, very loose monetary policy again and again and again, and that has created excess or misallocations of capital within the economy.

And so I think, whereas it seemed sort of unique in the ‘90s, I think probably—I can’t speak for Dave, but I would say probably for both of us—you know, it’s part of life now. And maybe we’re replaying it again today. But, you know, I wouldn’t describe it as PTSD. I would describe it as a learning experience that I sort of hoped was gonna be a one-off, but it really hasn’t been.

Matt: It’s remarkable to think about it that way because of how big it was, but these lessons that informed us forward. Dave, same question. You’ve talked to me before on recordings about this, too, just what that process did, how it reshaped how you think about the world. How much PTSD do you have from that?

David: Oh, I mean, zero. It was actually a great training ground, you know, to walk on hot charcoal for a number of those years. And it helps you build resolve. And I think that’s the biggest part of it. It’s not as if, by the way, that I didn’t have doubts.

You know, one of our clients at Merrill, who I got to know very well, was John Paulson, who we know was shorting those mortgage-backed securities. And he was gonna be out of business in a matter of weeks before the bad stuff hit the fan, and then he became an instant billionaire. So, you know, Rich and I weren’t running money, but we had our reputations on the line. And there were moments, actually, when I had doubts.

And you have to always balance your resolve. You have to make sure your resolve doesn’t turn into stubbornness. So you’re always walking that fine line as an analyst or a strategist or an economist between having backbone but not sticking with a bad call for too long. So that was really the learning lesson, is walking that fine line, that balancing act. So for me, it was actually a great learning lesson. And it’s helped me out in terms of shaping my convictions to this day.

Matt: So one of the convictions that shows up, and I wanna zero in on that word you just used, resolve, is something that watching you both operate in that crisis environment and then following your career arcs after, is the labels that get thrust upon you. Dave, they love to call you a perma-bear, and I go, “That’s not right.” And Rich, sometimes you kind of got thrown into that perma-bull camp. I reject both of these labels for both of you. That’s part of why I wanted you together on this to have this conversation.

And right now I wanna zero in because there’s some nuance in the way you’re parsing even stuff like what the Fed’s doing and what the Fed has in front of them. Rich, let me just kick this over to you first. I think you’ve been commenting on the internal models, not necessarily with your external commentary, that the Fed, by their own definition, should be hiking. Can we talk a little bit about how that morphs and how you’re looking at your own data versus what you’re actually thinking they’re gonna do?

Rich: Yeah. So you started out on a topic here that Dave and I may disagree. We may have some disagreement right at the beginning. But look, what we tried to point out, not so much that their own models are saying they should hike, but for many, many years, there was this notion in conservative monetary circles that the Taylor rule was the be all of the end all. I’m not sure I subscribe to that, by the way. But that was the story, that the Taylor rule said that the Fed should be hiking rates and therefore whether it was Bernanke or Yellen or whoever was the Fed chair, that they were lowering rates and they shouldn’t be. It was the wrong policy because the Taylor rule said they shouldn’t be.

And so all I’ve really done in my commentary over the past year or so is kind of poke people about that and say, “Hey, you know, how come the Taylor rule was the Rosetta Stone, if you will, of conservative monetary policy and now nobody talks about it?” And the reason nobody talks about it is because the Atlanta Fed has 30 different versions of the Taylor rule, and they do that on purpose because if you have one version, people say, “Oh, you’re using the wrong version.” So the Atlanta Fed has 30 different versions, all 30 suggest that the Fed should be hiking rates.

So the reason I bring that up is not so much to say that the Fed should be hiking rates—although I personally believe they should be hiking rates given some of the other economic data that’s going on—but to kind of say, what happened to all of you conservative economists that were saying for so long that monetary policy was too loose, and now the model is clearly, the Taylor rule is clearly, no matter how you want to configure it, clearly saying that the Fed should be hiking rates. Where are you guys? How come you’re all mute? That doesn’t make a lot of sense to me. And so I’m not sure I would argue that they should raise rates because of the Taylor rule. I think there’s better reasons, but it’s really just kind of poking people and having a little fun with people in politics.

Matt: Restraint points for no “poking the bear” references directed at your co-guest here in this seat. Dave, what are you thinking about that? ‘Cause you’ve been talking about the Fed in a different way. Which camp are you in? Give us the view on hikes.

David: Well, I don’t think the Fed should be hiking rates. I understand the arguments as to why they should. I don’t agree with them. And, you know, the Taylor rule, and there’s, as Rich said, dozens of different versions. They all have a lot of assumptions behind them, especially on the appropriate real interest rate and what measure of inflation expectations are you really using. So there’s a lot of guesswork. I wouldn’t say there’s anything that’s empirical, and that’s one of the reasons why for decades there’s been a huge deviation between where the funds rate actually is and where the Taylor rule is.

I come at it this way. Is there anything really telling the Fed, say from a macro perspective, that they should be raising rates? I’m taking a look, for example, at where we’re gonna be after we get the third quarter GDP numbers—this won’t be for several months—that we would’ve had a four-quarter average of real GDP growth of 1.4%. The Fed’s own estimate of potential GDP growth—’cause GDP itself is aggregate demand, the supply side estimated potential growth—is 2.0. So we have the situation now where the demand side of the economy is slowing below the potential supply, and that is gonna put downward pressure on underlying inflation.

Now, the one thing I will say about inflation is that we’ve been hit with recurring shocks. The people that actually say the Fed should tighten, they lament about the fact that the Fed’s missed its target of 2% for the past five years, which to me is immaterial because you’re gonna lament the past five years and look through the rear view mirror, or you’re gonna drive looking through the front window of the car. We’ve been hit with a series of recurring shocks that have created these bouts of inflation.

But it’s very interesting, and Warsh didn’t talk about it at the podium last week, although he should’ve, as explaining why did I not cast my vote for a rate hike, is because his once preferred measure of inflation, which is the Dallas Fed’s trimmed mean metric, which excludes the most volatile and extreme movements on both sides of the spectrum, and that measure is running at 2.1%. This time last year it was running at 2.7. I should correct myself. It’s running at 2.2. It was running at 2.7% a year ago, and it’s at the lowest trend in five years.

That is the real underlying rate of inflation when you strip out a lot of the noise, energy and its impact. Look what airfares have been doing. ‘Cause we talk about core inflation, but airlines and transportation services, delivery services, they’re included, but they’re basically first cousins to what’s happening with oil. Well, oil prices didn’t snap up because we have some booming demand in the United States. We know what the reason was. It was the US-Iran war.

And Warsh’s preferred metric—although now he’s got this task force that he’s gonna wait for and this commission on a new inflation measure—is running 2.2. It was 2.7 a year ago. It is decelerating. And so I don’t get a sense, despite the narrative, that inflation is really a problem. I can’t wrap my head around that when over 90% of the growth in the economy is coming from productivity and less than 10% is coming from labor input. I mean, for crying out loud, unit labor costs at last count, as productivity-adjusted wages, is running 0.5% year over year.

So, you know, we hear from some Fed officials, and Powell said this quite often. You know, it’s been a rough ride for Warsh in the early going. But Powell, you knew where Powell stood when he said that there’s no inflation coming out of the labor market. Well, there’s no inflation coming out of the labor market because there was a lot of inflation coming out of the labor market in 2021 and 2022, and that’s why they missed transitory. We had a wage price spiral that wasn’t like the 1970s. It didn’t last a decade, but it lasted 18 months.

There’s no wage price spiral right now. Right now, the price shocks are hitting a wall in the labor market, and you’re getting real negative incomes. Personal income, real disposable income in the United States is actually running fractionally negative year on year. All the growth on the income side in the US economy is coming out of corporate profits.

So I’m taking a look at where inflation’s going. I’m taking a look at the building slack in the economy. I’m trying to be forward-looking. I think that unless we continue to get recurring shocks, the trend in underlying inflation is gonna be a lot lower than people think. So that really underpins my view on the Fed. I think it would be a mistake, especially when you consider that the lags between what the Fed does in time A and time Z, I mean, they could be 12 to 18 months. Those lags are long and variable, as they say in the economic textbooks.

I think it would be a mistake. I think there’s more fragility to the US economy than meets the eye. We all know why the US stock market is doing what it’s doing, and it has nothing to do with the Fed. It has to do with this generational situation with AI. If you look at the home building stocks, for example, which are in between a correction and a bear market. I look at the home building stocks, and I look at the housing sector because that’s at the root of interest rates. The Fed controls interest rates. And if you look at auto sales and you look at the housing market, the stuff that really is connected to Fed policy, there’s no economic boom going on there.

I don’t know if there’s an interest rate that would bring what’s happening with AI to its knees. I think if anything, the Fed doesn’t have to do anything. The markets will figure it out because the one thing that’s happening, as all these tech stocks are hitting new highs, is look what’s happening in the debt markets, because their financing costs are going up and CDS spreads are widening out pretty dramatically. Credit spreads are widening.

And there’s one thing that Rich and I used to talk about during the housing bubble, was the equity market figures it out about a year after the credit market figures it out. The problems in ABS spreads and mortgage bonds was happening long before October 2007, which is when the equity market peaked. I think that the credit market will lead the ultimate rolling over of this AI trade. I don’t think the Fed has to do anything.

So I come at it from a situation where I’m seeing the relative supply and demand curves in the US shifting between now and, say, the end of 2027 into a fundamental disinflationary environment. And so against that backdrop, I don’t see why the Fed would be raising interest rates.

Matt: Rich, take me to the AI story. You’ve had a lot to say about this. You’ve been writing a lot about this and thinking about it for some time, and both what was driving the growth in the market before and where we are now. We’re gonna loop this back to inflation and energy, some other stuff. Open me off with AI.

Rich: So Dave actually said something which is very interesting and relates to some of the things we’ve been publishing quite recently about housing versus data centers. And one of the things that came out of our work for the tech bubble was that bubbles are inherently inflationary, and they’re inflationary because they grossly misallocate capital within the economy, right?

In the 1998, ‘99, 2000 period, money was going to dot-coms, into fiber optics, into all this kind of stuff, and there was no investment in the energy sector. And for those of you who might not remember or weren’t in the business world back then, refineries in the United States were literally exploding. It was 1970s technology, and there was no investment in them, and they were exploding.

And so the argument that we made at Merrill back then was that you did not want to invest in dot-coms and technology and fiber optics and all these different things. Rather, what you wanted to do was focus on energy, that the energy sector was starved for capital, and you could be the provider of scarce capital. And knock on wood, that turned out to be correct, right? I’m not saying everything I’ve ever done in my career has been correct, but that one turned out well. And for the next decade, energy was one of the best-performing sectors.

And I think we’re there again, in terms of all the capital that’s being thrown at anything related to AI, data centers, chips, everything. Money is being thrown at them. And so if you look at construction spending on data centers compared to construction spending on residential housing, you can see how the bubble is misallocating capital relative to housing affordability in the United States. Housing is not affordable, and it’s being priced out of reach for people, and part of the reason why is that there’s no new supply.

Well, why is there no new supply? As Dave pointed out, the housing stocks are performing miserably. The cost of capital is way too high. There’s no investment going into the infrastructure of housing. And therefore, you get this misallocation of capital.

And so I think that the Fed does not appreciate—I don’t think the Fed has ever appreciated—that abnormal pricing in the real economy, which we would call inflation, all of us would call inflation, and abnormal pricing in the financial economy, which we would call a bull market, when taken to an extreme, is just as damaging to the economy as is real inflation. Because you get this misallocation of capital within the economy and it distorts the economy.

So, you know, my joke has been that Elon Musk wants to go to Mars. That’s great. I wanna navigate the Cross Bronx Expressway in under an hour. I mean, why would anybody think that going to Mars is a great idea when you go home tonight, everybody goes home tonight, you’re getting caught in a traffic jam, and 18-wheelers are not gonna be able to deliver their goods. You know, you wonder why the United States economy is becoming less and less competitive around the world. Well, I would argue this is one of the reasons why.

Matt: The Bernstein Hyperloop, under construction any day now.

Rich: The Hyperloop. I’m not sure about that one, but that’s okay.

Matt: What do you think about that, Dave? How are you processing the allocation of capital between AI and literally everything else right now?

David: Well, I mean, except for the comparison with the inflation of the late ‘90s, which was rooted in something different than what’s happening today, I think Rich is 100% correct that basically we’re at a point now where about 50% of business CapEx is AI and AI related. And that 50% is growing in real terms at like 18% growth. The other half, what we call the old economy—I don’t know what’s old economy anymore, as Caterpillar used to be old economy—but the ex-AI CapEx is running negative year over year. So Rich is right that it’s sapping the momentum out of the rest of business capital spending.

The one point that I would make is this. When it comes back down to the inflation, that’s probably where Rich and I probably would disagree the most. Yeah, you could argue that AI’s created inflationary pressure in the memory chip prices and putting strains on the power grid and so on and so forth. Although when you look toward the CPI, the PCE deflator, most of the energy people pay is gasoline at the pumps, and nobody was talking about that inflation a few months ago even though AI was still booming, and that’s because the war started.

The difference now is back in the late 1990s, it wasn’t just a tech and telecom boom. It wasn’t just, if you wanna call it, a dot-com boom. We used to call it TMT. Remember, Rich? Technology, media, telecom. But the whole economy was booming. Nobody was talking about divergences and imbalances, and nobody was talking about a K-shaped economy back then. The consumer was really strong across the board. You can’t say that today.

It was broadly based strength in the economy, and the difference between now and then—I mean, think about it. Here we had tremendous growth in AI spending once again. It was double digits. We got the second quarter GDP number. But what was that GDP number in the second quarter? It was 1.5. I mean, as Billy Joel would say, “That’s all you get for your money?” You weren’t printing 1.5 GDP numbers in the late ‘90s. It was broadly based strength in aggregate demand that was running above the prevailing trend in aggregate supply. And you don’t have to be an economic rocket scientist to know that when you get the demand curve running above the supply curve, you’re gonna get inflationary pressures, and the Fed appropriately raised interest rates. Well, then we know what happened next with the economy.

But that’s one of the key differences, is that when you strip out the AI spend, the economy is actually very weak. You didn’t have this in the late ‘90s. Non-residential construction is running negative year on year. Not happening in the late ‘90s. The housing sector right now is contracting on a year-over-year basis. That was not happening back in the late ‘90s. It had broadly based strength. Ex-tech manufacturing was very strong during that period. It wasn’t just about technology back in the late ‘90s. Right now it’s just all about technology.

So I come at it from that perspective, that actually we only have a couple of prongs for the US economy right now. There’s more fragility beneath the system than meets the eye. But I’m not looking at one quarter, you know. I’m looking at Q4, Q1, Q2, how I think things are shaping up for Q3. So the run rate that I’m expecting to see, the four-quarter run rate on real GDP—and that’s a trend, that’s not noise—is gonna be less than 1.5%. Well, we didn’t have that in the late ‘90s, and that’s even with the AI boom. Without the AI boom, we probably would be in a recession. That’s the difference, is there’s too many other critical components of the economy that are really soft to lead me to believe that we’re gonna get a generalized inflation problem for the Fed to have to act on.

Matt: Billy Joel, I think also possibly referring to old economy stocks, did say, “Only the good die young.” Not sure. Sub commentary on Allentown might have been embedded in that statement.

Then what about in that drama—and Dave, you go first on this one—what about gold? What’s going on with the price of gold? Should gold be responding to the inflationary conditions you’re speaking to? Has it already responded? What role does gold serve in thinking about any of this?

David: I don’t think of gold as really... I mean, you could argue that it is over time an inflation hedge, you know, being a hard asset. But again, I look at gold in terms of, on one hand, what are the driving factors, and that’s more on a near-term basis as to why gold’s been undermined for a good part of the last several months in particular.

I mean, gold got stupid, and silver, back in January. It did look like a dot-com stock. And so there was lots of speculation, as we got to—what did we get to, Rich? Like 5,500 an ounce or something like that. It looked crazy. You just had to look at the chart to know it was crazy.

But what has undermined gold recently has been the fact that—and this is interesting—the run-up in Treasury yields has not been in inflation expectations. The TIPS break-evens haven’t moved. They’re actually not far off the Fed’s target. They’re like 2.2%. It’s all been driven by the term premium, by the real rate, which is related a lot to policy uncertainty. You can argue that it could be related to inflation uncertainty, but it’s been real interest rate driven. Well, the gold price has almost a perfectly inverse correlation with real interest rates. And you notice that gold’s done better the past number of days. Don’t get too excited, but that’s ‘cause real rates have come off their highs.

And then of course, you had a big flight into US dollars during this war with Iran. Talk about de-dollarization—well, that didn’t really happen in the past several months. There was a flight to US dollars for liquidity. Gold’s priced in US dollars. So it got hit by these two forces.

But ultimately, if you’re gonna put on a big picture hat, this is like the tenth mini bear market or correction in gold since it bottomed in 1999. And the question is, is it something permanent, or was this another blip? There’s been lots of blips. You just see what gold did when a lot of investors had margin calls to face. Gold did not rally after the Lehman collapse in 2008. It sold off, and then it rallied again.

The bigger picture is this, ‘cause you can’t take a look at gold without looking at it in the context of what happened from 1980 to 1999, when gold went from $850 to like $300. It was like a 60% two-decade bear market, and the question is, why? And it’s because the global central banks were dumping their gold reserves and buying Treasury bills. The share of bullion in the vaults of the central banks went from over 70% share in 1980, and by 1999 it got to 10%. But then the Washington Agreement was signed in 1999, where the global central banks put a moratorium on the sales of gold, and that’s when gold bottomed. It wasn’t just pure happenstance.

And then starting in 2010 is when the central bank buying program actually started. By that time, gold had already gone from, call it 250, 300 to $1,000 an ounce. And so what’s been happening every single year, and that’s why gold has been in a secular bull market, is that the principal buyers with deep pockets have been these central banks that continue to reallocate their share of reserves into gold.

The supply of gold is very stable. That’s not hard to predict. Most of the gold in the world has already been mined. So the supply of gold runs annually between 1 and 1.5% growth of production. The question always is, what’s the demand? And demand has consistently been between 2% and 3%. And it’s not because people are running out to Costco to buy those shiny gold coins, and it’s not because of some spectacular dowry season in India. The global central banks have been your best friend. That’s been your tailwind.

Now, the share of global reserves that’s in gold is about 25% to 30%. Remember, it got to the peak of 70%. And if that mean reverts—and remember mean reversion necessarily means that one extreme gets corrected by another extreme—and you draw the supply and demand curves, the demand being driven by the central banks. And the central banks are always at the poker table with the rest of us, especially with QE. They’re involved in the markets. In this case, we’re talking about gold.

And there’s no evidence, even with this downdraft we had in the past few months, which was mostly related to the dollar strength and real rates going up, the global central banks are still buying gold. So when all this settles out and the dollar is no longer making new highs and real rates are no longer making new highs, then those fundamental forces that in the past several years caused gold to be a terrific investment, I think is gonna reassert itself.

So once again, this is why you wanna pay attention to the economist, right? Not just ‘cause we’re a bunch of fun-loving people, well aware of the strategists in particular, but because we were trained to draw supply and demand curves as a nerdy... I’m not gonna get a whiteboard out, don’t worry. But for the economist, you have to get the shape of the curves right, and you have to get their direction right. And when I say the shape, measuring the elasticity, inelasticity, but the wonderful thing about supply and demand is at the intersection you get something which is something very important to Rich Bernstein—you get the price of anything, and that includes the price of gold.

So, you know, I know people have given up on gold ‘cause it’s been a pretty horrific year, but you know, I started in the business on October 19th, ‘87. I think Rich might have a few things to say about that, ‘cause I think you started at Merrill not too long after. But that was my first day as a street economist. The market was down more than 20% that day. Now was that the end of the bull market? We had a cyclical correction in 1990, ‘91 with the recession, but really you can actually just say maybe the bull market lasted another 13 years, a secondary bull market in equities.

So I find it very interesting that the stock market goes down today, you gotta buy the dips. No one ever says buy the price dips in bonds, ‘cause bonds are for losers. And no one says buy the dips in the gold price, ‘cause who wants to own gold? Gold and bonds just aren’t sexy.

However, I would say that people were just... You know, it’s amazing, you go back to January, I went to the gold conference in Vancouver. I was a speaker there, and they were like peacocks, the gold miners were like... And of course it was going parabolic, right? And I think I might have emailed Rich and said, “I think I’m back at a tech conference back in 1999.”

And so today everybody’s all morose ‘cause gold’s gone through its corrective phase. I actually think this is actually a really good buying opportunity, what’s happened in the past few months. And actually for people—it’s funny that people were talking to me about how they’re kicking themselves in the derriere. I speak a little bit of French, so that means... Rich used to say tush a lot, so—

Rich: Tush.

David: So there are people kicking themselves last year, “I didn’t get into gold. I didn’t get into gold.” And now that they have a better level to get into gold, “No, no, no, no, it’s in a bear market.” I’m saying, “No, no, no, no. Keep your eye on the supply and demand curves and the fundamental drivers.” And actually you can see in the charts, not that I’m a technical strategist, but it’s put in a nice basing formation. I think gold—my peak forecast has not changed, which is $6,000 an ounce. I just won’t give you the date, but I’ll give you the level.

Matt: We’ll take the level. And Rich, for you—I actually love this framing, I use this framing. You talk about gold in a portfolio as a spare tire.

Rich: Yes.

Matt: So give me how you’re thinking about gold now.

Rich: So let me add one thing to what Dave said. You know, about a year ago or so—you can always tell what sentiment is by the questions when you speak at a conference or I’m out visiting financial advisors or something. Whatever the questions are that people ask tells you a lot about sentiment. It’s a great sentiment indicator.

And about a year ago, out of nowhere, all of a sudden people started to ask me about silver. Nobody had asked me about silver probably for 15 years or something before. Now all of a sudden everybody’s asking me about silver, and silver is really just a high beta version of gold. So it says that people are like really bulled up. If gold’s no good, you want silver, then it says people are pretty bulled up. And we don’t trade gold. As you point out, we keep it as a spare tire, but that was clearly a warning sign to us that we should not add to our gold positions. When people are asking about silver, it’s usually a pretty bad sign.

So yeah, we don’t trade gold. As I was saying before, we tend to keep it in our portfolio because—and Dave alludes to this—it’s a pretty good hedge against uncertainty. And so we keep it in the portfolio as a spare tire. And the reason I use the analogy is, why do you carry a spare tire in the trunk of your car? Do they call it a trunk in Canada, Dave, or is it a boot?

David: I just don’t know what the French equivalent is, but yeah, it’s called... No, it’s not... I mean, in Europe it’s where they put the dead bodies, though, so.

Rich: Yeah. So in the derriere of your car, you keep your spare tire. And why do you do that? Because you can’t predict when you’re gonna get a flat tire. So we always have a spare tire on hand in our car, and it’s the same in a portfolio. You can’t predict uncertainty, right? The things that are uncertain by definition cannot be predicted, so we keep a little gold in the portfolio as a ballast against that unforeseen uncertainty.

And I think it works pretty well if you think of it that way. I think if you try to trade it, to Dave’s point before, you tend to be wrong-footed because it goes through these big moves and in some cases the moves can be very dramatic. And I’ll just say nobody’s asking me about silver anymore, so might be a good sign.

Matt: Okay. So one thing they might be asking about—and stick with me on this one, Rich, because it’s another place where there’s a sentiment indicator in here somewhere. Nobody likes to talk about international stocks. Nobody likes to talk about small caps. Nobody likes to think about these things. What are you seeing here?

Rich: So, Matt, I have to tell you, this is one of the craziest things I have ever seen, in that we’ve looked at data and we published this in a number of different ways throughout my career. But if you look at, say, the prior 15 or 18 years or so prior to 2001 or 2000—let’s say up to prior to the last five years—you would find that venture capital absolutely destroyed non-US stocks. Completely destroyed them. Wasn’t even on the same chart. You can’t even see non-US stocks. It looks like there’s not even a line there on the chart. And everybody, when we would publish that in the past or something similar—well, of course, venture capital is doing so well.

Okay. In the last five years, non-US stocks have outperformed venture capital, and all I hear is there’s something wrong with the data. Wait a minute. Everybody loved the data prior to this chart that we just put out. All of a sudden, the data’s no good. And there’s a million and five reasons why this index is no good anymore, and why it doesn’t show it and everything else.

My point simply is that something is changing in the secular backdrop of the financial markets. And what we are seeing in this AI blow-off, and people are using leverage on top of leverage on top of leverage to buy perpetual ETFs and all this kind of stuff, is the final blow-off phase—how long that lasts I don’t know—in this huge venture capital, AI, data center, technology-oriented trade that has gone on.

But meanwhile, behind the scenes, non-US stocks are outperforming venture capital. I mean, who knows that? Nobody knows that that is going on. It’s an incredible thing to see. Now that doesn’t mean that they’re outperforming US stocks, of course not, because US stocks are being driven by the narrow leadership, which is this AI and technology-type trade. But just in the backdrop here, something is beginning to change, and nobody wants to think about that.

And so when we started RBA—now RBA is owned by Janus Henderson, of course—but when we started RBA in 2009, 2010, we were wildly bullish on the United States. We thought one of the reasons we started RBA was we thought we were at the beginning of a major bull market in the United States. And we had virtually no emerging market exposure at all in our portfolios. We were dramatically underweight non-US developed. And everybody thought we were crazy because in 2009, ‘10, ‘11, ‘12, ‘13, if you wanted growth, whatever that was, you had to invest in emerging markets. And we said, “No, the opportunity set is actually better here in the United States.”

Well, here we are now 15, 16, 17 years later, and we have our biggest non-US overweight in the history of our firm right now. Right now. We think the opportunity set outside the United States is much better. Now everybody has known that they’re cheaper. You get cheaper stocks outside the United States. Everybody, I think, knows that they have considerably higher dividend yields outside the United States. But what people don’t realize is that the growth story is beginning to converge between US and non-US. It hasn’t converged, past tense, but it is converging.

And there’s a chart that we put in our last quarterly webinar, which people can watch online. We showed all the stocks around the world in the ACWI Index, the global index, that have projected long-term earnings growth rates of 25% or more, okay? Every single company around the world that right now has a projected earnings growth rate of 25% or more.

Two things. One, the chart looks like some weird calico of colors because what we did was we gave each region a different color. And the reason you have this calico of colors is that there are companies all around the world that are projected to grow earnings 25% or more. It’s not just a US event. All around the world, this is actually happening. There are about 200-odd companies, by the way, around the world that are projected to grow earnings 25% or more.

Here’s the real kicker. Only one of the Mag Seven is in that group. Only one Mag Seven company—one data center, hyperscaler, all this stuff—only one of them is in that group. So what it says is that there is growth all around the world. The story has been dividends, the story has been undervaluation, but you can’t go outside the United States for growth. That is terribly inaccurate right now. There are growth opportunities all around the world, it’s just that people are unwilling to look at them. And so we think we’re trying to take advantage of that.

Matt: Bonus points for calico. Great word. Dave, what about you? How do you see both US versus ex-US, getting away from the US mega cap concentration? How are you seeing that and interpreting it right now?

David: Well, you know, look, firstly, the US is not the only country with mega concentration. You can point to Korea and Taiwan as even being more concentrated.

Matt: Yeah. Absolutely.

David: So I mean, you’ve gotta be... You know, Asia is not a homogeneous group and actually neither are emerging markets. So the opportunities are better in other parts of the world.

The problem in the US market itself, and this is different than what happened in the late ‘90s—in the late ‘90s, the only sector that was really strongly correlated with technology was media and telecom. That’s what we called the TMT. But this AI situation is totally different. You look at the correlations across most of the sectors—utilities, financials, industrials. I mentioned Caterpillar before, it has become an AI derivative. The only two sectors in the S&P 500 that don’t have a very high correlation to the AI trade is healthcare and consumer staples.

So that’s something that we have to consider when we talk about AI concentration in the United States and we talk about, say there’s 40%. It’s actually bigger than that when you look at other sectors that are tied right to it, and that doesn’t exist in other countries in the world. So I’m only saying that because I believe in... I don’t believe diversification is a dirty 15-letter word. I know a lot of people do. Am I right on that? I’m talking Canadian English and now I got Canadian math. I’m pretty sure I’m right on that, but I’m wearing glasses for a reason.

Rich: I think you are actually. Might be 14, but—

David: You know, we did meetings at Merrill. Richard always said, when I talked, he always said, “I’m gonna take the under on that.”

So in any event, I think that... Look, and I know Rich agrees with this, ‘cause we respect valuations, and they say valuations aren’t a timing tool, and they’re not. But to be able to say that by the time valuations matter—they only matter until they matter—by the time they matter, you had your head sliced off. They were saying that back in the opening months of 2000 as well. They only matter when they matter. But valuations at any point in the investing spectrum tell you whether you’re investing with the wind at your back or the wind in your face.

I think the US is in a huge bubble. And actually the only banker that has been honest about it was Jamie Dimon, ‘cause back on October 14th, he actually said the US stock market is in a classic bubble. And he said at the same time it does not mean that it can’t go up another 20%. And we’re up about 17% since he said that.

So the only thing about a bubble is just to know that yes, you can make money in a bubble ‘cause a bubble can last a couple of years. It can last several months. But really, you’re in extra innings in the ball game. You’re not in the eighth or ninth inning. You’re in extra innings. And you have to think about that, that you’re really in the late stages, and then what bubbles do is bubbles burst.

So people don’t like it when I talk about bubbles. When I talked about the housing bubble at Merrill, they didn’t like that either, but here we have Jamie Dimon talking openly about a bubble, and I would respect what he says.

Now, Jeremy Grantham famously said in the book that he just published not too long ago that he has defined a bubble arithmetically as anything that is more than a two-standard deviation event vis-à-vis the historical norm. And the valuation metric that I use the most is the Shiller, is the CAPE multiple, the smoothed multiple, and it goes back to 1900. So you have a really rich—hi, Rich—you have a very rich database to work with. We just, by the way, crossed over 41. The CAPE multiple is the highest it’s been since 2000. And outside of the tech bubble in the late ‘90s—again, nobody admitted back then it was in a bubble. Rich was on top of that, by the way, ‘cause I had just joined Merrill at that point. Then you go back historically, this is actually like a three sigma event.

But people are greedy, you know? But the bottom line is that fear and greed, sentiment, is a big part of this game. You know, Bob Farrell, who Rich worked closely with and is a mentor of both of us, he actually was the pioneer in introducing sentiment into his technical strategy work back as early as the 1950s. So we have a wildly sentiment-driven market. It’s a sentiment that’s tough to break. Talk about resolve.

But the US market is the only one where the CAPE has only been this expensive in the past 1.5% of the time. Think about that. We’re in insanity land. Now there’s no market in the world that you say is quote cheap. It’s all a relative game. In Canada, for example, 25% of the time in the past was the market this expensive. Not 1.5, 25%. But you can go to other parts of the world where it’s 50, 60%. I mean, if you’re willing to go into China or go into Brazil or Mexico, or you’re willing to go into even Japan, for example. Japan is not an expensive market at all. Relatively speaking, one of the most attractive in the world. I would say India. A lot of Southeast Asia, by the way, that doesn’t have a high AI representation is actually a very good place to be.

You can actually go and buy an ETF that doesn’t include or can hedge against the exposure you have in Korea and Taiwan. Those are interesting areas because if you don’t wanna have cash, and I can understand that, but you wanna be hedged against this bubble bursting at some point, unless you think there’s not a bubble. But then again, if you wanna take on Jeremy Grantham, be my guest. You wanna take on Jamie Dimon, be my guest.

What did Warren Buffett just recently call this, just about a few weeks ago? He said that the stock market is just basically resembling now a gambling society, where it’s tough to find value. Some people say these are all dinosaurs, and other people will respect their collective wisdom and experience, and I’m one of those that do.

Matt: Yeah.

David: So I would say that Rich is right. A great way to still be in the equity market and not be hurt badly when the AI trade turns around is to be in most other parts of the world. We already saw with Korea and Taiwan what can happen when things go a little hairy with the AI trade. But there’s other parts of Asia, and there’s parts of Europe too, and Latin America that you can certainly look at. ‘Cause the equity market is a global market.

I agree with Rich. Everybody’s got a home bias. Everybody’s got a home bias. But it’s a global stock market. The US does not own the global stock market. Nobody owns the global stock market, and they’re all somewhat correlated. But when you’re at this stage of the cycle, and you’re ready to acknowledge that this is a bubble-like atmosphere—and it does fit. In fact, Rich wrote a seminal report on the definition of a bubble back when I was there in the 2000s, and everything from leverage to sentiment to market positioning to valuations, it all smacks of a bubble. And bubbles don’t just roll over. Bubbles burst. The way you protect yourself is you internationally diversify. I 100% agree with him.

Rich: Yeah. So Matt, I was just gonna say, I think people get too caught up in the word bubble, right? Like, is it a bubble or is it not? And if you say it’s not a bubble, you dismiss everything that Dave just said, right? And I don’t think that’s the right way to approach this.

I think it’s very hard to argue right now that we’re not in some kind of hyper-speculative period, right? When people can’t tell the difference between the financial markets and the prediction markets, it’s clear that something has gone wrong, right? The financial markets are here for capital formation, to build plant and equipment and expand employment and all these kind of things. The prediction markets are here to make a bet. And as much as they try to tell people it is not betting, it’s betting, right? There’s no economic value added that occurs because you decide that the Knicks are gonna win the championship, right? That’s a bet. Or whether the president is gonna say a certain term in his speech. It’s a bet. And there’s no economic value that comes out of that. So when people can’t tell the difference between the two markets, it’s very clear we’re in some kind of hyper-speculative environment.

The second thing I would point out is another sign of this kind of bubble that Dave was referring to—again, maybe it’s not a bubble, maybe it’s a super, super speculative period—is that people are confusing short term and long term. That’s very typical of a bubble. You get increased turnover. You get people’s time horizon shortened. And that’s happening, where everybody says AI is a great long-term story. If it’s a great long-term story, why are people trading the Mag Seven’s quarterly reports? Why would we even care about the Mag Seven’s quarterly reports if this was a long-term story? It’s not a long-term story in anybody’s mind. It has become a speculative story that they need to trade, and so you’re seeing that.

And the third thing I would say, very much agreeing with Dave on some of this—although I have to admit I did not realize diversification had 15 letters, and I did check, and he’s absolutely right. It has 15 letters. The other thing I would point out is that during periods of like a bubble or hyper-speculative activity, people don’t want to be diversified. Diversification becomes a lead weight on performance, and they want nothing to do with it. And we see that in our discussions with our clients and our investors, that they think diversification’s silly. You see it in the data that comes from the big wire houses, and you can look at aggregate holdings. You can look at cash positions. You can look at betas of portfolios. People are not diversified. They think diversification is actually silly right now.

And these are, you know—if you just step back for a second, we all know that there are certain building blocks to building wealth over the long term, and they’re pretty simple building blocks. And one of them is, if we just say we have a well-diversified portfolio and we hold it for the long term, people do pretty well. Well, is that what people are doing right now? Are they holding a well-diversified portfolio for the long term? Absolutely not. They are not doing that. So what’s funny is our portfolios right now are the polar opposite. So it’s kind of interesting to see how our portfolios change as well relative to the bubble speculative activity. Again, I’m trying not to get caught up in this word bubble because people tend to discount whatever you say if you use the word bubble.

Matt: I always go back to the—I believe it’s a Brian Portnoy-ism—”Diversification means always having something you have to apologize for.”

Rich: Absolutely, 100%.

Matt: Not a lot of that going on right now.

Rich: That’s totally correct.

Matt: Okay, we’re playing a bonus game here as we wind down on time. WWBFD: what would Bob Farrell do? I’m curious. Through his eyes, David, what do you think Bob Farrell would be saying about this market where we are right now?

David: Well, I guess what you’d be asking me is which of the 10 rules apply right now.

Matt: And I would... We already counted to 15. I know we can count to 10.

David: No, there’s 10 rules I got there. You can see I got from 15 to 10. So Bob Farrell’s 10 market rules to remember. And all of them actually apply. But the one that applies to me the most is I think it’s rule number nine. When all the forecasts and experts agree, something else is gonna happen.

And I just find that everybody is all in all at the same time. I mentioned some of the stuff that Rich would look at back in the Merrill days. I mentioned market positioning, for example. I mean, you look at the net speculative long position in the hedge funds, and you look at the fact that mutual fund portfolio managers are down to 1% cash. 1% cash. And sentiment, market-based sentiment, is like 78%. It’s pretty well at its highest level ever.

It’s unbelievable, when even though consumer confidence, whatever survey you look at, is so weak. But when they ask the question of where do you see the stock market going, it’s in the top 5% readings of all time. It’s like, no matter what your view is on the economy, everybody is bulled up on the stock market.

You know, when you go to the Fed flow of funds data, it’s remarkable. A record 73% of the household asset mix is in equities. Only 7% are in bonds, ‘cause of course bonds are for losers. You’re not gonna go to your neighbor’s cocktail party and tell people that you just loaded up on two-year treasury notes because you wanna make friends. You know, they’re gonna walk away from you. And then the rest of it is in cash. You’ve never had this phenomenon before.

So everybody’s on the same side at the same time. The view is this: that after not having a recession in 2022, 2023, people think the US economy is now recession-proof, that the business cycle has been repealed. And people believe that the market cycle has been repealed, and that is the prevailing... And how do you know that? Because our old firm, well, now it’s Bank of America—it’s unbelievable that 2% share of global portfolio managers believe that there will be an economic downturn in the next year. And you know, when you look historically, in any given moment in time, you draw the horizontal line, there’s always an average 15% chance of recession. Two percent. It’s never been that low.

So I think that there’s a dangerous psychology and a very lopsided, momentum-based rally that’s ongoing, and I don’t know how long it’s gonna last. I’m not saying that I’m not in the equity market. 50% of our model portfolio is in equities. I’m not shorting any stocks. I don’t have cash. It is diversified. But I’m running the beta very low and the Sharpe ratio high. So I’m risk adjusting whatever returns I expect to see. So, long-winded answer to say rule number nine: when everybody’s on the same side of the trade, it’s time to take some chips off the table.

Matt: Rich, you had some experience with Bob too. How do you think he would interpret this?

Rich: I would say, yeah, Bob and his colleague Dick McCabe, who was the chief strategist at Merrill for a long time—Dick was an absolutely wonderful person who, when he retired from Merrill Lynch, became an EMT, and was an EMT until he passed away, which was incredible. I mean, that’s just a marvelous, marvelous individual.

My guess is that the two of them would be telling people to look at charts that are improving outside the tech sector, right? That’s clearly happening. There are better charts, and there have to be some good charts somewhere. My guess is they would be scouring, looking for charts that are improving outside the tech sector. That’s my guess. I can almost hear Dick saying that. But that’d be my guess, you know. A little psychobabble of course, but that’s my guess.

Matt: What is it without a little psychobabble?

David: But I would say, some of those sectors, you have to be careful, are still correlated with the AI trade.

Rich: Well, Bob didn’t ask us that. Matt just said, “What would Bob be saying?” So I’m just telling you what Bob would be saying. I’m not saying whether necessarily it was good or bad. I’m just telling you what Bob would be saying.

David: That would be Bob and Dick on one side and me and you on the other.

Rich: Oh, yeah. Probably. Probably.

David: Charts versus the fundamentals.

Rich: Right.

Matt: We’re gonna do a tag team episode next time. I’m gonna get a bunch of faux tag teams. We’ll get that Jamie Dimon, Bob Shiller tag team we were talking about before. We’ll get this tag team.

David: Let me just say one thing about the history of me and Rich. We were at the airport, I forget where. I think it might’ve been Atlanta, and we were waiting for a flight, and it was delayed, we had a beer. And we’re watching TV. Do you remember this? And CNBC was on and they had Robert Toll from Toll Brothers, and this is back in like 2006 or 2007, and he was being interviewed on CNBC and he said, “The housing industry is no longer cyclical.” And we looked at each other and just burst out laughing.

Rich: Right. So there’s lots of stories we could tell. If anybody that’s watching this wants to have a beer with Dave and I, we’ll take you down memory lane and give you some real toe-curling stories of things that went on inside our firm and outside our firm.

Matt: All right, I’m pitching the after hours episode then. We’ll loop that up somewhere behind the scenes. Maybe that’ll be an end of year treat or something like that. Dave, people wanna find you, where can we send them to bug you on the internet?

David: Well, you can just, if you Google Rosenberg Research, it’ll take you right onto the website. And you do information@rosenbergresearch.com, it’ll do the same thing. And if you wanna sign on for a free trial—free, my favorite four-letter word that starts with F. We said no walk-offs, but I’m saying free. Free trial. So, you know, we pride ourselves in everything that Rich and I did together, right? I sort of rolled Rich. I adopted him into my mindset. So it’s all about how to connect the dots between the macro and the markets. And we span the globe. So feel free to come on, sign up for the trial, and kick my tires.

Matt: Take that trial, kick those tires. Note the word count. We’ll fit 15 letters down to 10. Now we’re down to four letters in words. This is just incredible, the marketing refinement that you have here. Rich, same question. People wanna bug you, where should we send them?

Rich: So the RBA website still exists. That’s rbadvisors.com. But I would encourage everybody to check out the Janus Henderson website, where not only can you see our work at RBA and the work that Mike Kantrowitz and I put out, but also all of our new colleagues at Janus Henderson. And there’s lots of stuff there on topics that, quite honestly, Mike and I know nothing about. So you get a much broader set of research than just the two of us.

Matt: Well, fantastic. I wanna thank both of you so much for the time today. This is really special getting you together. You’re watching Excess Returns. Check us out on the Substack. We’ll have the transcript, we’ll have an article on this episode, and a bunch more good stuff coming out of this. Make sure you subscribe to the Substack if you’re not already. In the meantime, wherever you’re watching or listening, thanks, like, comment, all the things below. We are out.