The plummeting stock market is merely a prelude to the calamitous upheaval to come, legendary investor Robert Rodriguez tells ThinkAdvisor in an interview.
The former CEO of First Pacific Advisors for 25 years has been warning of another terrible financial crisis for the past several years. Now, he says, the likelihood of that is “near certainty.”
Rodriguez, who retired from FPA in 2016, is well known for forecasting the dot-com bust and the financial crisis of 2008-2009.
The odds of a recession are rising, and it could occur next year, says Rodriguez, who argues that the biggest threat to the market is the excessive leverage that’s been employed to stimulate U.S. economic growth, now slowing.
Rodriquez, 70, who, over the last four years or so, moved most of his personal assets out of the market, now has a tiny exposure to stocks, all of it in mutual funds. In the interview, he discusses this and his fixed income investments as well.
He chalked up a striking record at Los Angeles-based First Pacific. The FPA Capital Fund, which he managed from 1984 to 2009, had an annualized return of 14.2% during those years, according to Morningstar. It outperformed the market indexes by 500 to 600 basis points compounded during his 25 years with the firm, the former manager says. The FPA New Income Fund’s annualized return came to a strong 8.8% under his management.
Today, Rodriguez opines, reality is beginning to seep into the still “delusional” equity market, as evidenced by the current correction. In a ThinkAdvisor interview this past January, he likened the market to “Alice in Wonderland” populated by host of irrational Mad Hatters.
Interviewed by phone on Dec. 18, with an email exchange the following day, just after the Federal Reserve again raised interest rates, Rodriguez examined what he terms the Fed’s long-time “insane monetary policy” and his expectation for rates next year. He labeled the ever-swelling federal deficit a “non-sustainable trend.”
On Dec. 19, after the Fed raised rates and cut its expectation to two rate hikes in 2019 from three. He said in an email message:
“The reductions are a function of slightly weaker economic growth. I expect weaker GDP growth [in 2019] than what the Fed anticipates to be 2.3%, which is lower than its 2.5% September forecast. I expect to see growth rates of less than 2% or even 1%. Should I be correct, the two rate hikes may not occur; and the Fed may be forced to begin thinking about a reduction.”
He continued, “The longer term projection for the funds rate was lowered from 3% to 2.8%, and the 10-year bond yield fell to 2.76% from 2.82%, while the two-year inched up from 2.65% to 2.66%. In other words, the yield curve flattened more, to just 10 basis points. The flatter yield curve continues to pose a challenge for the equity market.”
In sum, “The market is now caught in a transition of Fed policy that includes shrinking its balance sheet, quantitative tightening and weaker economic growth expectations. This realization is causing additional downside equity price action, which has been and continues to be my view.”
In the interview, the star investor, speaking from his Lake Tahoe, Nevada, home, also offered his appraisal of President Donald Trump’s tenure thus far and enthused about his fun, highly unusual investing project that he hopes will be a smart inflation hedge.
Here are highlights of our conversation:
THINKADVISOR: Do you see a financial crisis on the way?
ROBERT RODRIQUEZ: It’s virtually impossible to forecast the timing, but I think the probability is near certainty.
What are your thoughts about the current market correction?
This is only the preamble. People are thinking, “Oh, we’ve already had a major correction, and we’re getting to the lows.” After nine years of insane monetary policy that has created unintended consequences that we don’t know about yet but will find out, this is only the initial phase.
What could happen?
If the S&P and Dow Jones levels break from where they are, you’ll get another rapid decline in the market because of quantitative-driven management strategies causing [managers] to jump on the downside.
In my Jan. 30, 2018, interview with you, you called the stock market “Alice in Wonderland” populated by a host of irrational “Mad Hatters.” Are they still in the Rabbit Hole?
The equity market was delusional and still is. All the excitement from the Trump tax cut has been washed away. And where did the corporate tax cuts go? Stock buybacks and dividends. Capital spending hasn’t occurred, which means that productivity is unlikely to improve appreciably. We’re substituting labor for capital. That’s part of the [reason for] lower unemployment rates.
What other evidence is there that big trouble is ahead?
You already have the Russell 2000 in bear market territory, down 20%. The S&P retailers are down 20%. You could argue they’re losing business to the Net; but even so, it’s a measure that things are changing. I believe this is the worst December for equities since 1931.
What does all this mean?
I think reality is starting to come into play [evidenced by] the stock market correction.
Do you forecast a U.S. recession?
The odds of a recession are increasing. It could occur next year very easily. At the least, you’re going to see a growth slowdown. I’ve been watching this for a decade, and the numbers are starting to come together in terms of the excessive growth in leverage in the system [and other factors]. When we have a recession, it will likely be a worldwide one, and that will create other issues.
You didn’t say, “If we have a recession.” You said, “When.” So you’re sure?
There’s no question that we’re going to have another recession. The laws of economics haven’t been eradicated. We’re getting close to a flat inverted yield curve [a predictor of recession], and that’s helping to cause uncertainty and consternation in the equity market too. I had expected that the yield curve was going to flatten. Historically, when the yield curve is flattened, stock market volatility has risen. It’s nothing new.
If the market correction is just the “preamble,” what comes next?
Economic growth is decelerating. It was only temporarily boosted by the tax cuts, and it will be weakening in 2019 and 2020. The higher GDP growth we’ve seen this year was a function of President Trump’s trade discussions or, shall we say, trade war. Corporations have been accelerating their inventory acquisitions in anticipation of higher import costs. So two-thirds of the GDP growth last quarter came from inventory accumulation. I doubt that in 2019 and 2020 you’re going to see inventory build-up again. I fully expect GDP growth to decelerate.
What’s the biggest threat to the market?
The excessive leverage that’s been built up domestically and internationally to try to stimulate the growth that’s now decelerating. What do you do for an encore?
What’s your earnings forecast for next year?
The consensus is calling for 8% earnings growth in 2019 and in 2020, nearly 11% growth. I don’t know what they’re smoking! Given that [marijuana] has been legalized in several states, maybe they’re getting their hands on it a little too frequently. Corporate profits are barely up from 2012. Last year we were getting a major P/E expansion; now we’re getting a P/E contraction.
What role do interest rates play?
If the Fed goes on hold or starts to reduce rates late next year, it’s because the economy is becoming considerably weaker than what they were expecting. If that’s the case, what does it mean to earnings growth rates in the stock market? It probably means they’ve got to be lower.
So the bull market is over?