Way back in the misty past — say, 2006 — practically all investments looked enticing, and the hard part was choosing. Today’s situation is the opposite. Stocks are worryingly high, bonds give you virtually nothing, and most global economies are troubled. Yet the problem is the same: You have to choose, because staying in cash guarantees losing out to inflation. How to do it?
To answer that question, we recently asked five top-tier investing authorities for their best ideas — and they delivered. Rob Arnott is the chairman and CEO of Research Affiliates, which has created strategies used to manage some $156 billion globally. Barbara Reinhard is Credit Suisse’s chief investment officer for Private Banking Americas. Thomas Lee is the chief U.S. equity strategist at J.P. Morgan. Barry Ritholtz is the chairman and CIO of Ritholtz Wealth Management. And Kimball Brooker is a portfolio manager for the $44 billion First Eagle Global and $14 billion First Eagle Overseas funds at First Eagle Investment Management. Here are edited excerpts of their conversation with Fortune’s Geoff Colvin:
The market’s had a tremendous run-up in 2013. Let’s start with a simple question. At recent levels, are you a buyer of U.S. equities overall? Rob?
Arnott: No.
Why not?
Arnott: How many people here think that this bull market, wonderful as it is, is built on a foundation of robust and impressive macroeconomic growth and policy choices that are laying a foundation for impressive growth in the years that lie ahead? And how many think that it’s [built on the Federal Reserve’s] printing press? I prefer to play in markets that are priced attractively, priced to offer strong, long-term returns, not ones that are expensive.
Tom, U.S. equities are your focus. What do you think?
Lee: I would say when bull markets begin, it’s rarely recognized that conditions are in place to support continued rising markets. Almost every institutional client I speak to today is very uncomfortable with either their long positions or the idea that markets can continue to rise. So, as a consequence, I think it actually makes sense that the market is still viable here.
And the rationale being?
Lee: Well, I think it’s increasingly going to depend on a delivery of better economic results. The economy does have to strengthen, and we have to see earnings growth re-accelerate. It’s going to depend on true pent-up demand — that housing and autos, along with construction and capital spending, pick up. And that’s something that we believe is going to happen.
Barry, how do you like that argument?
Ritholtz: I find myself somewhat between Rob and Tom. The reality is that from the nadir of the collapse, earnings have risen nearly 150%. That’s a huge snap-back from admittedly really low levels, but, then again, the market was down 57% at those levels, so this snap-back is not wholly unexpected.
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Are we a little long in the tooth? Has this cyclical move been longer than median? Are we above average valuation? Yes. We came into the year overweight U.S. equities. We’re now equal weight U.S. equities. But we’ve found value in emerging markets and in Europe, which started out the year being underweight and are now equal weight. I think investors are being rewarded for paying attention to valuation.
Barbara, you are a big-picture strategist. How do you weigh U.S. equities against all the other options out there?
Reinhard: In our mind, the thing that’s important is that U.S. economic growth next year is going to have less of a fiscal impediment. So growth in 2014 is likely to be about 2.6% for the U.S. That’s almost one full percentage point better than 2013. The fundamental change in the margin that we see is that Europe is pulling out of a recession. It’s not going to be a robust recovery, but we do see growth swinging from -0.4% in 2013 up to about 1.3%. It’s sluggish, but it’s sluggish enough, and inflation is low enough, that central banks can stay very committed to their easy accommodative policy. We think European equities are where you want to be next year.
Kimball, global value is what you’re looking for. Barbara is talking about bargains in Europe. Where do you see bargains?
Brooker: Well, it’s company by company, and we are still finding values in the U.S. and in Europe. The things that are on our minds with respect to the broader markets are, one, the fact that the rally in equities — and it’s been global and pretty synchronous across the developed world — hasn’t come with commensurate earnings growth. I think we’re a little ahead of ourselves broadly.
The other issue on our minds is profit margins. Profit margins, particularly in the U.S., but in the emerging world and surprisingly in Europe as well, are at elevated levels. And I think when you talk about broad market valuations, you have to sort of ask yourself whether or not these margin levels are sustainable or whether they revert to more historical levels, which would be lower.
Reinhard: But profit margins are a very important key to this market, and profit margins are a direct result of labor costs as well. Profit margins can stay at elevated levels because labor costs are not infringing on margins just yet. So in our opinion, margins can stay far higher than probably what most investors expect.
Tom, for investors who want to invest specifically in the U.S. markets, where would you advise putting money now?
Lee: I think one of the best opportunities in the stock market today is large-cap technology because what you’re getting there is a group that’s essentially been orphaned. I think it’s on a relative P/E the cheapest in more than 35 years. If you look at what Wall Street has “buys” on, it’s the least-liked sector today.
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But what you’re picking up is top-line growth that’s double U.S. GDP, free cash yield of over 10%, and you’ve got a free call option if, in fact, technology spending is bottoming. Technology spending has been terrible for seven years, and we think we’re at the end of that cycle. And if it’s true, we’re going to get double-digit growth in large-cap tech, and this is a group that’s going to re-rate from, you know, 11 to 12 times [earnings] toward 15, which is a huge move.
So we’re looking at Microsoft (MSFT), Intel (INTC), Cisco (CSCO), HP (HPQ), IBM (IBM).
Lee: Yes, all of the above.
Reinhard: And you know, [capital expenditures are] a big part of that as well. Credit Suisse did a survey of 135 corporate clients in the U.S. and in Europe, and we found that capex momentum in Europe was really coming off the bottom, and capex could be a very big play that actually is a very big underpinning for growth for sectors such as technology for next year.
Lee: Yeah. And in the U.S., about 50% of capex is technology spend.
Ritholtz: You know, we have a technology exposure, but we really had to wrestle with a way to do it that wasn’t just five stocks. If you look at the typical index or mutual fund, it ends up being Apple (AAPL), Google (GOOG), Microsoft (MSFT). But there are actually equal-cap holdings. One is an exchange-traded fund called the Guggenheim S&P 500 Equal Weight Technology, ticker RYT (RYT), which is a good way to get exposure to that space. But if you really want to find the sector that is disliked — and I’m one of the biggest critics of the individual components in this — but if you look at the Financial Select Sector exchange-traded fund, the ticker is XLF (XLF), it’s still 50% off its pre-crash highs. It’s pretty clear the government’s not going to let these companies fall behind, and their earnings capacity is quite astounding.
Right. So we’re looking at Bank of America (BAC), J.P. Morgan Chase (JPM) —
Ritholtz: Wells Fargo (WFC), Citi (C), Goldman (GS), Morgan Stanley (MS) — go through the list. MetLife (MET) is in that group. You’ll have the top 10 holdings in XLF. Name-brand companies with tremendous earnings capacity.
Right. Rob, we’re talking here about where to find the best returns. But in the big picture, what return should investors realistically expect to get for the next five, 10 years?
Arnott: Well, I think one of the biggest problems we have today is an expectations gap. When you have low yields, you’re going to have lower future returns. Simple fact. When you have slower growth in the labor force, you’re going to have slower GDP growth. People talk about 3% GDP growth as if that’s normal. What’s our 40-year growth? It’s 2.1%.
People think that it’s a horrible thing to suggest lower returns. No, it’s not. If you’re expecting lower returns, you’re simply going to save more aggressively, spend more cautiously, work a couple years longer. Is that a disaster? Not compared with saving too little, spending too much, retiring too early, and running out of money halfway through your retirement.
We haven’t talked at all yet about emerging markets. Big picture: bargains? Overpriced?
Brooker: You know, the emerging markets writ large have been a very popular place to invest, and I think that some people confuse some very attractive macroeconomic characteristics with potential returns on investments. And they’re often unrelated.
Arnott: That actually brings up, I think, a really important point, and that is, when we invest, often we use index funds. Often those index funds are capitalization weighted. The more expensive the company is, the more weight it gets. And in emerging economies, that is catastrophically flawed. So looking at the United States, the S&P 500 (SPX) recently traded at 25 times its 10-year smoothed earnings — meaning its “Shiller P/E ratio” is at 25. Well, that’s pretty darned expensive. The MSCI Emerging Markets index Shiller P/E ratio is 14 times 10-year earnings.
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But in a fundamental index in emerging markets — weighting emerging-markets companies according to the size of their business — the Shiller P/E ratio is 9. That index has a 4% yield and better growth than the U.S. as far as the eye can see. That’s a reasonable opportunity. And fundamentally weighted bonds in emerging markets have a 4% yield spread. And instead of being rated double-A, like sovereign debt in the developed world, it’s single-A. Okay, one tick down for 4% more yield.
Tom, there are a lot of investors who are looking for yield and having a hard time finding it. What would you tell them?
Lee: I think it’s a tough proposition to be buying U.S. stocks for yields. Part of the reason is high dividend-payer stocks, those with above-market yields today, trade at around 19 times earnings, with earnings growth that’s a touch slower than the S&P 500 overall. So you’re paying a premium to get slower growth. I think you’re taking a lot of risk. It might be better to search for total return. In other words, this whole idea of finding bond proxies in the stock market, which has been a great strategy since ’09, I think, is about to become a losing strategy.
Reinhard: But there are still opportunities in the fixed-income markets as well. There is an opportunity in the U.S. with non-agency residential mortgage-backed securities, or RMBS. You have to buy them through some type of a managed-fund structure — that’s the best way to do it. But the play on the continuing recovery in the U.S. housing market, even if home prices — which were on pace to be up about 10% in 2013 — even if that slows, you can still get total returns of mid to high single digits on RMBS, non-agency prime jumbo borrowers. That’s a very attractive total return, and you’re taking very little interest rate risk, and you’re also taking on very little credit risk.
Ritholtz: The other place where people should be looking for yields that has really gotten a bad rep is in munis. If you actually take a high-credit individual muni, you’re getting tax-free 3%, 3.5%, 4%. That’s not unattractive compared to 2.7% on a Treasury —
Arnott: Or zero at the bank.
Reinhard: And you’ve seen a big repair in state and local balance sheets that has been very much unheralded by this market. Municipal bonds are a very good way to diversify higher beta or equity holdings.
Let’s talk about the outlook for inflation. What are you expecting?
Ritholtz: We’ve been hearing currency debasement, imminent inflation, since the first quantitative easing began in ’09, and now we’re four, almost five years later. I think everybody’s looking at QE, and what you really need to look at is employment. As long as there is seven-plus-percent unemployment and a much larger subset of underemployment, the velocity of money that the Fed is putting out there isn’t gaining traction. You don’t have too many dollars chasing too few goods. So inflation for now seems to be fairly subdued. That doesn’t mean it’s not out there somewhere. It’s just way off in the horizon.
Rob, when do we have to worry about inflation?
Arnott: The thing about inflation is that it doesn’t pre-announce. It arrives unannounced. And when it arrives, it’s too late to put your inflation hedges in place. So my view on inflation is actually very simple: Could happen, might not happen. I think it will happen. I think the prodigious money printing all over the developed world sows seeds for a major acceleration in inflation.
Tom, how do you think about this?
Lee: A stable inflation or potentially rising inflationary environment generally favors equities as a real return vehicle because of both earnings growth and nominal — basically a linkage to nominal GDP growth. I think the prescription I’d offer someone is to just stick with quality. You know, sticking with high quality at a price, whether it’s in municipal assets or in fixed income. I’d probably strongly urge anyone looking at equities to stick with high quality. And the reality is, I think this may sound biased, but I think when you think about where the blue-chip businesses are, it really is U.S. large-cap.
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Barbara, your take on inflation?
Reinhard: At Credit Suisse, we invest on behalf of individuals, so maintaining your purchasing power and getting a real return is of critical importance. In terms of an inflation hedge, equities are an inflation hedge up to a point. So a little bit of pricing power isn’t necessarily a bad thing. Once you start getting over 4% or 5% inflation, that’s when you start to see the kind of crushing effects of multiples. But that’s why we allocate across a number of different asset classes, to maintain that long-term purchasing power.
Let’s talk about some specific ideas. Kimball, what do you like these days?
Brooker: I agree with Tom on large-cap tech companies. And a number of them have found their way into our portfolio. But one I would highlight would be Oracle (ORCL), the software company. Its main business is providing software that helps manage databases, which are ubiquitous. I mean, if you make a phone call, you’re going to touch a number of different databases. Very entrenched business, high level of recurring revenue. Very healthy balance sheet. High level of inside ownership, and available at single-digit multiple of operating income. Management has bought back quite a bit of stock. They pay a dividend now.
Barry, who do you like?
Ritholtz: I mentioned XLF previously. We try to steer people to ETFs broadly. We like not having single-stock risk. If you want to look at emerging markets and you want a dividend index, DVYE (DVYE), iShares Emerging Markets Dividend, is one we like. Also VAW (VAW), the Vanguard Materials ETF, and IEO (IEO), which is the iShares US Oil & Gas Exploration & Production. All of these have been doing pretty well. They’re fairly low cost. If you want to look at Europe, another Vanguard holding is VGK (VGK), Vanguard FTSE Europe.
Rob, what are you enthusiastic about?
Arnott: I’m also a believer in diversification using funds. And so with a cautious market view, I love the idea of market-neutral strategies, ones that are long assets that I like, short assets that I dislike. One of my biggest personal investments is in a fundamental long-short strategy that Pimco has called Pimco Worldwide Fundamental Advantage (PWWAX). Research Affiliates is the sub-adviser for the fund. It’s long fundamental indexes in 19 countries around the world, short the cap-weighted indexes in those 19 countries. How cool. Talk about diversification. And it’s backed by an absolute return-oriented bond strategy.
And if I wanted to make individual stock plays, I’d make them on the short side. I’d short Twitter (TWTR). I’d short Tesla (TSLA). And, heck, I’d even short Google.
Tom, you’ve mentioned big tech already. What else do you like?
Lee: One of the interesting developments in 2014, because we’ll be hopefully in the sixth year of a bull market, is that it’s really at that point in the cycle that you see lagging industries get rediscovered by investors. This happened in the ’90s. It happened in 2005-06. And if you look at what hasn’t really participated in this bull market, it’s been aluminum, steels, chemicals — so basic materials, broadly. And then groups like for-profit education. So I suspect that the fact that some of these have come to life in the fourth quarter is telling us next year’s going to be a year where you want to look at some of these lagging groups.
Kimball, you mentioned Oracle before. Any names you like outside the U.S.?
Brooker: One name that I think is quite interesting that has both exposure to emerging markets and I think is probably a pretty good inflation hedge over time is a company called Jardine Matheson Holdings (JARLF), which is based in Hong Kong. It’s a conglomerate that owns a number of different publicly traded companies, and the businesses range from commercial real estate to convenience stores to palm-oil plantations around Asia. It trades for 11 or 12 times earnings. It has a nice dividend yield. Insiders own over a billion dollars’ worth of stock. It’s a very well-managed company that’s well-positioned to benefit from the growth of a number of different emerging markets.
Okay. Thanks, everyone.
This story is from the December 23, 2013 issue of Fortune.
