Investors buying stocks merely because the market keeps going up clearly calls for a big “Caution” sign. So caution is exactly what famed economist Gary Shilling urges, as he tells ThinkAdvisor in an interview.
The former physicist, who has built a career largely on vigilantly looking for crash-triggering market bubbles, and forecasting and predicting their demise, sees no bubble now. Nonetheless, he warns, there is ever the possibility of an external shock bringing the long running, record-setting bull market to an end.
Shilling drills down — looking beyond the consensus view priced into the markets — searching for indicators that other economists ignore or don’t expect. Among his accurate forecasts are the 1960 and 1991 recessions; the end of a lengthy span of acute 1970s inflation; and in 2003, that the Federal Reserve would cut short-term interest rates the following year.
Long a critic of the Federal Reserve, the economist, 80, argues that interest rate increases and the central bank’s selling off its vast portfolio could trigger a recession down the road. He is deeply at odds with the Fed about its view on inflation, seeing instead the likelihood of deflation.
Consequently, Shilling is bullish on bonds, based on what he describes as the “bond rally of a lifetime,” which he called 37 years ago.
In the interview, the informal economic advisor to George H.W. Bush names President Donald Trump’s biggest accomplishment thus far and discusses an international investing opportunity he discerned six years ago, and which he favors still.
President of A. Gary Shilling & Co., an economic consultancy and investment advisory firm, Shilling started out as a physicist but soon found that he was drawn to finance. After stints at the Federal Reserve Bank of San Francisco and Bank of America, Merrill Lynch tapped him as its first chief economist. Later, he was senior vice president-chief economist of White Weld & Co. By 1978, he had launched his own firm.
ThinkAdvisor recently interviewed Shilling, a Bloomberg View columnist, on the phone from his office in Short Hills, New Jersey. Author of the bestseller, “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation” (John Wiley 2010), he looks for 2018 GDP growth of only 2%-2.5%. In our conversation, he discusses the peril of investor complacency and provides a concise tutorial on how and why market bubbles develop. Here are highlights:
THINKADVISOR: Are you bullish about the market?
GARY SHILLING: No, I’m not rampantly bullish. Stocks are expensive. The economy is getting long in the tooth. There’s reason for caution. But by the same token, I don’t see the party coming to a grinding halt in the immediate future.
When we talked last July, you said the biggest threat to the market was complacency. Is it still?
Yes. It’s very much there. When you see this mad rush into index funds — passive investments — the attitude is: “I don’t care what the fundamentals are. I’m buying it because it’s going up.” So it’s onward and upward with no discrimination. The other manifestation is speculation — the same kind of speculative complacency we’ve seen in the Bitcoin area.
What’s the stock market’s tipping point?
Good question. Historically, bull markets haven’t died of old age. There’s always some trigger mechanism. In the post-World War II period, they’ve come from two sources. One is that the Federal Reserve worries about an overheating economy and tightens up credit. By my reckoning, in 11 out of 12 tries, that has precipitated a recession. The only soft landing was in the mid-90s.
What’s the Fed’s strategy now, and how do you think it will turn out?
They’re not only raising interest rates but starting to sell off their huge portfolio. They’ve had this lack of success with just raising interest rates for over a century. Selling off the portfolio is newer and exotic, and they’ve never had anything the size of $4.5 trillion. So I think the odds of their pulling [all of] it off successfully are zilch.
Well, that isn’t optimistic.
I’m not saying you’ve got a Fed-induced recession coming up immediately, which would be related to a bear market in stocks. There’s a lot of liquidity in the system, and the Fed is moving slowly. So it could be years before they sop up enough liquidity to start to pinch things. Of course, we could get a shock at any time. But I don’t see anything that’s just waiting to happen.
So you haven’t spotted a bubble?
I don’t see anything on the immediate horizon that’s cruisin’ for a bruisin’. Yes, you can conjure up some shock coming out of a blowup in the Middle East, Venezuela disappears from sight, oil prices spike, some kind of military mix-up with North Korea. But I don’t see anything sticking out like a sore thumb, as you had with the dot-com excesses in the late 90s or the subprime mortgage zeal of the mid-2000s that just went the way of all flesh.
You look for odd and atypical things occurring, which haven’t been discounted, in order to discover investment opportunities. What do you like now?
One that we’ve been very optimistic about is India, though it’s better known today than it was six years ago, when we first got enthusiastic about it. I wrote a report back then that India was a better bet in the long run than China. It’s a long-term play and still has a lot to go.
What’s promising about India?
It has a lot of advantages: It’s a democracy, albeit a messy one — there’s a lot of graft and corruption — but it’s a democracy. China is a top-down dictatorship and is becoming more so. The world is pretty much saturated with manufactured goods now; and as economies grow, a greater portion of spending is on services. India is much more into services — software and so on. They’ve got a knack for it. And India has large private corporations. In China, they’re basically state-controlled and very inefficient.
Turning to fixed income investing in the U.S., what’s your outlook for bonds in 2018?
I’m not of the opinion that interest rates are going to go through the roof. The correlation of inflation with Treasury bonds is very high. So that says if you’re right on inflation, you’re going to be right on bond yields over a reasonable length of time. If you have a deflationary bias [as I do], you’ve got to be bullish on bonds.
You’ve been a bond enthusiast for a long time.
I’ve been a fan of treasury bonds since 1981, when I said we were entering the bond rally of a lifetime. And since the early 80s, long treasuries have outperformed the S&P 500 by six times. I’ve been steadfast in that bullishness about bonds for 37 years.
So, do you see deflation on the way?
It’s a distinct possibility. There’s so much excess capacity in the world and so many downward pressures. Look what’s happening with Amazon and online selling! It’s a competitive race to the bottom. Amazon can pretty much dictate price. If an outside seller on their platform is selling something at say, $10, and Amazon decides they want more traffic in that area, they’ll list it at $9 and make up the difference to the supplier. They have tremendous market power.
Arguing that inflation won’t rise, you recently noted that “inflation continues to undershoot the Fed’s 2% target.” Why do you believe the Fed has it wrong?
The Fed is misreading reality for a whole host of reasons. One of the biggest is globalization. They’re very much in a domestic world and don’t realize the power of what globalization has done to manufacturing, how it’s decimated unions in this county, what it’s doing to the service areas, where companies are outsourcing legal and accounting work to India. The Fed is oblivious to all that.
What’s an additional reason?
The Fed looks at the unemployment rate, which is a very poor measure of labor markets. They’re not measuring employment; they’re measuring how many people are looking for work. That doesn’t address the labor participation rates, which are barely off their lows.
What are the chief positives of President Trump’s tax package?
The cuts, kind of, even up the playing field in the corporate area. They don’t really do much net-net in the individual area. They front-loaded them, with the idea of spurring the economy. But it was a political game — we’ve got an election coming up this fall. However, there was serious need in the corporate area for updating in a globalized world. We had a 35% tax rate, and now it’s 21%. Amazon and Microsoft and [other companies] had cash stashed overseas.
Why will the cuts have little effect on individuals?
There’s an effect in the next year or two because they’re front-loaded. But then that’s basically taken away in the succeeding years. So it may spur incomes in the next year or two, but that fades over time.
Will people start spending more?
Higher-end people don’t adjust their spending when their incomes or assets go up and down. But with more money in their hands, middle- and lower-income people tend to spend. So I think that whatever increases they get in income will probably go to rebuilding their savings, particularly baby boomers, who have been notoriously poor savers throughout their entire lifespan.
Why is there a need for consumers’ savings to be “rebuilt”?
People have been reducing their saving rate, which has gone from about 6% to 3% in the last couple of years. If a lot of them don’t start saving like crazy, they’re going to end up working till they drop dead.
How much do you credit Trump for the stock market’s record-setting performance?
Some things that Trump has accomplished suggest that he has had a measurable impact on stocks. The most important one is deregulation. That’s his biggest accomplishment. Deregulation isn’t dramatic. [I mean], there’s no Rose Garden signing ceremony for deregulation. It’s a little of this, a little of that. It’s putting different people in charge. It’s either ignoring regulations that they want to avoid or changing them.
What are examples of deregulation under Trump?
OKing pipelines and cutting back on some EPA and Labor Department requirements. Of course, there are always two sides to these things. There’s the whole question of: Is the cost worth the effect? But Trump is riding the wave of a lot of people saying that regulation was excessive, and a certain amount of what’s happening in the stock market reflects that.
Back to market bubbles: Why is it so hard to detect them?
They’re never clearly apparent until after the fact. That’s why I’m always very vigilant and don’t hesitate to look for those problems. But I don’t see an overwhelming number of them right now.
You were a physicist: How does a bubble form?
Usually they start out with some rationale. For example, the rationale with Bitcoin was that it’s an underground economy. But then, bubbles take on a life of their own, and the basic reason is long left behind: People are buying because it’s going up.
Where does that lead?
Bubbles continually expand because there are more buyers than sellers. They finally peak when the buyers run out, and there’s nothing but potential sellers. That’s when bubbles break.
What makes them enlarge so, to the breaking point?
The problem is that the participants in a bubble have every interest in having the thing expand forever. They come up with all kinds of rationales that are often very convincing. So it’s sometimes hard to separate the wheat from the chaff and see the extent to which bubbles are there.
You said in our previous interview, and much the same in this one, that the Fed is “completely clueless.” How can the U.S. central bank be so unaware?
My view is that there aren’t many people there who have ever met a payroll — never had the responsibility for running a business and paying people. Almost all of them are academics or people who have spent their whole career in the regulatory area or in government agencies.
Ergo, what would their thinking be?
They believe [for example] in the Phillips curve [theory] that says: As the unemployment rate goes down, inflation goes up. Well, since the Great Recession, both the unemployment rate and inflation have come down. Those are facts. But the Fed doesn’t seem to be overly swayed by the facts. They’re stuck on this theoretical model.
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