Call it a tale of two bulls: one on Wall Street—the market; the other in a china shop—the federal government.
If the gawky latter bull would simply step aside, the Wall Street bull could gain some real stability. That’s the consensus of this year’s Research Roundtable of experts.
Predicting the economy and securities markets for 2014, our panelists cast a mostly critical eye at the government’s fiscal and monetary policy, and the negative effects they say this will continue to wreak on the economy and markets.
Roundtable members, interviewed in October during the debt ceiling crisis and government shutdown, forecast a volatile market next year but with the considerable upside potential of emerging markets, which, despite strife in some, are in growth mode. Other notable sectors include high tech, pharmaceuticals and industrials.
Here are highlights from our discussion. Our panelists are:
ROB ARNOTT (Newport Beach, Calif.) Founder-chair, Research Affiliates, managing $149 billion in assets. Manager, PIMCO All Asset Fund, with $32.28 billion in assets as of Sept. 5, 2013.
JOHN BUCKINGHAM (Aliso Viejo, Calif.) Chief investment officer, Al Frank Asset Management, managing about $550 million in assets. Editor The Prudent Speculator newsletter. Manager, the $90 million Al Frank Fund, with an annualized 10-year return of 8.38% through Sept. 30, 2013; since its 1998 inception, the fund has averaged a 10.6% return.
KENNETH L. FISHER (Woodside, Calif.) Chair-CEO, Fisher Investments, which manages $50 billion in assets. Forbes “Portfolio Strategy” columnist for 29 years. His 10th book: Plan Your Prosperity (Wiley, 2012).
ROBERT RODRIGUEZ (Los Angeles) CEO-managing partner, First Pacific Advisors; advisor to FPA Capital and FPA New Income funds. Firm manages assets of $26 billion. FPA Capital’s compounded rate of return from July 1984 through Sept. 30, 2013, is 14.80%. FPA New Income hasn’t had a down year in almost 30.
What’s the current state of the economy?
Fisher: Great, much better than people think.
Buckingham: Even though things haven’t been great, when you’re expecting miserable, good is good enough.
Rodriguez: We’re going through Future Shock. The Future Shocks of today are quantitative easing and ad hoc governmental intrusion into the system.
Arnott: Still a sputtering, sluggish economy. It leads to companies and individuals setting money aside rather than investing. The fiscal and monetary stimulus is like an open fire hydrant draining water pressure from the neighborhood. But those who have buckets closest to the hydrant, providing goods and services, do just fine while the private macro economy does not.
What’s the current state of the stock market?
Rodriguez: Still a function of risk-on, risk-off and the nature of quantitative easing. Since February 2012, it’s been driven primarily by P/E expansion, not robust earnings growth.
Arnott: A bull market built on a foundation of hope and a printing press. That’s not healthy.
Fisher: We’re in a long bull market, with a little volatility throughout the year.
Buckingham: It’s performed very well. But people are still scared and sitting on the sidelines. Yes, stocks are trading at the higher end of their historical range in terms of P/E ratios; but you have to look at where else you can put your money in building a diversified portfolio.
Your forecast for the economy in 2014?
Arnott: As long as we’re willing to run the printing press as an enabler of bad behavior in the form of deficit spending, this game can keep going on for a while. But eventually, it breaks. The longer we put off the day of reckoning, the worse that break is. We’re setting the stage for very serious macroeconomic damage and very serious market shocks in the years ahead.
Fisher: I hope that next year will be the end of quantitative easing. That’s the most bullish thing we can do. Everybody has quantitative easing backwards: It’s not a stimulus; it’s depressive. We’re doing well not because of it but despite it. It flattens the yield curve and slows things down. Historically, the steeper that slope, the more bullish for the economy ahead.
Rodriguez: Economic growth will be weaker than expected, and governmental chaos will be a key factor. I don’t see any reasons why we should grow at a more historical 3% or 3½%. All the Federal Reserve forecasts have been consistently overly optimistic. That will be the case again next year. We face a period of higher volatility in terms of economic trends, and then you layer on new regulations.
Your outlook for the stock market next year?
Buckingham: Returns in line with the historical 10% to 12% average are not unreasonable, though equity market participants should be happy even with modest returns—given the [awful] yields on competing investments.
Fisher: We’re in a long bull market because we’re not past the part where people are fighting the past; they’re still skeptical.
Arnott: Returns are going to be pretty anemic in mainstream stocks.
Rodriguez: We do not find this an attractively valued environment. Valuations are being driven by non-sustainable policy, both monetary and fiscal. I would want a higher margin of safety: a lower valuation to risk capital.
What’s the likelihood of a market crash next year?
Arnott: A repeat of ‘08-‘09 is very unlikely. But a correction, an ordinary bear market, is very likely in the next 12 to 18 months.
Rodriguez: It’s impossible to forecast a crash, but the course we’re on cannot be sustained. It’s very much like blowing up a balloon. You blow it up and—Ahh, it hasn’t popped. You blow it up some more—Ahh, still hasn’t popped. Then you finally hit that moment—Bang! That’s how financial crises typically happen. When we face the next one, liquidity will be very limited; and price reactions will be quite sharper.
Biggest threat to the market next year?
Fisher: The biggest single likelihood is that it comes from stupid government policy.
Buckingham: A major economic slowdown in China or a significant spike in interest rates that negatively impacts the housing market and consumer confidence.
Rodriguez: Governmental surprises.
Arnott: The poisonous environment in Washington and constant meddling is the No. 1 stress to the market after high valuations levels. Washington seems incapable of according any respect to capitalism and free markets. Constantly changing rules and regulatory landscape leaves investors and business managers in a quandary. [Companies] hoarding money creates an illusion of massively higher profits, and that’s an unhealthy foundation for current valuation levels.
What about corporate earnings next year?
Fisher: They’ll be fine.
Buckingham: We’re optimistic but want to see some topline growth.
Rodriguez: The odds of earnings disappointments next year are a reasonably high probability. We’re already at eye-popping profit margins.
Arnott: Being at an all-time peak in earnings relative to GDP is a pretty dangerous space for further profit growth. Can profits go much higher? Not without risk of a major political backlash—a risk of Occupy Wall Street’s suddenly becoming a mainstream movement.
Your predictions for bonds?
Rodriguez: They don’t provide a safe haven. With interest rates and long-term yields at these levels, it’s a fool’s paradise. We continue to stay short in our bond portfolios—approximately two years. And that has been successful. We could go back to lower yield levels if the Fed accelerates quantitative easing, which is a reasonable possibility: Rather than taper, they buy for a longer period. That might lead to somewhat of a bond market rally. But with each year that we continue to expand the debt or liabilities and keep interest rates down, the odds of unintended negative consequences rise.
Buckingham: Investors have had an eight-year love affair with bonds, but the red ink this year will finally lead to a rotation into equities.
Arnott: The run-up in bond yields paired with a relatively bleak economic outlook suggests that bonds could surprise to the upside. I would not be a seller of bonds at the moment. I’m a very mild bond bull.
What will happen, then, with interest rates?
Buckingham: The Fed will very likely remain accommodative throughout 2014. We saw that even a modest uptick can cause fickle bond fund investors to head for the hills.
Fisher: Assuming quantitative easing ends, long rates go up and short rates stay low; and the spread between short and long rates rises.
Rodriguez: Interest rates are being massively manipulated by the Fed. When you drive rates to zero, almost anything qualifies as an investment; and people are running away from liquidity. Keeping interest rates down for a progressively longer period only blows up the bubble larger and larger—and it will pop.
Thoughts on Federal Reserve Vice Chairwoman Janet Yellen’s nomination as Fed head?
Buckingham: Ben Bernanke has done a terrific job of bringing the financial systems and economy back from the brink. You need to let the existing regime finish what they started.
Arnott: The Fed is currently run by academics who have never run a business or a bank—and that’s very dangerous. At some point they must taper and stop this nonsense of buying government bonds in what is ostensibly a recovery. Why should there be monetary stimulus in an economy they claim is growing? They have a failed policy, painted themselves into a corner and don’t know how to get out. It’s a very scary situation.
Rodriguez: The Federal Reserve is a temple with divine entities. But given that we’ve had the two biggest bubbles in the last 15 years and the Fed didn’t appear to be aware of either one, doesn’t give me a lot of confidence! [Yellen] will have to bring in a wider array of economic speed limits. But will that improve Fed policy outcome? I doubt it.
Fisher: Fed chairs’ activities before they head the Fed have not been terribly predictive of what they’ll do—though Mr. Bernanke remembered some of the things he knew before, and what he knew was wrong! The best thing the Fed head can do is remember: First do no harm.
Expectations for the SEC chaired by Mary Jo White?
Rodriguez: More regulatory changes. But have any that occurred over the last 42 years I’ve been in the business really helped? No. The captain of the ship, whether the Fed chairman or regulatory heads, were off the bridge when the new S.S. Titanic hit the iceberg in ’07. I give the last two administrations—which covered most of the two greatest bubbles—an “F,” as in failure.
Buckingham: A renewed focus on transparency and little patience with technical glitches with investing exchanges. Flash crashes and flash freezes matter psychologically: Investors are already soured on the financial markets. I’d like to see money spent on having a redundant system. It’s necessary.
Fisher: Mary Jo White will be more of what you could view as anti-financial services than recent SEC heads. But I don’t think that will change anything very much.
What sectors or stocks do you like for next year?
Rodriguez: When we look at valuations on equities, the number of companies qualifying are few. Our defensive positions and liquidity levels are in the top quartile. We have been reducing exposure to energy for the last two years. We’ve been primarily net sellers of stock. Pretty much the entire firm has more of a cautious attitude. No sectors pop out. It’s very one-off. Two recent additions to Capital Fund were Apollo Group and Centene Corp.
Fisher: There’s a long bull market ahead. That means you move into a realm where big, high-quality pays off: pharmaceuticals; big, boring names in technology; a little energy; consumer staples. Midsized banks and [non-European] foreign banks look pretty good—banks that are in the business of taking in deposits and making loans.
Buckingham: We’re overweight energy, industrials, materials and information technology. We like, for example, Ensco PLC, Caterpillar, Mosaic and Apple, all laggards so far this year. Also, Barrick Gold, American Eagle Outfitters, Deere & Co., Corning, HollyFrontier and Norfolk Southern.
Arnott: Beware of some of the more popular and trendy segments of the market because they’re fully priced. Broadly, I would be wary of U.S. investments because parts of Washington are at war with capitalism and the private sector, and that’s very sad and dangerous. Break through the risk of a portfolio of mainstream stocks and bonds with a diversified one that can respond to inflationary pressures and that invests in emerging market stocks and bonds, TIPs, commodities, REITs, high-yield bonds—the whole spectrum of assets that offer higher yield and higher growth rates.
And your outlook for international investing?
Fisher: The U.S. stock market has done better than the world. As we move through the rest of this bull market, that begins to equalize. Emerging markets are beaten up pretty badly and will probably get a bounce-back. European stocks are starting to play catch-up.
Arnott: I like diversification into emerging markets stocks and bonds because more and more of these economies are becoming less dependent on the developed world, less dependent on the U.S. than they’ve ever been. There’s blood in the streets in some of these emerging economies. That’s why they’re cheap. But does anyone really think their growth can be slower than U.S. growth? Faster growth and cheaper markets are a great combination.
Buckingham: We see opportunities in Europe, with names in the integrated oil space, including Eni, Royal Dutch and Total.
Any other prognostications for next year?
Rodriguez: Volatility in bonds is very high; volatility in stocks will be very high over the next several years. All the economic flows add volatility to investor expectations. When volatility rises, confidence tends to fall. If you’re not prepared for [all] that, you’re going to be in for a rude awakening.
Arnott: There’s tension between deflationary pressures and inflationary pressures. My betting is that inflation wins. With inflation, mainstream bonds are very dangerous and mainstream stocks are moderately dangerous. That’s not to say that very dangerous portfolio won’t perform well on a short-term basis. Next year might be OK, but at some stage it’s likely to be very disappointing.
Buckingham: We expect a gradual tapering. That is, there will be plenty of support from the Fed and thus no reason to think that the adage, “Don’t fight the Fed!” will be anything but a tailwind for equity investors.