Fascinating interview With Richard Arvedlund, Founder, Cypress Capital Management, who is not particularly optimistic on the economy going forward:
WE CAN ALWAYS COUNT ON RICHARD ARVEDLUND to take a different tack. Independent and bold calls on the economy come easy to this longtime money manager, who’s seen it all in his 30-plus-year career. But his balanced investment approach, with a focus on high-yielding, big-cap stocks combined with some bets on bonds, helps his clients preserve their capital as much as build it. The founder of Wilmington, Del.-based Cypress Capital Management, which has $450 million in assets and is now a unit of WSFS Financial, is at his best in troubled times. Trouble, the way he sees it, is straight ahead.
Barron’s: It took a year, but the calls you made when we last spoke are looking pretty good now.
Arvedlund: Well, until midyear the economy was running much stronger than I had thought it would. However, a GDP [growth domestic product] slowdown has clearly begun. The GDP growth rate dropped to 1.6% in the third quarter from 2.6% in the prior quarter and 5.6% in the first quarter. We have not seen GDP growth below 2% for four or five years. We now have preconditions in place for a recession.
The preconditions would be the following: Whenever housing starts and permits drop by the rates of decline that have been exhibited — 10% to 20% — it has always preceded a recession. What is remarkably different in housing than just about any other sector of the economy is that whenever housing cycles turn down, and that’s happened twice in the last 30 years, once in the late ‘Seventies and once in the late ‘Eighties, the downturn tends to last much longer than people dream. The average cycle is three to four years.
Recession: The Stage Is Set
Interview With Richard Arvedlund, Founder, Cypress Capital Management
Barron’s, Monday, November 13, 2006
From our perspective, this one began in late 2005, when housing starts and sales and permits peaked, and should last at least through all of 2008. The rate of price appreciation in this housing boom has been the highest we have seen. We had a string of five years where the compound growth in housing prices approached 15% a year. Whereas housing kept the economic recovery going much, much longer and stronger than expected, housing now will drag it down for a much longer period than people think.
The other area that will hurt the economy is that all the major domestic auto makers have announced double-digit production declines for the quarter and into early 2007. This has happened before but, again, only preceding recessions or very dramatic slowdowns. The third precondition for a recession is a flat to inverted yield curve. Flat to inverted yield curves only occur before recessions, not slowdowns. All rates from three months to two years are above long-term rates. The yield on short-term paper is over 5% and the yield of the long bond is 4.75%. Where we had been looking for a slowdown, we now think there’s a 40% to 50% probability of a recession. Next year could be a very difficult time in the U.S. economy.
You have been concerned, too, about how the low-end consumer was holding up. Wal-Mart’s numbers suggest they are not holding up well.
Wal-Mart [ticker: WMT] is my favorite economist. It is huge, reflects the low- to middle-income sector of the economy and it gives us monthly statistics. What has happened is a dramatic reduction in spending by low-end consumers. It is starting to impact not only Wal-Mart’s outlook but, we presume, quite a few other retailers. Wal-Mart’s reaction has been to become even more competitive, so I would suspect the retail-sales environment will be the next sector of the economy that we will start to hear less exciting news from.
How does the election play into your view?
We’ve had bull and bear markets with both Republicans and Democrats alike, so you can’t make a case that one party in power is good and one party in power is bad.
What we are dealing with is possible change, and the most significant change would be if our tax policy were to be reversed by the Democrats. A major reason this stock-market cycle has done so well was because of the passage of lower capital-gains and lower dividend taxes, which took place in May 2003. The stock market bottomed in early 2003. Anything that would negatively influence the tax treatment on capital gains or dividends would be a serious negative now. The tax treatment is in place until 2010, but even any verbiage about changing it would be negative. Secondly, the Democrats plan to immediately raise the minimum wage by a meaningful percentage. That will raise unit labor costs throughout the economy, not just for the low-level workers but everybody else. It will impact profit margins. It will definitely have an impact on employment. It will definitely hurt job creation. If you raise the price of labor by a high percentage, business will figure out a way to use less of it.
The Democrats have also been making noises about a windfall tax on the oil companies.
That would be a major negative. Any windfall tax on anything would be a major negative. The last time that was implemented was by President Carter. It resulted in a serious blow to the oil industry, and it resulted in less exploration.
Are you worried at all about inflation?
No. Inflation will peak by the end of this year or early 2007, and the reason for that will be much lower economic activity and a significant drop in the price of oil. There’ll be a meaningful contraction in the housing industries, other commodities will be declining in price, and then the job market will soften. The time to worry about inflation is over. Inflation numbers always lag both ways. The inflation numbers tend to peak after the economy has seen peak rates of growth, and the peak rates of growth were early-to-mid-2006 at 4% or 5% year-over-year. The worry about inflation is overstated, and for the next 18 months we will see good news on the inflation front, not bad.
I would remind you that inflation rates in just about every other part of the developed world are extremely low. Inflation always comes down when the GDP decelerates or you have a recession.
Will commodities peak if China and India continue their strong growth?
I don’t buy that noise at all. We are the major user of commodities, and by my standards you have two areas of the world where growth rates are going to really take a beating: here and Europe. China and India might keep the declines in some perspective but not prevent them. Look at oil. We’ve seen a peak in the 80s or so. Oil is now in the 60s. Even with China and India using a lot of oil, we think the price of oil could drop to a range of $45 to $50 by this time next year. We’ve witnessed forecasts as high as $100 a barrel or more. Here we’ve had a drop of about $20 a barrel, and everybody I read or talk to tells me it has nothing to do with economics 101. My argument is that somewhere in the world the demand for oil is moderating, and I would pick this country for starters. You don’t get a drop in oil from $80 to $60 without demand causing it.
This is exactly what happened in the last economic cycle. In 1998 the price of oil bottomed at $10, rose close to $40 by 2000 and then dropped to $20 by 2002. That drop in the last cycle correlated with the peak in the economy, and the same thing is going to occur here.
Is this good news for the fixed-income market, which you have been bullish on for the last few years?
Yes. The fixed-income market in 2005 was reasonably decent; there wasn’t much volatility. Volatility in the fixed-income markets this year was enormous and bond yields rose for the first six months on the strength of the economy, which really undermined our bond positions.
Did you stick with them though?
We stuck with them. We feel the bond market peaked in yield in May or June of this year and that was totally coincident with the peak of GDP growth. It was coincident with the Federal Reserve finishing their rate hikes.
As far as the outlook, we think the Federal Reserve has finished raising short-term rates. Historically, they normally go on hold for six to nine months. In almost every cycle they’ve done that — including the last one, I might add. This implies Mr. [Ben] Bernanke [Fed chairman] will keep rates flat here until the first or second quarter of ’07, and by then he will see that the GDP has slowed down or dropped. Once he starts cutting rates, I see a 200- basis-point [two percentage point] drop from early ’07 to early ’08. This should bring the long bond yield to 4% or 4.25% by this time next year.
Bond markets always do well in recessions or slowdowns. I have never seen a slowdown or a recession where bond yields go up. The consensus for GDP growth is anywhere from 2% to 4% over the next two years.
Our argument is that 2% will be the high end next year, and you should consider the odds that some quarters will be zero. It wouldn’t surprise me if the five-year Treasury, which is near 5% today, dropped to 3% in the next 18 months.
Do we have to worry then about the dollar?
Yes. The dollar is about to resume a fairly extended decline. And under that scenario, it obviously raises the attraction of foreign investments. It also significantly raises the attractiveness of precious metals. We remain very, very positive on gold and the precious metals, because in an economic slowdown, demand for the dollar will decline.
Have you stuck with your gold and silver positions?
We’ve stayed the course. It has been one of the most volatile situations I have ever been involved with. When I chatted with you last year, gold was about $475 or $500, then had a magnificent rally to $700-plus in May, and then began a magnificent correction — I’m being Christian — which drubbed the gold stocks.
Now, gold has rebounded above $600, and I would look for a very significant move in gold the next two years. I would hazard a guess that the gold market will appreciate by $200 to $300 an ounce over that time frame, and it will be driven by another decline in the dollar. We would recommend people would have a hedge position in precious metals using either the bullion directly or gold-mining stocks.
We’re using a closed-end fund called Central Fund of Canada [CEF], which owns the physical metals, one half silver and one half gold, in bullion form. It trades totally in line with the price of the two metals and rarely is at a premium or a discount.
The two stock candidates we would recommend are Newmont Mining and also Barrick Gold. We are putting 3% to 5% of client assets in precious metals.
Moving on to the stock market. How will it hold up under this scenario?
The stock market is very, very related to GDP growth, and it has done extremely well over the last four years since the economy rebounded. We have achieved record levels of profit margins and we don’t think that’s sustainable. All of our valuation metrics imply that the P/E of the stock market today at 16 or 17 times is more than adequate.
We would argue that S&P earnings will flatten or decline in the next 18 months. So the stock market looks fully valued. Stay away from economically sensitive sectors, including anything to do with commodities such as energy, steel, copper, aluminum and you name it. Avoid industrial companies, and emphasize sectors that would benefit from declining interest rates.
Which would be?
I would highlight the insurance sector. We find this group dramatically underfollowed. These are stocks that have done little if anything for years. The major asset of any insurance company is a bond portfolio. Last time we mentioned St. Paul Travelers [STA]; we’ve hung onto it and would still purchase it here. We also like a smaller company, Delphi Financial [DFG], but the whole group looks attractive to us.Table: Arvedlund’s Picks are below
From Katrina to litigation to asbestos, the group has had its problems. They raised rates dramatically from late 2005 through now, and I would say that game is over. But the losses of yesteryear are going away and their capital reserves have improved, and from this point forward pricing will probably be flat.
This is not a high-growth industry, but the P/Es on these stocks are very low, 10-12. There is no reason why this industry should sell at such a dramatic discount. That would be our favorite interest-sensitive group. The second interest-sensitive group would be the telephone area.
What do you like there?
Verizon Communications [VC], because of its dividend yield and also because they will be able to refinance their debt at more attractive rates. We also like Windstream [WIN], a spin-out and subsidiary of the telephone company Alltel. They operate in the country’s rural areas where people do not have high wireless concentration, and they are converting their client base slowly into wireless and broadband. In the meantime, it generates enormous cash flow and pays out a high proportion of their earnings in dividends. Windstream has a dividend yield of 7%.
How about another pick?
The supermarket Supervalu [SVU]. We were attracted by their purchase of Albertson’s. We’re very familiar with management and believe they can execute and make the merger work. It’s a defensive name in a sector where unit growth will continue fairly steady and won’t be impacted by economic trends.
We think the anti-oil outlook we’ve had the past year is a valuable theme. While oil prices stayed much higher for much longer than I expected, the price has clearly broken trend, and the most obvious beneficiary would be the airline sector.
Even in light of your economic outlook?
Well, the airline industry has consolidated. Some of them have crawled out of bankruptcy, and we think they are running their companies in a much more efficient manner. Our favorite candidate is JetBlue Airways. JetBlue has the most sensitivity to a decline in oil prices and rates.
What about the labor costs there?
Labor costs are OK and are going up in line with their growth. But the bogeyman for them was that they had no hedges on oil, and it scorched them. They are continuing to gain market share. They are watching costs. They have a very leveraged balance sheet, and so any reduction in interest rates would really help them.
Any other names come to mind?
Dow Chemical [DOW], which is also on the list of unloved companies. It sports a 4% dividend yield, and they raised the dividend for the first time in many years this year. They are repurchasing shares, and they sell at a fairly low multiple. They will benefit if, as we expect, raw-material costs come down.
What about your old favorites, the real-estate investment trusts and utilities?
We are paring back because the yields on REITs have really dropped as the stocks have done well. All our utilities are near highs. We can’t make a case for further purchase here. We are running into a pretty fully valued stock market. There are isolated stocks but very few sectors that look attractive.
How does this compare with other periods?
To us, year end 2006 has a remarkable similarity to year end 2000. In 2000, there was a double peak in most equity indices and new highs in small-caps. There were peak rates of GDP in mid-2000 and this year. Oil prices peaked in late 2000 just as they have been peaking here. And there was a flat-to-inverted yield curve. It led to the making of a very difficult economic environment in 2001 and ’02. The only area that stood out from that point forward was the bond market.
From an asset-class perspective, fixed-income is our best bet. The focus is on longer bonds. The 10-year Treasury yield could drop from 4.75% to 4%-4.25% by this time next year, for a return of 8% to 10%.
St. Paul Travelers
Central Fund of Canada
30-year Treasury Bond
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