Wednesday, April 15, 2009 5 comments ++[ CLICK TO COMMENT ]++

Gary Shilling still bearish... maintains deflationary view

Superbear Gary Shilling is still maintaining his bearish views. Many have accused him of being a permabear--Shilling had been bearish for many years and was even bearish during the 90's, with several calls for a deflationary market crash--but he was proven right with the stock market crash that started in 2007.

Gary Shilling is also unique in being one of the few true deflationists out there. His deflation call was completely off in the late 90's--he even wrote a book, that I plan to read--but he has maintained that view. Also, unlike many fairweather deflationists, he put his money where is mouth is, by going long US Treasuries.

Bloomberg has a nice, short, interview that updates viewers on Shilling's current stance. Here are some quick notes on some of his comments:


  • Gary Shilling says that the bank tests need to be made public. He expects all the banks to pass the test; otherwise, the bank has to be seized or nationalized right away. I think the bank situation is going to get very cloudy, as if it already hasn't. We are going to see banks posting record profits--it's difficult for a bank not to post such high profits when they can borrow money at super-low rates--but the assets on the balance sheet are big question marks. Meredith Whitney has suggested that the next big potential for humongous losses are in credit cards. I think we should be watching how the credit card situation unfolds.
  • Thinks we are not out of the woods yet. Sees weak economic growth averaging 2% even when the economy recovers (My view is similar to his.) I think investors, if they believe this lower growth forecast, should not lose sight of the fact that this implies that corporate profits will be much lower in the future. I'm not an economist but using some very simplistic thinking... given how the economy was growing around 3% before, a growth of 2% is a 33% drop. I think corporate profits will drop at least that much, and possibly more (given how corporate profits as a share of the economy was extremly high in the last decade.) The stock market has declined slightly over 50% so the question is whether the decline in future profitability will be smaller than the market projection.
  • The decline in retail sales of 9% is brutal, says Gary, and hasn't been seen in the post-war period. I don't need to say much on this. All you need to think about is how Toyota, arguably one of the top car companies in the world, posted an operating loss for the first time in more than 50 years.
  • Gary Shilling for those not familiar is a famous deflationist. He repeats his stance and doesn't see inflation on the horizon (I share similar views as him but not to the same degree.) He refers to the almost-50% wipeout in credit default swaps to illustrate the scope of wealth destruction. But that example seems incorrect to me. Derivatives are a zero-sum game so even if the CDS market lost $20 trillion or whatever, it is offset by gains by someone else. As far as I'm concerned, wealth destruction mostly lies with non-derivative assets such as shares, real estate, commodities, art, collectibles, and so forth--these do not have zero net effect... presently, the market is pricing in a re-flation trade. The biggest rally in the last two months have been in all the high beta assets: small caps, commodities, emerging markets. The verdict over deflation won't be known until 3rd quarter in my opinion.
  • Shilling maintains his contrarian bet on long-term US Treasuries. He says capital gains potential is gone but says we may get 5% real return (around 3% nominal yield + 2% from deflation).
  • Needless to say, he is bullish on the US$ (if you are deflationist, you almost have to be.)
  • He also suggests that high quality corporate bonds may be attractive. I am not a bond investor and have a hard time making a call on that. I favour junk bonds but junk bonds can end up suffering if deflation is severe. High quality corporate bonds, in contrast, will do really well if the deflation is strong.

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5 Response to Gary Shilling still bearish... maintains deflationary view

John
April 16, 2009 at 2:34 AM

With Reserve Bank (and Central Banks around the world too?) printing masive amount of money, It's almost a given we're heading into worldwide inflation pretty soon... Well, that's at least Warren Buffet's view.

Sivaram
April 16, 2009 at 8:29 PM

Warren Buffett is not a good macro investor. This is not to dismiss him outright but I'm sure that even he would say that he isn't very good at making those calls. For instance, selling put options right before the market plunge--and this is more of a macro strategy than bottom-up value investing--shows one of his mistakes. No one can predict the timing but he wrote the put option when valuations were nowhere near being cheap...
 
Secondly, when something seems obvious, it rarely actually occurs as the consensus expects. This is certainly the case with investing.
 
My view is that we may get high inflation but if and only if the government decides purposely to pursue such a policy (an example would be if they lose a war and can't pay their debt; or if they want to devalue their debt obligations.) So far, very few, including those in the inflation camp are saying that is what will occur. Rather, they keep saying that inflation will come from the FedRes and other central banks losing control of their money supply.
 
We'll see... except for the really good stockpickers, the outcome of the inflation vs deflation battle will produce most of the gains or losses in the next decade.

John
April 16, 2009 at 10:05 PM

Sure, something that seems obvious rarely actually occurs. (I subscribe to your blog. I'm a contrarian. :) )
 
But I think it's fair to say there's a much higher probabiilty we're heading into inflation than deflation. Governments cannot afford deflation, and hence will over-respond, rather than under-respond. Inflation detoxes the toxic debts. They would rather have inflation than deflation.

Sivaram
April 16, 2009 at 10:39 PM

Contrarian disagreeing with a contrarian huh? ;)
 
 
It'll be a close call... I am skeptical that the governments can avoid the deflationary forces. I like to think that the governments are less powerful than the free market forces. I think governments can slow the effect but I doubt that they can mitigate it completely.
 
For instance, China right now is facing deflationary pressures (falling consumption in America has killed their export business so they have way too much overcapacity in many industries). But they are trying to avoid it by significantly boosting loan growth. THis will appear to stave off the deflationary force of collapsing demand in America but it may simply be setting up a deflationary bust in a few years when all these loans end up being non-performing loans. I don't know. That's how I'm thinking of the situation.
 
Similarly, the American consumer balance sheet is terrible. It could take years to repair that...

MrParkerBohn
April 17, 2009 at 1:27 AM

I don't invest based on macro calls, but it looks to me like there are currently strong deflationary pressures from the recession, which are being opposed by strong inflationary pressures from gov't policy.  I'm going to predict inflation jumps as we emerge from the recession.
 
It looks to me like the Bush people and the Obama people have something in common:  they both prefer to cut taxes (politically popular) while paying for increased spending by a 'hidden tax' of currency devaluation or price inflation.
 
Under Bush, gov't spending surged, taxes were cut, and the US dollar dropped dramatically.
 
Under Obama, gov't spending is surging and taxes are being cut.  I'm predicting that the value per dollar will inevitably have to drop.
Now, it is completely possible that the value per Euro, Yen, Yuan, etc could drop at the same time, and for the same reasons.
 
With trillions of dollars being magicked into existance, essentially the gov't is creating money rather than taxing it, but there is a cost nonetheless, in the form of inflation.  Of course, just like taxes, this is not neccessarily a bad thing if the money is used wisely.
 
Or at least this is how I think about it.  I'm no economist.
 

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