Economist and investment strategist A. Gary Shilling's
eponymous firm is based just west of Wall Street, in leafy Springfield, N.J. Not far away, but manifestly far enough for Gary to maintain the fierce independence and creativity of thought that have distinguished a long career built on introducing fresh insights and perspectives -most often spiced with healthy dashes of humor-to not-always-the-most-flexible institutional and corporate types.
Which means I was an easy audience. -KMW
Congratulations, Gary-25 years is quite a milestone for an economic research firm. Particularly one led by a fellow who frequently makes a point of going against Wall Street's grain-
I don't deny being willing to look at things in unconventional ways. Maybe it has something to do with the fact that I was a physics major as an undergraduate, which makes you a math major as well-whether you want to be or not.
That definitely means you were certifiable, but whether it permanently skewed your perspective, I don't know.
Me, either. But I do know that the markets discount the consensus view. Therefore, the only way you're going to add value is to find something that's new, very strange and exotic. Now, there's a fine line between taking a contrary position for the sake of notoriety and genuinely seeing something that the herd doesn't. But where we see something we think has a good chance of happening that is not in the consensus, we try to jump on it with all fours. Of course, one of the drawbacks is that you are usually talking about things far out on the horizon, so that by the time they happen, the media- and even some clients – have pretty much forgotten you have ever forecast it.
For instance, you've been writing for quite a while about some of the themes, like "20 Follies" that created a stir when Peter Bernstein gave a speech about similar lessons of the mania in January.
Exactly. Some I even put in my Forbes columns.
But you've got to be used to the fickle finger of Wall Street. How many times were you fired by Merrill Lynch?
Twice, and by the same fellow-not that I was trying! But Merrill ended up acquiring the firm I had gone to!
Proving, if nothing else, that you don't have perfect foresight! But aren't you risking being right but irrelevant when you get out too far ahead of the herd? Especially since a lot of investors think tomorrow is long-term?
Well, we try to alert institutional clients to what we think may happen. Not with the idea that they're going to take action immediately, but so, if they start to see signs, they'll be able to move faster than the crowd.
Deflation and a painful recession have been hallmarks of your outlook at least since your book ["Deflation: Why it's coming, whether it's good or bad, and how it will affect your investments, business and personal affairs"], came out in 1998. Yet most folks still blame 9/11 for last year's relatively mild downturn-
Funny, that recession started, I believe, in March 2001, and 9/11 didn't happen until that September, obviously. Meanwhile, most forecasters just don't see a double dip at all here. Because, first of all, they start out with a tremendous bias. As I know from my own experience, negative forecasts can shorten your job tenure tremendously.
So why risk the dour prediction?
It really is a question of how much weight you put on a retrenchment by consumers. I think the evidence is certainly in our favor. We're seeing a rapidly rising saving rate, weakness in auto sales, retail sales-
New consumer confidence numbers just came in with a big bounce-
The irony is that this was the largest jump in consumer sentiment since 1991-a jump that occurred right after the first Gulf War ended in victory. You might recall that it didn't last; that it, too, was a jobless recovery, and that the original President George Bush ended up winning his war but losing the next election because of the economy. Meanwhile, today, initial jobless claims just get worse and worse and the weekly economic flash numbers, post-this-Iraq victory, are not inspiring, either. Wal-Mart's sales came in at the low end of their range, weekly leading indicators are down. There's nothing to suggest that things have come alive. The interesting thing is that the bull model is that consumers are going to hold the debt-laden fort from being overrun by the Indians until the capital spending cavalry rides to the rescue. But in actual fact, capital spending is a lagging series. We've done some work on it, and it's really capacity utilization that pushes capital spending. Until that gets up, you're not going to see much. So capital spending is more the rear-guard chuck wagon than the hard-charging cavalry. Which makes the question whether the consumer has enough umph to create an economy strong enough to induce capital spending.
And the answer is?
I don't think so. It looks like housing is starting to crack and like consumers are using a lot of the money they are getting from refinancing to pay down credit card and other debt rather than for new spending. What I see here is a retrenchment. Yet historically, there just haven't been many economists willing to forecast a recession until the thing was staring them in the face. They wait until the stock market collapses and then say maybe a recession is in the cards. For investors, that's about as handy as a pocket in their underwear.
And now?
We've got vulnerability in housing and consumer spending.
You're well outside of the herd when you mention "vulnerability" and housing in the same breath.
That's true. Our rationale rests more on the guy on the bottom. The people who have bought into housing with 3 percent or less down payments; taken advantage of government efforts to get low-income people to become homeowners. The theory is that low-income home ownership helps create more stable families and neighborhoods.
You've heard [Fannie Mae Chairman Franklin] Raines' stump speech, too?
Yes. But it's not just Fannie. It's also HUD, Freddie, etc. My point is that our research shows that most people in these low-income categories (up to about $20,000 in income) have negative net worths. Their debts- mostly credit cards-exceed their assets. So if we are right about this second dip, and they lose their jobs, these new home owners with these low down payments are in trouble, as are prospective ones. Which won't exactly do wonders for the move-up market, where I think the vulnerability is. This is a nationwide phenomenon in terms of a lot of low-income people really balancing on a knife's edge. Everything has to go right for them to be able to service their debts. But the auto companies are probably the best candidates for subprime loan problems, with all their zero percent financing offers. Who can blame a guy for saying, "Hey wonderful, I'll take it." But when his first bill arrives, six months down the road or whatever, does he mail in a payment-or mail in the keys? We're going to look back and see that subprime lending was a tremendous systemic problem.
Okay. Now what?
Let me emphasize one very important thing: A lot of bears on the market and the economy fear the bad deflation of deficient demand, the deflation that spins out of control, as in the 1930s and in Japan today. That's not what I am forecasting. I'm talking about very moderate deflation, the good deflation of new-technology-driven excess supply. The sort of thing that happened in the late 1800s and during the Roaring 'Twenties, in other words. But yes, the history of deflation is a history of peace and the history of inflation is war.
So deflation is yesterday's threat?
No. I'm assuming that whatever happens politically, Iraq is not going to be that big a factor in ballooning government defense spending. Defense spending was about 7.5 percent of GDP during the Cold War. It's come down now as low as 4 percent. It's moved up a little now, but I'm assuming we won't have anything like 7 percent.
So investors will have to learn new lessons?
Yes, the whole very long bull market, (17 years, eight months), was caused by the unwinding of inflation. Not that there weren't other aspects: the end of the Cold War, etc. But the unwinding of inflation was very good for P/Es because it was pushing down interest rates, pushing up growth rate estimates and lowering the rate at which they were being discounted. Although they got out of hand, it also was very good for corporate earnings: It lessened and now has eliminated government taxation of inventory profits and under-depreciation, if you're familiar with those concepts, which have almost dropped out of the lexicon. So we saw a huge increase in profits' share of GDP from about 3 percent to 7 percent in the mid-'80s and late '90s. Meanwhile, the stock rally amounted to 15.3 percent compounded annually, from the July low in 1982 to March of 2000. So half of it was really a P/E play and half of it was the profits improvement. My point is that we've just been through an extraordinary period. But people, by the late '90s, thought that's the way God made the world.
When in fact reported profits numbers were turned into hokum, by managements that ran out of low-hanging restructuring fruit to harvest for the earnings "growth," but wanted, above all else, to push their options into the money.
Yes. The downside targets that we set in November of 2000, just looking at P/Es and price to book and price to cash flow and market cap to GDP and all that stuff, with Nasdaq down 70-80 percent, the S&P down 40-50 percent and the Dow, off 30- 40 percent. Well, they have all fallen into those ranges. But I'm not sure you've seen the bottom because we were basing those targets on "earnings" at that point. And we've seen subsequently a collapse in earnings-and learned that a lot of what we thought were earnings back then were phony baloney. So the situation is that despite these huge declines, stocks still aren't cheap. And people still have to unlearn the lessons of the bull. As Peter Bernstein pointed out to you, S&P profits grow more slowly than the economy. Why? Because they don't include a lot of young start-up companies that are not listed stocks; that are not even public, in many cases. So to expect the bull to live forever was not realistic.
Nor can P/Es grow to the sky?
Right. It seems to me that you've got to have some premium to the earnings yield (the inverse of the P/E), on Treasuries. So if I am right, and we get mild deflation of 1-2 percent, you could see long Treasuries at 3 percent. That would be a 4-5 percent real yield, which is actually low by historical standards, if you go way back. It's not low, by post-war standards, but I think the post-war period wasn't really typical. In any event, 4-5 percent real rates on long Treasuries with 3 percent stock yields and 1-2 percent deflation, wouldn't be bad. That's almost twice post-war standards. If you take that 3 percent and add 1 percent for the risk premium on stocks versus bonds, you've got a 4 percent earnings yield. And if you invert that, you've got a 25 P/E. Which is about where P/Es are today-but that's based on a forecast of Treasuries going to 3 percent.
Not exactly the consensus. What if you're wrong, and the herd somehow gets it right?
Okay, say Treasury yields go back up to 5-6 percent, and you add 100 basis points to that to come to 7 percent. You invert that, and you've got a 14 P/E, vs. now close to a 30 P/E on a trailing 12 month basis. We did some simulations on this and you've got to see just literally unbelievable profits growth or a huge further big stock decline-or both-to really accommodate the consensus view. The irony is that our forecast of mild deflation is much more hospitable to stocks from here than is the consensus view.
But the herd doesn't get it.
No. I keep hearing that certain stocks are "cheap," just because they've come down a lot. I still hear that investors should buy and hold; not try to time the market, even that being out of stocks is a losers' game. Yet way back in 1992, I wrote an article for the "Financial Analyst's Journal," looking at the post-war period, which found that even if you're out of stocks during bear markets, and even if you miss the best of the blow off phase of the bull market, you're still better off.
Which brings up the issue of investment fees. The fat years are over, you've said?
The irony is that now people are belatedly deciding they can't invest on their own a lot of people are very ripe to have their money professionally managed. But with the kinds of returns that they can reasonably expect, maybe 4 percent (and most of that from dividends) on stocks, 3 percent on bonds (or a couple of percentage points more if you accept the consensus view), it just won't fly to pay investment management fees of 3 percent or even 2 percent. So it will be interesting to see if the Street's traditional leaders will be flexible enough to change with the times.
It certainly implies that stocks still aren't cheap, enough.
And puts the lie to my favorite bull market fallacy, the notion that Treasury bonds are for wimps who are too timid and too stupid to grasp the wonderful world of stocks.
Don't you know that the next move in interest rates has to be up? You're not suggesting rates go to zero, are you?
Well, they aren't there yet. But people believe it is engraved in stone that they're going up from here. If the best you can expect on stocks going forward is about 4 percent, and if you can get 3 percent on long Treasuries, that favors bonds on a risk-adjusted basis. Certainly, deflation favors bonds. We're now close to 5 percent on a long Treasury. If we go to 3 percent, and let's say that happens over two years, you pick up two years' worth of interest (roughly 10 percent, at 5 percent a year), and you have a total return of about 50 percent. If you have a 30-year zero coupon bond, you'll have total return of about 80 percent over that period.
Those are awfully big numbers, considering how low nominal rates are-and even stranger, imply that the retail masses who've been piling into bond funds are doing something right for a change.
Stranger things have happened-for a while. As for the size of those potential returns, they're partly the result of compound interest. Also, again, simple math. Rates dropping by 100 basis points from 15 percent or whatever they were at the peak in 1981, doesn't produce huge appreciation in percentage terms. But if rates go from 5 percent to 4 percent, the appreciation on a zero is about 33 percent. Anyway, we were lucky enough to declare back in 1981 that we were entering the bond rally of a lifetime-and I think it's still intact.
Surely, though, it's awfully close to peaking-
Just like the long bull market in stocks did in its manic stage, I think the staying power of the bond bull will confound people trying to call the top. There are other things, besides the dawning disappointment in the returns on stocks, that are going to push bonds up. Not the least of which is what is happening with defined benefit pension plans, now that it's becoming clear that they aren't a steady source of pre-tax profits for their corporate sponsors. The actuarial complexities are practically impenetrable. What it comes down to is that companies have been taking advantage-to varying degrees-of the fact that they are allowed to set assumptions not only for their gains on stocks and other investments, but on the interest rates they use to discount their liabilities-
But none of those "profits" in any way benefits shareholders. Nor, in most cases, will they contribute anything towards actually paying future claims by retirees-something pension plan trustees might start getting a mite edgy about, if the stock market doesn't ride to their rescue soon.
That's right. What a lot of people don't realize about all the assumptions the pension funds make is that the regulations only give them so much leeway. As long as their assumed returns and actual results are within a 10 percent channel, they're okay. But if you get one nickel outside of that channel, then you've got to amortize the whole difference. And that's quite a time bomb. The upshot, I believe, is that you'll see a lot of defined benefit pension plans doing a lot of dramatic asset allocation rebalancing. Most investors, even sophisticated investors, understand very little about bonds. Yet I believe one of the big changes we're facing is that managers are going to be hired first and foremost to make money. Beating a benchmark is going to be secondary. People are going to give a lot more discretion to managers in terms of holding various classes of stocks, even holding bonds and cash-as long as they make money. But the fact is, you're going to have to be out of stocks at some points. In them, at others. You're going to have to risk losing your shirt because bear markets are more volatile than bull markets. The uncertainty principle says you can never exactly measure both the position and the momentum of a subatomic particle, because the very act of measuring it changes it in subtle ways. In other words, you can't pinpoint the exact location of something without changing it in an unpredictable way.
Thanks, Gary.
Kathryn M. Welling is the editor and publisher of welling@weeden, an independent research service of Weeden & Co. L.P., Greenwich, Conn. http://welling.weedenco.com
