Bill Bernstein: Bernanke Has Been Right


William Bernstein, the former neurologist turned money manager and author, is about as ardent a passive investor as you’ll ever find. He’s also one of the more piquant and colorful commentators on the world of investing, which makes any conversation with him as interesting as it is fun.

When Managing Editor Olivier Ludwig visited with Bernstein recently on the telephone, Bernstein talked about the need for more stimulus as the U.S. economy continues to slowly recover from the worst market meltdown since the Great Depression, and marveled that Fed Chairman Ben Bernanke has had it right all along.


Ludwig: It seems like the ETF industry continues to move forward. And depending on who you talk to, it’s got a long way to go. Do you have an opinion about that?

Bernstein: I just don’t see what all the hullabaloo is about. There’s not an awful lot of difference between ETFs and open-end funds. The more rational you are, the more of a buy-and-hold investor you are, the less difference there is. But there are certain disadvantages to ETFs, particularly when the world is in a bad state. But that’s a relatively small thing.

Ludwig: What weaknesses are you alluding to?

Bernstein: Liquidity. Look at what happened to the spreads on some of ETFs during the crisis. I want to be able to transact at the NAV at the end of the day. And in a bad state of the world, that’s worth something.

Ludwig: Understood. But what about “the race to the bottom,” as I heard somebody describe it recently, in terms of expense ratios? It seems that ETFs are trying to get their foot in the door through low pricing, no?

Bernstein: Yes, I think so. But at the end of the day, you’re talking about a few basis points here and there. And whatever basis points you make on the expense ratio, you lose them on the spread, unless you hold them forever. That’s deck chairs on the Titanic—a really small consideration.

Ludwig: That’s a great image! So, what’s your overall view of things? As you take measure of what happens after the November election, is the political class going to get it together or what?

Bernstein: The good news is that we may go off the fiscal cliff, which I don’t see as being a terrible thing. Think about what happens if there is absolute gridlock and nothing passes. Well, the Bush tax cuts go away, which actually, in my mind, might be a good thing—more money for schools; less money for billionaires. And spending might go down a little bit. That’ll close the fiscal gap. We may see a bit of a recession because of that.

But at the end of the day, that’s better than the bond market waking up one day and deciding that no one in the world wants to buy Treasurys.



Ludwig: So you see that as an intermediate step of crisis, as opposed to the worst-case scenario, that people love to talk about, namely the day when the bond market decides, unilaterally, that, forget about it, we’re not showing up to the next auction, and yields jump to some astronomical level and everyone is freaking out. That’s off the table?

Bernstein: I don’t think it’s off the table, but I think it’s less likely than it was. The scenario that everyone worries about does have a silver lining. There are good economic reasons to worry about paralysis. I think, in the short term we need stimulus, and in the long term we need fiscal conservatism. But getting at least one of them is better than getting nothing. When I say “nothing,” I mean having both a crisis and a recession. In other words, there are two bad things that can happen. And if there is absolute paralysis, we know for sure only one of those bad things is going to happen. The other bad thing probably won’t.

Ludwig: Talking about the need for stimulus might be an answer to this question, but people seem to disagree quite a lot about the macroeconomy these days. For example, at the indexing conference we put on in Philadelphia a couple months ago, Ed Yardeni was saying, “It’s just too bad that the Fed doesn’t understand what an extended vacation means. If they would just get out of the way and let the economy do what it’s going to do, it’ll do just fine, thank you very much.” And meanwhile, you have the Atlantic Monthly putting Bernanke on the cover with the title “The Hero.” Between those two extremes, I’m wondering, What’s a reasonable person to think?

Bernstein: The Great Depression should have taught everybody a lesson. The onus certainly is on the person who is in favor of austerity, because that is what Hoover did, and also what Roosevelt did in 1937 when he decided that it was time to balance the budget. So I think we haven’t had enough stimulus. Helicopter Ben has flooded the world with money, and we haven’t had inflation. Isn’t that amazing? Both he and his Princeton colleague Paul Krugman predicted that, and they were both right.

Ludwig: And what is it that has made Bernanke right?

Bernstein: PQ = MV:price x quantity = money supply x the velocity of money. So you can double the money supply as long as the velocity has been cut in half, which is approximately what happened.

Ludwig: Which is telling us what—that the financial sector is still wounded, and it’s not really moving that money around?

Bernstein: Well, that’s one way of looking at it, but I’m more convinced by the opposite case, which is that the reason rates are so low is simply because business demand is so low. It’s not so much what the Fed is doing, although the Fed is doing its part. But it’s more important that businesses aren’t demanding capital.



Ludwig: Right, although they say that that bond issuance has replaced bank loans, which would suggest that there is demand, but it’s being met through a different mechanism. Is that hogwash?

Bernstein: More and more companies are accessing the capital markets directly, instead of through bank intermediaries; that’s been a long-term trend over at least the past century.

Ludwig: So this is just a part of the megatrend that’s being sort of mischaracterized, to some extent?

Bernstein: I think so.

Ludwig: Now, as far as the energy picture goes, it seems to me that every time the economy has seemed to pick itself up, oil prices climb to over $100. And then people talk about oil prices having a deleterious effect on growth. Then comes another outbreak of the eurozone problems. And then oil goes below $100, and everyone talks about how that’s good for the economy. And so it goes—energy seems to be like the canary in the coal mine. Do you have any particular thoughts about the longer-term energy picture?

Bernstein: Yes. We’ve been running out of oil since Colonel Drake discovered it in Western Pennsylvania 150 years ago. This is Economics 101:If the price of oil stays this high for this long, we will find new sources of it. Oil is a commodity. And in the very long term, the real economy grows at 2 percent per capita per year in developed countries. That’s just another way of saying that the economy grows 2 percent faster than the prices of commodities. So in well-functioning, growing, industrial and postindustrial economies, commodities get relatively cheaper over time. And that’s exactly what’s happened. Look at what’s happened over the past, say, 50 years or 100 years—the real price of oil has gone down.

Ludwig: In inflation-adjusted terms?

Bernstein: Yes. And it’s high right now. But if it stays this high, three things happen:First, oil companies will find more oil. Second, there comes a point—and maybe it’s not $100 a barrel, maybe it’s at $200 or $300 a barrel—where all sorts of alternatives become very economical. And lastly, people will conserve. You know, economics is a wonderful thing.

Ludwig: So this is not something that preoccupies you in any extreme way?

Bernstein: No.

Ludwig: What do you make of the argument about China being underrepresented in a lot of the indexes in this day and age? Do you buy that? I can hear Burt Malkiel talking about a big, broad indexing tool like (VT - News) from Vanguard, which is what, 98 percent of the world’s stock markets? But investors should add a little bit of China on the side, the way Malkiel sees it.

Bernstein: Well, I’ll repeat what I’ve said to you before, which is that a country that doesn’t protect its children from lead-contaminated toys is not likely to protect the interests of minority shareholders. I think Burt is a bright guy, and I respect his enthusiasm about China , and maybe he’s right. But when you look, for example, at measured stock dilution in China over the past 10 years, it’s been astronomically high. So yes, its economy and aggregate corporate profits may be growing at 10 percent per year, but if the Chinese are diluting the stock pool by 15 or 20 or 30 percent per year, you don’t want to be owning those shares.



Ludwig: Any other emerging market countries that loom largely in your mind?

Bernstein: I don’t play that game. I tend to look at emerging markets as one great big asset class. I don’t try and pick countries because I don’t think it can be done. I don’t think the single-country vehicles are very good. I’d rather go with a well-diversified fund with low turnover, low expenses, and some value and small-cap exposure in that part of the investing world and be done with it.

When people ask me what I think of emerging markets equity, my standard response is that the wonderful thing about it is that, from time to time, it gets very cheap.

Ludwig: Yes, you’ve told me that before. And are we on the cusp of that again? It seems like it’s just leading the way down here, as this whole eurozone thing takes center stage again.

Bernstein: Could happen. If you wait long enough, the market eventually comes to you.

Ludwig: And what about the state of passive management? You are as pure a passive investor as one would find, I gather.

Bernstein: The debate between active and passive management is like the debate between astrology and astronomy. Take the case, again, of emerging markets:If you’re going to have an edge somewhere as an active investor, it ought to be in emerging markets. Well, there is no edge in emerging markets; the passive funds, particularly the value and small-loaded products from Dimensional Fund Advisors, have done spectacularly well.

Ludwig: As far as the overall move toward passive, which has been proceeding, perhaps, at a snail’s pace, do you see that continuing, or do you see very hard limits at a certain percentage?

Bernstein: In general, the learning curve is shallower than the birth rate—which is just a fancy, statistical way of saying there’s a sucker born every minute. There will always be people who fall for active management. Where does indexing stop, 65 percent, 80 percent, 95 percent? I have no idea.

Ludwig: What do you make of the whole view that, at the end of the day, the market needs active investors for price discovery purposes?

Bernstein: Of course it does. There could come a point at which there will be so many indexers that the active managers will be the only ones making money. Or rather, not that that will happen, but that markets could become very unstable. Still, we’ll never get there.

Someone from Texas once asked me how many participants it took to make a market efficient, and the first thing that popped into my head was:“Two dentists having lunch together in Lubbock.”


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