The Gold Report: For more than a decade, you led Morgan
Stanley Investment Management's global investment strategy; now you own your
own research firm based on your observations of the industry for more than 50
years. How do you explain the volatility in the markets right now and how
should investors position themselves to prepare for what is coming?
Joe McAlinden: It has been a wonderful bull market, a wild ride
going all the way back to 2007 when the market made its top. That was followed
by a horrendous plunge. We've not only made that back, but the market has
reached highs that were 36% above the 2007 highs. I had been concerned
recently, however, that price-earnings ratios have become elevated and we are
seeing other spooky similarities to the conditions that prevailed prior to
the 1987 crash, including the absence of a more than a 10% correction for
three years and a breakdown of small-cap stocks. The market could be
vulnerable to some kind of major shock. I believe that the big shock is only
beginning to unfold and that as it does, this correction will get
considerably worse, perhaps double what we've had so far and maybe even worse
than that.
TGR: What do you think the market expects the Federal Reserve Board
to do?
JM: The market is hoping the Fed will bail them out by postponing
the tightening, but I don't think that's going to happen. It is appropriate
for the Fed to begin the tightening process now. It's not the Fed's job to
regulate what's going on in the stock market. It's job is to maintain the
purchasing power of our currency. The Fed is tasked with keeping inflation
and inflation expectations stable and fostering full employment.
The U.S. government should not be in the business of trying to manipulate
the stock market the way the central planners in Beijing do. We're supposed
to be a free market economy. The Fed should not allow monetary policy actions
to be determined by what the Dow does on a given day. I think that, as some
Fed officials have indicated, it should and will go ahead with the
quarter-point move in September.
I am worried about the tremendous gap between the Federal Open Market
Committee (FOMC) members' expectations and the market's perception about the
path ahead for the federal funds rate. When you look out to 2017, the gap is
about 130 basis points. That is a big deal because we all learned in
securities analysis 101 that stocks are worth the present value of the future
stream of earnings. In the case of high-growth equities, future earnings are
a big part of the current value, especially when the discount rate is
influenced by the current policy of zero interest rates in the U.S. So my
concern is that a) the market is overvalued, b) there are these similarities
to 1987, and c) the gap between market expectations and what the Fed plans to
do needs to be closed. My guess is that as it closes, there will be downward
adjustment in equity prices and bond prices.
TGR: What were the causes of the "flash crash" that
happened at the end of August? Are there black swans that could bring back
painful 2008 scenarios?
JM: The consensus interpretation of the flash crash is that the
volatility was due to the China slowdown. I don't argue that is not a factor,
but the bigger problem was China's peg of the currency to the dollar, which
just kept getting stronger. They couldn't hold the peg any longer and did
that devaluation. I think it will probably not be the last.
Derivatives, which have proliferated throughout the markets, are
vulnerable to jolts. It is unknown to what degree big players afraid of being
exposed to liquidity problems played a role in the crash. The ability of
banks to step in with capital has been greatly diminished and that could have
played a role, along with Dodd-Frank and other reporting requirements. Many
hedge funds today are driven by algorithms, so there is no human compassion
in place to make rational decisions when anomalies occur. More corrections
are likely.
The big question is: Where can investors hide if we are heading into major
correction territory? I think we're going to see the relative strength of
precious metals turn up sharply—it already appears to have perked up—simply
because when you get into a scary environment, there tends to be that flight
into hard money. But I think there's more involved here.
Conventional wisdom is that a hike in interest rates is going to hurt
gold, but that is not borne out by history. When rates have gone up in the
past, gold has risen, as have other precious metals. That is what will happen
again. That makes me positive on gold, which, to be honest, I haven't been in
a long time.
Oil follows the same trends. Interest rates rose in the mid-1970s by a ginormous
amount, but so did oil and gold. I was there and I can tell you I witnessed a
broad move in precious metals and hard assets. Energy also enjoyed a
tremendous move. Last month, I wrote a piece for our subscribers called
"Time for Value" that predicted the value side of the market, which
includes a lot of hard asset categories, will outperform on a relative
strength basis. In other words, if you were short growth and long value, I
think you'd make money irrespective of how deep this correction goes. A part
of that call would be to go out there and catch a falling knife on the energy
and precious metals side of the market.
TGR: Are there specific areas in the energy sector that you see
thriving in the scenario you describe?
JM: Crude oil prices are the key to the sector. There are a lot of
moving parts. Fracking is becoming more economic and competitive. Production
costs continue to fall in the U.S. But the world depends on non-U.S.
production. Countries like Saudi Arabia and Russia need higher oil prices to
pay for the social programs that keep leaders in office, creating pressure on
prices. That includes prices for production from North American shale and tar
sands.
At the same time, technology is improving for solar production and prices
are coming down. That is where the future lies.
TGR: Streetwise Reports looks for investing ideas across all sectors.
Where else would you find value?
JM: I've been very positive on the U.S. residential housing market,
largely because of demographics. Home-ownership for American families is the
hard asset of choice. Home prices will continue to rise to above where they
were at the so-called bubble peak in 2006–2007.
The problem with housing up until recently has been that people born after
1980 have been slow to form new households. It is part of the "failure
to launch syndrome," where folks are staying with family because jobs
have been hard to find. Job data for that age cohort has picked up
dramatically and, as a result, household formations have spiked up like a
hockey stick. For several years, household formations were running around
500,000 per year. Now, they're in the 1.5–2 million per year range. A lot of
that is going into rentals, but now rentals have skyrocketed, vacancy rates
are down and young people are being motivated to find a way to buy a first
home. First-time home buyers as a percentage of the total are up from where
they were a year ago. This is true across the country, in large and small
cities. The negative view of housing after the crash and the disinflationary
environment will be reversed as people continue to see housing prices rise.
They are already up at least 35% from the bottom, with way more to go.
Just as in the 1970s, when a housing recovery was driven by a shortage due
to underbuilding in the previous decade, prices will go up. The Case Shiller
statistics show that home prices dropped 35% from the peak in 2007 to the
trough, and they've come back more than halfway over the better part of a
decade. At the peak, house prices were probably higher than they should have
been at the time. But when you look at some of the components of what it takes
to build a house, like construction wages, the average hourly pay of
construction workers is actually 20% higher now than it was in 2007. That is
a sign replacement costs are increasing, which indicates home prices will
continue to move higher. That is why I think housing is the other area that
will do well in spite of what's going on in the broader market.
TGR: I know you are a true hedger. I understand your concept of
shorting growth and being long value, but is there an exchange-traded fund
that would capture this real estate play? Would you be buying the builders or
the apartment Real Estate Investment Trusts (REITs)? Where should our readers
be looking?
JM: I think the home builders are going to continue to do well and
outperform the market. I think everything related in that food chain—home
furnishings and home improvement—is part of that story. It helps existing
home sales as well.
I'm reluctant to make a general statement about REITs because there are so
many different kinds. Sometimes you think you're buying real estate but
you're really getting the mortgages. But if you can find a true equity play
on the value of the underlying residential asset, whether it's apartments or
single-family homes, there is shopping to be done in the REIT space.
If I'm right, we're going to see bond prices continue to erode from the
cyclical highs that they hit at the end of January when yields got down to a
one handle on the 10-year government bond. Over the next several years, I
think we are heading toward a three handle and maybe between a four and a
five for the 10-year treasury.
TGR: What else can investors do to protect themselves?
JM: The Nobel Prize winning economist Paul Samuelson joked in the
1960s that the stock market has correctly predicted nine out of the last five
recessions. More often than not, when you have a major stock market crash,
it's a sign the economy is going into a recession, but every once in a while,
a historic drop is not followed by an economic downturn. That's what I think
we're dealing with here. This is a market and financial asset phenomenon, and
it's going to be part of a re-allocation globally away from financial assets
and toward hard assets. That takes you to a lot of commodity-cyclical stocks,
the precious metals and real estate to the extent that it gives you exposure
to the equity side.
TGR: You are a wise man who has seen a lot from your perch at
Morgan Stanley and now in the companies you founded, McAlinden Research
Partners and Catalpa Capital Advisors. How are you positioning yourself based
on what you see coming?
JM: I work with hedge funds and portfolio managers and, now,
increasingly other investors, doing market strategy research. I focus on
change and only write about a sector when I see a shift. We are at a major
turning point in the macro picture right now. There is potential for big
moves up and down in sectors and specific securities.
For my own portfolio, right now, I'm very heavily in cash. I'm getting
ready to deploy some money in energy. Precious metals are also going to be a
safe haven.
TGR: Thank you for your insights.
