Gary Shilling interview with Advisor Perspectives

Sticking to my contrarian knitting, albeit with the potential to go completely astray and lose my shirt, let me go against a strongly rallying market and present a bearish view from Gary Shilling. Thanks to GuruFocus for pointing me to a Gary Shilling interview with Advisor Perspectives.

For those not familiar, Gary Shilling is considered by the mainstream to be a perma-bear since he has mostly been bearish and called for a deflationary bust that never materialized in the late 90's. I dismissed him a few years ago, similar to my ill-advised dismissal of Jeremy Grantham, because he seemed too bearish.

One of the things that has separated Gary from other bears is that he is an economist and approaches things from a macro point of view. In contrast, many other bears tend to be traders that rely on technical analysis (Mike Shedlock of Mish's Global Econmic Analysis blog, for instance, says a lot of economics but seems to make his investment decisions off technical analysis.) In addition, unlike most bears, who tend to think that hyperinflation or collaspe of US$ and hence USA, or some scenario like that is most likely, Gary Shilling is a deflationist who has historically been bullish on long-term US government bonds and US$.

From what little I understand, Gary made his money from betting on long bonds in the early 80's. He used leverage to become financially independent but even if you didn't use leverage, someone rolling over the long bond for the last 30 years would have outperformed stocks. Someone reading present history 200 years from now would probably be more amazed at the bull market in bonds the last 28 years more so than the technology boom or the housing boom or globalization boom. (I have an investment idea on this in an upcoming post.)

Anyone interested in some of my thoughts on what Gary is saying, click through to read more.

Robert Huebscher: You’ve been forecasting deflation for some time, and the March CPI numbers validated these forecasts – the first deflationary month since 1955. Can you summarize the major forces in the economy that will continue to keep the CPI numbers in negative territory?

Gary Shilling: In the short term - for the duration of this recession, which will be at least another year - four very deflationary forces are at play.

First is the ongoing weakness in commodity prices, which takes time to work its way through the system...Second are excess inventories, which are the mortal enemy of price increases...

The most interesting phenomenon, which we are now seeing for the first time since the 1930s, is wage cuts and shorter hours. In the post-World War II period, the only way employers could cut costs was to lay people off. Under high inflation, employers used another method of controlling labor costs, which was to freeze pay or raise pay less than the rate of inflation. Now, however, there is no inflation and we are back to the 1930s, when deflation reigned. To lower costs, you must get rid of people or cut hours. About 6% of employers have cut wages or hours in the last year, and another 10% plan to do so. This is less than the number of employers that have had layoffs, which in the 20% area, but it is growing and it is highly deflationary.

The fourth and final deflationary force is excess capacity in the economy. The Commerce Department has an interesting measure, which shows the excess capacity versus demand across the economy. An interesting and powerful relationship is apparent, which shows that excess capacity reduces the CPI with a six-month lag.

For the duration of this year, deflation is the odds-on bet.

Right now, almost everyone is expecting inflation. Even the bond market, which was signalling deflation, has switched to an inflation stance right now.

The wild card in my eyes will be worker compensation. If workers are cut or if wages decline (say due to work-sharing) it is hard for me to see much inflation. Unemployment lags and, historically, this never meant much since we had strong recoveries that materialize within an year. Right now, however, I think unemployment will have a material impact. We still haven't seen the ripple effects from unemployment because it always lags everything. The fact that the severe problem in America lies with the consumer (i.e. worker) also likely means that unemployment will have all sorts of side-effects, unlike anything we have seen in the last 50 years. For instance, even though unemployment was even worse in 1982 and 1974, the impact of the consumer on the economy will likely be more meaningful right now. Things like credit card losses, decline in durable purchases (e.g. cars), defaults on mortgages, and so on, will be far more damaging now.

(On a side note, what is discussed here are the bad deflationary forces. On top of all this, we have the good deflationary forces of technological advancement, cheaper foreign labour, improved efificencies, and so forth.)

What are your reasons for this economic decline?

Gary Shilling: I see five factors inhibiting economic growth.

First is the de-leveraging of the consumer sector, which was on a leveraging tear for three decades...

Like the consumer sector, the financial sector is de-leveraging, after having been on a leveraging binge for three decades. A lot of that leveraging was financial fluff, but it did finance important goods and services. Growth in Eastern Europe and the Baltic region was financed by Western banks. Banks are going back to spread lending, which we can see now, for example, in the recent announcements by Bank of America. With skill, luck, hard work and unlimited free government money, they can’t fail. Their balance sheets are still terrible, though. We don’t know how much bad paper they have and we can’t figure it out. Apparently, the banks don’t know either, and were making calculations until the last minute before releasing their numbers. Going back to spread lending will have a big negative effect on economic growth, but is hard to quantify.

Third, we are at the end of the commodities boom. Big commodity producers were spending at a high level, as were smaller countries like Zambia, Peru and Chile, who produce copper. During the boom, buyers lost while producers won, and now the reverse is true. But the buyers are the big industrial countries, so the countries suffering now are the smaller ones. Oil is a very minor part of our GDP, but for Saudi Arabia it is everything.

Increased government involvement has decreased economic efficiency. Banks are wards of the state. They are not interested in taking risk, just in preserving their empires. Government intervention stifles initiatives, and it never quite works. Wall Street will figure their way around regulations, and Sarbanes Oxley is the prime example.

The final factor is protectionism, which is growing rapidly. Protectionism started in the financial sector.

Well known reasons and I think the market has priced all this in. It's interesting that Gary considers various government actions in the financial sector to be protectionist. Now that I think about it, he seems to be right. Of course, very few in the financial sector, whose jobs and fortunes are dependent on bailouts, consider these as protectionist.

Q: In late January you wrote that it is “way too early to get back into U.S. stocks.” Is that still your recommendation? What signs are you watching to determine when US equities will be attractive?

Gary Shilling: Stocks anticipate the economy. It’s normally five to six months before the end of a recession that they hit their low point. If we are right that the economy will bottom a year from now, then stocks will bottom late this year. Since stocks are a leading indicator, the question is what leads this leading indicator.

Three things must happen to clear the path for stocks to recover.

First, we must eliminate excess housing inventories...If nature runs its course, it will take until the end of next year to get down to where home prices will level off. We need another 15% decline (for a 37% total decline) in housing prices. Half of homeowners with mortgages - about 25 out of 50 million people - will be underwater, to the tune of one trillion dollars...

Second, we must deal with additional financial problems that are surfacing. So far, our problems have been related to residential mortgages, but consumers are treating payments on other kinds of loans – credit cards, auto loans, home equity loans, student loans – as discretionary. Financial responsibility is going out the window. The TALF is supposed to deal with this, and we will see if it really works. As it stands, the Fed can buy only AAA-rated paper, but the problem lies in paper that is not rated AAA.

Commercial real estate (except for hotels) is suffering from overbuilding. We have excess capacity in warehouses, malls, and offices. Sublease space is competing with new space. Hotels are facing declining occupancy. The underlying problem was refinancing that added leverage, and a lot of this debt is coming due and will be difficult to roll over.

Markets still face a problem with junk bonds (which are now at 18% spreads) and leveraged loans. Delinquencies and charge-offs are just getting under way. Holders of these securities have not anticipated the write-offs that will come.

Third, the fiscal stimulus is too small to break the cycle of lack of consumer spending, inventory build-up, production cutbacks, and unemployment...

Couple of thoughts...

My feeling is that the stock market is not going to rally 6 months ahead of the bottom. I'm reading Anatomy of the Bear and major bear markets have seen the stock market rally alongside the economy. The market doesn't necessarily look ahead for major bear markets and crashes. In any case, Gary thinks the bottom may still be ahead.

I don't understand Gary's point about junk bonds. How could he say that the bondholders haven't anticipated the write-offs when the spread is 18%? I think junk bonds can still sell off further but most of it seems to be priced in. If anything, my feeling is that the junk bond market is looking far ahead into the future, more so than any other market.

Q: What is your target for the S&P?

Gary Shilling: I am on record with a target of 600 on the downside for the S&P 500, based on my forecast of $40 in operating earnings and a generous multiple of 15. I made that projection last November when the bottom-up analysts’ forecast was $83 and the top-down forecast was $62. They are closing in on me. We have another 25% decline to hit the bottom, which I expect in the later part of this year.

S&P 500 at 600 is pretty low but is a reasonable bearish call. Unlike some that mistakenly use trough earnings and trough P/Es to arrive at their estimates, Gary correctly uses trough earnings with normal P/Es (an alternative is to use peak earnings with trough P/Es.)

No one can predict the future and the S&P 500 may not hit 600 but it's a rough idea of what can happen.

Q: A year ago you offered 13 investment strategies for 2008, and in hindsight they were very prescient. Can you discuss some of the strategies you are recommending for 2009?

Every year, in the January issue of our Insight publication, we offer our investment strategies. Last year, 13 out of 13 worked well. Probably a lot of luck was involved, but someone in my office calculated the odds of batting 13 out of 13, and it was one out of 8,192, so it is more than just dumb luck. We updated this in January. A number of our ideas from a year ago are pretty well exploited. For example, investors can no longer profit from the collapse in the subprime market or from the decline in Treasury bond yields. Thirty-year Treasury bonds have been one of my favorite asset classes since 1981 when yields were 14.1%. Yields went to 2.6% at the end of last year, and investors in this asset class, which is supposedly only suitable for conservative investors, earned a 42.5% total return. That is over. Another fully exploited asset class is junk bonds, as charge-offs haven’t leaped but spreads have.

Stocks are going down, but I am still bullish on the dollar – it is the best of a bad lot...

I am cautiously recommending high-grade municipal and corporate bonds. They have rallied nicely since the beginning of the year, but downgrades – not defaults – are a tricky problem there.

There will be downward pressure on homebuilding and housing-related stocks, consumer discretionary stocks, commodities, and emerging market debt and equity.

I really don't understand Gary Shilling's view on junk bonds. He says one can't profit from it but what am I missing? It seems now is better than the last few years? Or is he talking about short selling junk bonds?

Q: What is your personal asset allocation, at an asset class level?

The best way to answer that is to look at how we run our portfolios, which is on the basis of strategies.

We are long the dollar, short stocks, and long Treasury bonds. A lot of these are the same trade. Last year only three asset classes went up: Treasury bonds, gold, and the Yen. Everything else went down. There is so much hot money that it ends up on same side of every trade at the same time. Investors bail out of bad ideas at the same time to preserve capital.

Q: What about gold?

I am agnostic on gold.

Gary is agnostic on gold but not me. I'm bearish and am maintaining my view from earlier this year of a potential short of gold. We haven't seen the speculative blow-off in gold yet and I'm still waiting for it to hit $1500, at which point it is worth considering a short. Similar to oil last year, it's possible that gold will skyrocket on erroneous views of hyperinflation at the first signs of high inflation.