Outlook from a bear, Gary Shilling

Gary Shilling must have had a very bad year in 2009. I think 8 or 9 of his calls were wrong. Nevertheless, going into 2010, he maintains most of his calls. I don't agree with all his views but I do share his thinking for the most part.

Writing for MarketWatch, Paul Farrel summarizes Shilling's 17 picks for the year. Six of the seventeen are buys while the rest are sells. I think there is a typo with the numbering and I have corrected it below. For some of the points, I have chosen not to excerpt the detailed text. You can read the original article at MarketWatch if you are interested. I decided to do this to maintain fair-use (don't want to quote almost the whole article) and to avoid repeating the same points I have quoted in the recent past.


Be careful to note that the actual words from Gary Shilling are in quotes. Since a journalist is extracting Shilling's thoughts, there is always the possibility of misquotes or misunderstandings. I have inserted my thoughts in square brackets [].

Six Long for 2010

1. Buy treasury bonds. Back in 1981 Shilling first recommended Treasurys. Last year he said the "bond rally of a lifetime" was over. Not so fast: "We've reactivated the strategy with our forecast of a return in yields to 3.0% or lower." Treasurys are a "safe haven in a troubled world." Three reasons: Liquidity, limited calls and "best credits in the world."

[This is one of the major strategies I was investigating before personal circumstances put a hold on everything. I am happy to see Gary Shilling put a number on a likely bottom for yields. One of the hard things for anyone contemplating US Treasuries is to price in the low for the bond yield. Now I feel that I have some idea of what a successful investor thinks might be a low. Current yield is around 4% so one is looking at around 25% upside if yields decline to 3%.]

2. Buy income-producing securities. Wall Street's a loser: The S&P 500 "declined 23% in the last decade in nominal terms and has fallen 39% adjusted for inflation." Investors want "returns here and now as opposed to asset appreciation." Best bets: "High-quality corporate and municipal bonds ... stocks of utilities, consumer-product companies, health-care firms and others that pay meaningful dividends that are likely to rise.

[I think corporate bonds are attractive (corporate balance sheet of non-financial companies in America is very strong) but I am very wary of the income-oriented route in general. I have nothing concrete to prove my case but I just get the feeling that income-oriented assets are not the place to be. Such strategies worked spectacularly in the last 3 decades therefore the contrarian in me says to be careful. Companies were able to raise dividends on a continuous basis in the last 30 years (sometimes as much as 10% per year for decades) but I think that streak is going to break. A lot of consumer and healthcare companies have lived off the American consumer-worker and I suspect it's not going to be so easy when the consumer deleverages. Income-oriented strategies worked well in prior deflationary times but dividend yields were much higher back then. Right now, dividend yields are kind of low.]

3. Buy consumer staples and foods. Think "laundry detergent, bread and toothpaste ... basic essentials of life purchased in good times and bad." More from supermarkets, discounters as national brands "adapt to consumer downgrading by emphasizing cheaper 'value' products."

[This was the bread & butter for Warren Buffett in the past but I am not bullish on these companies. Many of these companies trade at high multiples—always have for the last 30 or so years—and have relied on consumers to pay up for the brand. Right now, they are going to face huge battles with discount brands, especially so-called house brands.]


4. Buy 'small luxuries.' Shilling created this new sector: Hard-pressed consumers "buy the very best of what they can afford, even if it's within a low-priced category ... California winemakers are emphasizing cheaper wines ... Tiffany sales of products over $50,000 are weak, but high-quality small items continue to sell well, always in its trademark blue box."

[An interesting, new, pick. I can see this working because consumers would still want to enjoy life even if their incomes aren't going up or need to pay down debt. Speaking as someone who doesn't make much money and is similar to the general population, I wouldn't mind paying up a bit for small things here and there. I can see someone buying premium shoes or jeans or movies or whatever, even if their income and savings situation isn't so good. The problem with this macro call is that it is hard to capitalize on this. How is an investor supposed to figure out if most of the profits are coming from "small luxuries"? Perhaps one needs to look at small and medium sized businesses offering these products.]

5. Buy the U. S. dollar. Despite drawbacks, "the dollar remains the world's reserve currency and safe haven, regardless of suggestions by the Chinese and others that the dollar should eventually be replaced by a global currency." How about gold? Fuggetaboutit. Never. "The recent strength in gold prices suggests that many investors distrust all currencies." But "the supply of gold is far too small, even at current prices, to again serve as money. Gold in private and government hands is worth about $5 trillion compared to global M3 money supply of $60 trillion. Gold would have to sell at $32,128 per ounce, vs. $1,097 at present, to replace the M2 money supply dollar-for-dollar."

[If one was ever dreaming of the return of the gold standard, the above argument is why it is not possible. Gold would have to skyrocket 32x what it is now, and possibly turning gold producing countries into some of the richest on earth (and possibly starting wars); or money/assets would have to deflate so much that the Great Depression would be a joke compared to what this requires... Anyway, I'm really nervous about the US$. I have remained bullish on it but it's not a pretty position to maintain. I keep looking at my portfolio at it keeps declining even if prices go nowhere :(]

6. Buy eurodollar futures. "Eurodollars are deposits denominated in United States dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve," and "are subject to much less regulation than similar deposits within the U.S., allowing for higher margins." Note: "the 'euro' prefix can be used to indicate any currency held in a country where it is not the official currency. For example, euroyen or even euroeuro."

[New idea. You have to be bullish on the US$ to pursue this strategy. Reaching for yield is always risky—as Jason Zweig has said, investing for yield is kind of like marrying for sex. When it dries up, you have nothing left—so one should be really careful. I don't know anything about eurodollar deposits but the fact they have less regulation might also mean they have less safety. I'm not sure if foreign governments insure those deposits. You may be familiar with the huge controversy with deposits in Icelandic banks in Britain and The Netherlands so one needs to be careful.]

Eleven Shorts for 2010

One probably shouldn't think of these calls as short sales. You can also think of it as "avoid" rather than a "sale."

1. Sell U.S. stocks in general. Sorry, but Shilling says P/E ratios are at a "nosebleed 22.5 level" for a vulnerable 2010 market. But he's hedging his bet: "Be well aware that our forecast of a declining U.S. stock market is critical to many other strategies we'll discuss later that involve selling or avoiding equity sectors here and abroad. We believe they all will perform worse than the stock market overall, but if we're wrong and the stock market leaps this year, we'll probably also be wrong on many of these other strategies." Yes, a very big "if."

[If you are looking at any of these bearish calls, pay attention to what is said above. Namely, a lot of the calls are based on a scenario where the US stock market declines. If that doesn't materialie, a lot of the calls below will blow up badly. This is what separates macro-oriented investing from value investing. Classical value investors would never pin any investments on outlooks.]

2. Sell home-builder and selected related stocks. ...

[Nothing new here. Same bearish reasons as last year.]

3. Sell big-ticket consumer discretionary equities. Two reasons: Consumers are on a "saving spree" cutting "spending on expensive postponeable items. Second, as widespread price declines persist, they will be anticipated ... buyers will wait for lower prices ... excess inventories and unused capacity will mount, forcing prices lower," confirming "prospective buyers' suspicions."

[This is a very dangerous bet, if anyone makes it. The problem I see is that this requires a change in consumer psychology. That is not something that happens in one year, or even two or three. One of the most dangerous bets you can make is to bet against the American consumer. Americans live for the moment and they buy for the present. That may never change. I just don't know. All I know is that debt usage is going down and savings will go up. But how much of that translates into changes in purchasing behaviour remains to be seen.]


4. Sell banks & other financial institutions. ...

[Same view as before]

5. Sell consumer lenders' stocks. Shilling warns: "Recent developments are virtually all negative for the credit-card business now and for years to come. ... With the switch from a quarter century consumer borrowing-and-spending binge to a long-run saving spree, the credit-card business has moved from a growth industry to a laggard."

[I share the same view.]

6. Sell many low- and old-tech capital-equipment producers. They will remain "depressed in a world of chronic excess capacity. When operating rates are low, producers don't need more capacity and worry that revenues, prices and profits won't be adequate to justify even existing capacity:" Autos, machine tools, automatic transfer lines and other equipment fell. And remember how "excess capacity in airlines has caused massive cancellations and postponements of orders for Boeing's Dreamliner."

[I think Shilling has made this point before but there is more elaboration here... This is a tricky call and goes against the commodity bulls. If you are bullish on commodities, you will be bullish on "old-tech" capital goods companies... One other thing: If you invest in capital goods manufacturers, one of the things you will learn really quickly—I certainly did, and I didn't even own them—is that backorders are most useless concept out there. Do not price stocks based on recent supply & demand and reported backorders. Shilling mentions Boeing's cancelled orders but I believe others like Caterpillar, Emerson, and GE have also seen huge cancellations.]

8. If you plan to sell a home or investment house, do so yesterday. ... "After the final bottom is reached, house prices will likely mirror inflation, or in future years, deflation as they have historically ..."

[A lot depends on government policies and economic recovery. Overall, it will take years for housing to recover... I'm just curious about Canada, where housing hasn't seen a correction.]

8. Sell junk bonds. ...

[Shouldn't surprise anyone, including junk bond investors. The rally in junk bonds looks overdone.]

9. Sell commercial real estate. Today looks worse than when I was with Morgan Stanley real estate banking group in the 1970s winding down outfits like Tishman. Shilling says excess capacity and refinancing will "continue to plague hotels, malls, warehouses and office buildings."

[The good thing about the commercial real estate market is that the properties are clearing the market. I suspect it is also because we don't have issues like fraud, which has plagued some portions of the residential real estate market. Some of the residential real estate market is so messed up that banks can't even find the official documents; such issues don't seem to be present in the commercial real estate market.]

10. Sell most commodities. Cheap money was behind last year's rebound in commodity prices. "Some live in their own worlds:" Petroleum, natural gas, some agriculture commodities. Still "economic supply and demand will rule most industrial commodity prices this year and result in weakness due to sluggish global business conditions. ... Many commodity-producing companies and their suppliers," and Gulf economies dependent on petroleum "will be unattractive investments as weak demand, excess capacity and soft prices persist."

[Anyone who leans towards deflation is bearish on commodities so this shouldn't be a surprise to commodity bulls. I share his views but do keep in mind that some "commodities live in their own world."]

11. Sell developing company stocks and bonds. Many forecasters still believe in decoupling: If our domestic economy is set back, "developing countries like China and India would continue to flourish ... even aid the U.S. as they bought more American exports." Shilling disagrees. They go down with us.

[Like most people who are bearish on commodities, Shilling is also not a fan of emergin markets. I share a similar stance and have avoided emerging markets for the last 4 or 5 years. The difficulty with emerging markets is that little makes sense to me. How could the Indian market or the Chinese market be up something like 100% last year? Was the market wrong the year before or is it wrong now? Long-term investors can probably ignore some of these concerns but the ride is going to be a roller-coaster.]