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(Jonathan Alcorn)
(Jonathan Alcorn)

Inside the Market

Q&A: Gary Shilling on why the latest rush into stocks will end miserably Add to ...

Last week, we asked our readers to submit questions for Gary Shilling, one of the world's best-known economists and money managers. We selected 10 of these and posed them to him.

Mr. Shilling may be one of the last big-name bears standing - and he didn't disappoint on his downbeat outlook for markets and global economies. What follows are his views on everything from stock markets (get ready for a big correction), U.S. housing (forget about any price recovery) and how to invest (ditch high yield in favour of secure corporate bonds).

More Related to this Story

Next week, we'll return with our weekly live investing chat at Inside the Market, at 1 p.m. (ET).

The S&P has already reached the highest level since 2009. Do you see it going higher from here, or see it cooling down a little bit?  -- Neil Godeum Suh, Winnipeg

Right now we’re in what I call the grand disconnect. The economies of the world are growing slowly, if at all. The euro zone is in recession, the U.K. is in recession, Japan is in recession, China’s growth has slowed, and U.S. growth is not all that robust. But investors couldn’t care less. All they are concerned about is the money being shoveled out the door by central banks. And I call that the grand disconnect between the real economy and investors’ view of the world.

On top of that, there’s this zeal for yield: low interest rates engineered by central banks have encouraged people to go after the junkiest of the junk. The lowest credit rating investment vehicles, junk bonds, emerging markets bonds and the like. They couldn’t care less about the risk - all they care about is yield. The combination of these factors gives us what is clearly a risk-on position.

As long as this grand disconnect and zeal for yield persists, we’re probably going to see more of the same. And there’s some feeling now that, when looking at the near-trivial returns on junk bonds and other low-grade fixed income investments, people are saying ‘gee, maybe I better go for equities instead.’ So I think as long as this grand disconnect and zeal for field persists we’re probably going to see higher stock prices.

It’s a very unsubstantiated grand disconnect and I think sooner or later it will be eliminated by some big shock. I don’t know the timing of that, but it could be like a big spike in oil prices because of problems in the Middle East. It could be Washington not dealing with the postponed fiscal cliff…

I think it could (be this year) but forecasting big shocks like this is obviously difficult. It’s in the cards, it’s just a question of when it will happen. But things are getting very frothy. For example, 46 per cent of junk bonds in the US are selling at or above call. In other words, they are selling at or a higher price at which the issuers can call them back and regain them. Well that normally doesn’t happen because the assumption is they will be redeemed. It just shows the frothy nature and this is very speculative, very bubble-like in many areas.

Q: What is the outlook you have for Canada, as we are a resource rich country? Are we seeing a new chapter of trade and diversification into Europe and Asia? -- Candace Bower of Vancouver, and John Bourassa of Red Deer, Alberta.

Canada is a commodity country. …  This makes it very susceptible to commodity prices globally and the reality is that this depends on two things: the pace of exports to the major buyers of other people's goods and services, and that’s the U.S. and Europe. And the other is China, which is manufacturing most of these goods that are getting exported. …

I think ultimately the bet on Canada really depends on what’s happening in the U.S., Europe and China. I don’t think the outlook there is all that rosy. China is definitely trying to shift away from an export-oriented economy to a more domestically driven one. Europe is in a serious recession and the U.S. is distinctly subpar.

I think we’re going to find the Canadian economy subdued by these dramatic disorders. Having said that, Canada has done a much better job  than the U.S. in the earlier period, and didn’t have the excesses and consequently didn’t have such a huge financial crisis…but I don’t think that makes Canada invulnerable to global forces because it is a much exposed economy due to its commodity and export driven nature.

Q: I would like to hear your advice for a conservative, passive investor with a nest egg currently held in cash. Specifically, I am asking about investment capital that is not likely to be needed in the next 5-10 years.  Assume an adequate emergency fund and savings for living expenses in the next 5-10 years. -- Unnamed male from Toronto.

A: Very good question! I think for a conservative investor right now, cash is not a bad option. There still is some inflation in the economies of the world – but not much. So cash is not eroding due to inflation the way it was way back in the 1970s. But when you really look at investments…we are going through this de-leveraging - in other words, working down the excess debt that was driven up by financial institutions of the world.. while that’s going on I think we are going to have very slow growth in the economy.

Certainly, for equity markets, things have gotten very frothy, people are not paying attention to fundamentals and the slow growth in the world. But I think they will be forced to. With this in mind and the likelihood that we got another five years of this de-leveraging to go … I think cash is not a bad place to be for the foreseeable future for the conservative investor.

The fact is, the S&P 500 is actually down from its peak in 2000. From 12 years ago, it is actually down 4 per cent. If anybody at the onset of 2000 had said, you’re going to lose money over the next 12 years, would that person want to go into stocks? I don’t think so. Why take a tremendous risk if you’re going no where and I think that’s the condition we continue to be in. The downside risk is much greater than the upside potential.

Q:  You have been very quiet lately on real estate. Do you still believe we will have a 20 per cent decline? Based on the fact that it has gone up about 5 per cent since you said that, do you believe we should expect a 25 per cent decline in 2013? -- Mike Ynez from San Jose, Calif.

A: I’m not going to quibble about the numbers, but it will take a 21 per cent decline in median single family house prices in the U.S. to bring them back to a long-term trend that goes back to 1890. I'm a big believer in the reversion to trends, particularly trends that are over a century in length. The housing market is looking a bit stronger now, but of course that was also true in 2010 when we had the new homeowner tax credit and everybody got excited. … If you look now and at the strength in housing, it’s not new homeowners, which is what you really need for a sustained housing boom --  it’s rentals, it’s people renting houses, it's investors buying houses….that’s what’s driving housing in this country. On top of that, I think there’s still a lot of inventory out there - vacant houses that are not listed for sale - that are probably going to come out of the woodwork. Some are foreclosed houses that haven’t been sold, some are empty houses that people listed earlier for sale, couldn’t stomach the bids they got so they pulled them off the market. But they probably still want to sell them. And if you add this to what is listed … it says you need to reduce inventories by 1.9 million to get back to the normal trends and that’s a lot. 1.9 million is a tremendous surplus. We only build 1.5 million a year in the U.S. I think we will see substantial weakness in housing.

Hello Mr. Shilling. Would you suggest to invest in silver and gold (or just one or another) during a bear market?  Does gold represent a good investment? Or do you think gold and/or silver will lose value in 2013? -- The Dividend Girl of Montreal

I’m agnostic on precious metals. I just have no opinion. Obviously industrial metals, I think they are vulnerable. This is copper, tin, lead, zinc... they are very much driven by industrial  production and on top of that, there’s been this extra zeal because people assumed China was going to buy all of them in sight. Indeed, in recent years China has consumed more than 40 per cent of all of this metal. … but I think with the likelihood of slow growth and weakness in exports, and China’s growth being subdued, I don’t think these nonferrous metals are going to be attractive. I think they are going to be really unattractive for a number of years.

Q: I have very high regard for your expertise, rigorous analysis and economic investment views. Here is my question on equities. What if corporations maintain, and even better, grow earnings at about a 5 per cent rate, despite all the headwinds you are worried about? Is it possible that the worry over the peak margins/earnings cliff may be misplaced given the efficiencies the corporate sector has achieved and the stagnant GDP growth. -- Madhu Kodali of New Jersey

A: The trick is to achieve that profit growth. There are three factors that I think are affecting corporate profits now. One is revenue growth, top line growth, with the world moving as slowly and perhaps getting more slow in terms of economic expansion. I think there’s limited potential there. Second factor, and this really applies more to U.S.-based corporations, is the currency. I’m of the opinion that the dollar is going to continue to strengthen against many major currencies. The yen certainly - they want that weaker; the euro,  probably. And that means currency translation losses. In other words, foreign earnings by U.S. corporations and export earnings translate into fewer US dollars. So that’s a negative. Third factor is an interesting one: profit margins. And that’s where the efficiencies come in. American  business did a very robust job of cutting costs in the early part of this recovery.  It was almost impossible to raise prices, so the route to profit increases was to cut costs, and of course that’s reflected in the declining real wages in this economy. … Also, there was productivity-enhancing equipment. The reality is, that worked beautifully in 2009 and 2010, but recently that productivity growth has been much less reliable. What this means is that businesses are simply scraping the bottom of the barrel, there isn’t a lot of these cost-cutting productivity boosting opportunities… I think that which really was primarily the driver of corporate profits is not there. Now somebody says 5 per cent growth rate. But where are you going to get it? Are the economies of the world suddenly going to come to life? Is there further opportunity in terms of margin improvement, productivity improvement? Is the dollar going to weaken? ….i think that’s where you have to look before you conclude that you have a 5 per cent higher profits growth rate in store.

Q: What do you think of high-quality corporate bonds and would you ever recommend getting exposure to it through a bond ETF. --William England of Edmonton

A: I’m favourably disposed to high-quality corporate bonds, and we use corporate bond ETFs in portfolios that we manage. And that is what we are doing now. We talked earlier about this zeal for yield and this grand disconnect, and while it is ongoing, it is a risk for trade. The way we’re handling that in our portfolios is by not going out and buying a bunch of junk bonds and emerging market bonds that are really at the high end of the risk curve. I think they are most vulnerable and most bubbly. Instead, we’re sticking to much more conservative investments such as high-quality corporate bonds. The yield is not spectacular, but I think on a risk-adjusted basis, I think it’s way ahead of the high-risk areas.

Q: At what point should a person reduce their exposure to government bonds? What should they use to replace them? --Dave Founk of Calgary.

I’ve been a fan of U.S. treasury bonds, and particularly the 30-year bond, since 1981. The yield at that point was 15.2 per cent. And I said back then we are entering the bond rally of a lifetime. Prices have just skyrocketed, since the yield has now dropped to 3 per cent. I’ve never, never, never bought Treasury bonds for yield. I couldn’t care less what the yield is, as long as they are going down. In other words, I want the appreciation and that’s the same reason most people buy stocks of course. I’m of the opinion that if we’re right, and there’s a global recession shaping up, that will reduce demand for credit, and it will enhance the appeal of treasuries as a safe haven, and it will probably get more people worried about deflation then inflation. Those three factors I think could drive yields on treasuries down further, and if they go down further, we will go from 3 per cent to two per cent. You’ll have appreciation of about 16 per cent on a 30-year coupon bond assuming it takes place over a one year and you get a year’s worth of interest. And on a zero coupon bond it’ll be a total return of about 25 per cent.

Q: You have expressed a strong preference for income-producing securities for 2013. Very few Canadians are aware of U.S. mortgage REITs. What are you views on mortgage backed securities, and both agency and non-agency mortgage REITs? Thank you.  --Walter Schwager of Toronto

A: There’s been a big rush into mortgage backed securities, and particularly in the commercial area they are frothy. That’s in the category of junk bonds and I would definitely avoid them. Some of the others, some that are backed by Freddie May and Freddie Mac, or the federal housing administration, I think are probably much more desirable. They have government backing and if you’re going to get involved, that’s where I would get involved. ….I’m just taking a cautious attitude now because I think we’re in a never-never land where markets have departed from reality of what’s going on in the economies with this ongoing deleveraging and slow growth.

Q My concern is high valuation of some companies, in particular companies that may be years away from making any real profit. Linkedin comes to mind, and even Amazon. Do you feel that we are in bubble territory again and what is contributing to the bubble if, as they say, investors are staying away from the stock markets? -- Sean More from Prince George, BC.

Well I think we are in bubble territory and a lot of these … high growth rates just dazzle investors and it's always a question of, 'at what point do you get paid back? At what point do they have some earnings? At  what point will we see a possible dividend?’ The only reason you buy is that you think there’s a great fool out there who will pay an even higher price for them later. And of course, the whole idea is if they have exploding  earnings, well, they are going to be worth more eventually. But when that finally comes to fruition is questionable. I think a lot of these things have gotten away from reality and of course we saw the absolute fiasco with Facebook. I think a lot of people thought that, because they were users, they said ‘ok, I use it, I like it, it’s good,’ and they didn’t realize there’s a big difference between a social media vehicle that they enjoy using, and an investment. I think a lot of these things have gotten carried away.

 

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