Transcripts after the jump
ON THE RECESSION AND THE FED
Well, there is always a recession that is inevitable. This is a normal part of the business cycle. The Fed tightens, things slow down; the Fed loosens up, things get better. The issue that we’re dealing with is that we’re not so much in a post-election economy as we are still in a post-credit-crisis economy.
What we’ve learned from looking at history, from looking at the data that Reinhart and Rogoff put together in a lot of their research, is post-credit-crisis economies have very weak job creations, sub-par GDP, poor recovery in housing, poor recovery in jobs. And so we have this muddle-along, mediocre, just-above-stall-speed type of recovery that always looks like we’re on the verge of slipping back into recession, but hasn’t quite stalled. The flip side to that is the Fed has been putting a fire hose worth of liquidity directly into the economy, directly into the market. The problem that we’re running into is as we go through QE14, QE19, QE27, each subsequent QE seems to have less of an impact on the broad economy and has its bigger impact – although that’s insinuating as well – on assets. So we see it in the bond market, we see it in the equity market, but we’re not really seeing it so much in the broad economy outside of things that are purchased with credit.
I just got offered a 30-year fixed, no-point mortgage for 3 and 3/8%. That is an insane number considering when I was a kid, mortgages were 9%. It’s hard to fathom the impact that has specifically on housing. As much as people think housing is in a full-blown recovery, it’s really more accurate to say that housing has been stabilized by these absurdly low rates. We also had a mortgage-foreclosure abatement while we were negotiating the settlements of the robo-signing scandal. But outside of that, the rest of the economy is looking a little soft, and the way we see it most of all is in the earnings of the S&P 500.
ON THE FISCAL CLIFF
First of all, I don’t really care about the fiscal cliff. I find all this to be spasmodic stupidity. “Oh no – the fiscal cliff!” The worst-case scenario about the fiscal cliff is we’ll lose $600 billion in spending we can’t afford and increase taxes that we should have increased a while ago. So $600 billion in a $14 or $15-trillion economy is a relatively modest impact. Might it cause a slowdown? Sure, if we’re running at 2% GDP and this takes half a percent off, we are now running a 1.5% GDP. The only way it really causes a severe recession is if there is a lot of shenanigans that go around, and if everybody causes trouble. Remember what happened when none of the parties would come to the table and behave, we had the downgrade back in the summer of – what was that – 2011? Although ironically, that downgrade did nothing more than help lower rates.
Stop and think about how ridiculous that is. America is much less trustworthy as a lender, so lend them money for 1.5% for ten years. It’s ridiculous. Although keep in mind that rating agencies themselves are completely corrupt. I don’t know any asset manager in the United States that pays attention to anything they say or do. Had we had that same attitude before the crisis, we very much could have avoided the crisis. So the downgrade that is being threatened, again, I don’t think it’s a big concern. It’s much ado about very little. The fiscal cliff – hey, it wouldn’t be the worst thing in the world to say you have to pay for what you buy. I know that’s a crazy thought process, but…
Ed D’Agostino: You would argue that the fiscal cliff is not the end of the world, so to speak?
Barry: No, absolutely not. It’s not the end of the world. Again, it’s $600 billion. Now, the stimulus package – which a lot of people said had no impact – was $800 billion and change. So if $800 billion didn’t help the economy, then how much can $600 billion really hurt the economy?
Ideally, if we were rational adults and weren’t engaged in this sort of primal warfare between tribes known as politics, we would all agree that the ideal time to cut spending and raise rates is during an economic expansion. The ideal time to cut rates and raise spending is during a contraction, and John Maynard Keynes said that a long time ago. People only hear half of it. People only hear, “During a recession we cut taxes and raise spending; that’s great.” They forget that Keynes says when you come out of this, you have to take that away. So we’ve had the people who say Keynesianism doesn’t work. Well, if you only do half of it, it sure as hell doesn’t work. Pretty much that’s been the approach of the United States for the past half-century.
ON CORPORATE EARNINGS
Well, it’s clear that corporate borrowing costs have been exceedingly low. We see IBM and other companies refinancing long-term debt at 1 and 2%, numbers that are quite insane. But the bigger issue that we’re running into is, look at how much of the S&P 500 earnings comes from overseas in general and Europe in particular. Europe is in a recession; I don’t know how else to say that. Spain and Greece are in a depression, although I can’t define what a depression is. It’s like pornography; we know it when we see it. But the rest of Europe outside of Germany is contracting, and I don’t know if Germany can decouple for very long because they export so much stuff to the rest of the Eurozone. So we have a significant slowdown in Europe, if not a full-blown recession.
We have an ongoing slowdown in Asia. The United States really is the best of the worst – there is no other way to say it. “Except in the land of the blind, the one eyed man is king,” is my new favorite expression. The United States – partly due to QE, partly due to a very healthy set of balance sheets in corporate America – has been muddling along better than lots of the rest of the world. That doesn’t mean, though, that’s a forever situation. There is a tendency amongst economists to just extrapolate wherever we’re going; and that is how they end up missing the turn. They say, “Oh look, we’re trending upwards, therefore we’re going to keep going.” Well, no; these things are cyclical, and eventually it comes in.
My concern about earnings is the ongoing decrease in revenues, the lack of guidance we keep hearing from CEOs, and then the not-necessarily-great earnings numbers we continue to see. It suggests that this cyclical rally that began in March 2009 – and here we are four years later – is getting a little long in the tooth. I can’t tell you if we’re ending November 15, 2012 or if it’s going to go on for a couple of more months or quarters, but it’s pretty straightforward to say we’re up at the peak 107% from the March 2009 lows. The typical post-crisis snapback is about 70%, so we’ve had a nice run and then some. We may be living on borrowed time and we may be living on Fed money; it will end eventually.
The Fed’s concern about propping up asset prices is another issue that is a whole separate conversation. I think the whole concept of the wealth effect is wildly overstated. It’s just a correlation error in my opinion. But all that aside, all expansions end, every cyclical bull market within the longer secular bear market. So March 2000, we began a bear market. Here we are a dozen years later, and it’s not quite over. Perhaps it will be parallel to the 1966-1982 bear market. The DOW was at 1,000 in 1966; and sixteen years later the DOW was still 1,000. You ended up losing about 75% of that break-even due to effects of inflation, but it took sixteen years and an oil embargo and Vietnam and Watergate and all of that other stuff that generally causes a negative societal sentiment. Eventually you come out of it; and by the time we got to 1992, we were off to the races. Here we are in 2012, and we’re probably in the seventh or eighth inning of the bear market that started back then. I can’t tell you if it ends next Tuesday or by 2017, but somewhere in that range the bear market that we’ve been suffering through from 2000 will end, and equities will become a lot more attractive and investing will become a lot more easier. In a secular bear market it really is a challenge to separate the risks from the reward.
ON SECTORS IN THIS BEAR MARKET
Now within that broad, secular bear market, we are looking at the cyclical bull market, which seems to be coming to a top. I’m not ready to say it’s over, but we’ve taken some steps to become more defensive. So in a circumstance like this, you cut back on technology, you cut back on consumer discretionaries, you rotate into things like health care or consumer staples that are more likely to do well regardless of what we see from the economy. By the way, that might be relatively well – meaning if technology falls 30-40%, this will fall 10-20%.
Overall, since you never know how accurate your expectations are to what’s going on, you don’t just jump out of the market and go 100% cash. We started the year overweight equities; around the middle of the year we went to equal-weight equities; and at the end of October we’ve raised about 25% cash, and so now we’re underweight equities. You need to have some cash if-when things get cheap enough you want to buy. If you never sell, when stocks get cheaper you don’t necessarily have the cash to buy things, but for now a 25% cash weight intel is our way of assessing the probability of a 25% plus or minus correction; 25-35%. So far we are nowhere near that. Off the top, the market we’re down 6.5, 7%; it’s not like the market is really getting shellacked.
By the way, I can’t remember the last time when 6% off a multiyear peak caused such angst. Everybody has been freaking out about this. “Hey, 7% –, the markets moved 7%!” That’s a two-day hiccup; it’s not the end of the world. Maybe our view of the recession is wrong, maybe our view of the earnings are wrong, maybe our view of the correction is wrong, and we go back to make multiyear highs, but if you listen to the way people are screaming about this move – “Oh, this is it; the world is coming to an end!” – it’s quite astonishing.
ON EMERGING MARKETS
There is a couple of different ways to play emerging markets. In October we moved out of all our emerging markets on a temporary basis. There are a few very interesting things going on in emerging markets. If we’re going into a slowdown, we don’t want to have exposure to energy, which as we see every time there is a slowdown the price of oil plummets, but that is a big chunk of what we see in South America; it’s kind of interesting.
The other thing is if you look at the rules overseas in terms of how dividends are treated, outside the United States there is a far friendlier treatment of dividends than stock buybacks. In the United States there is a lot more stock buybacks than dividends, which is unfortunate. I would rather have the cash coming to clients each month than actually the engineering of stock buybacks. If you look overseas, their dividend rates are more attractive, and there are a handful of ETFs and other vehicles that allow you to buy non-European, non-bank entities – meaning emerging market, Asia, South America, Middle-East, Africa – allows you to buy those things that are big dividend yielders without getting exposure to all the sovereign debt issues you have in the European banks. That is a relatively safe way to play things when you come out of the recession.
If you want something that is faster, if you want a little more alpha, then you look at telecom in Asia and South America. You look at energy – although again it’s got to be after the recession, not before a recession – and you look at manufacturing. Overseas, a lot of the overseas companies that we see are much, much less expensive than in the United States where the PE is fairly reasonable. I am fond of saying if I didn’t have a job and family here in the United States, I would pick up, move to Europe, and start turning over companies, looking to buy them one by one. Companies in Europe are trading at absurd valuations because everybody seems to think it’s all going to hell in a handbasket. We think that eventually the Europeans figure out a way around their problems; we just don’t know when that is going to happen and how expensive it’s going to be if you are six months or so early. But to buy companies one by one when you have boots on the ground and able. Stuff is trading at not one times sales, it’s trading at one times profits. That is a ridiculous valuation. Dirt cheap, but you’ve got to be there to separate the good companies from the bad.
ON GETTING TACTICAL
It’s amusing to those of us who grew up tactical, who grew up saying, “Hey, I understand the value of buy and hold.” But if I’m sitting on railroad tracks and I hear noise and a bright light coming at me, it doesn’t mean I have to sit on the tracks because I’m a buy-and-hold guy. So we use a number of inputs to help us make decisions as to when to get out of the way on a tactical basis. It’s a combination of valuation and trend and earnings momentum, and there are other factors that go into it.
You don’t want to make the tactical decision too often, because it’s a very imperfect science. It’s a little bit of art and a little bit of science. So we try and do it less frequently than many do. I don’t care about the 5 to 10% moves; I’m never going to catch those, and I know very few people who can consistently catch those. I’m much more concerned about the 25%, 35%, 45% moves. When we have a high degree of confidence that they are coming down the pipe, we’ll take our highest, our most volatile names, our highest beta names off, and we’ll step back a little bit. We did that at the end of October by raising 25% cash.
That doesn’t mean that we think the world is coming to an end. I certainly didn’t raise 25% cash because I was concerned about a 7% move down. That’s enough cash off of the equity portfolio to say that if things get worse we can sell more items, but at least we are removing some of our risk in case this does what we fear it might do. On the other hand, if we’re wrong and we’ve lowered our equity exposure that much and the markets then turn around and start heading north, well, it’s not the worst thing in the world; and we can redeploy that capital fairly quickly. We primarily work through ETFs and very deep, liquid stocks, so if I have to turn around tomorrow morning and say, “Okay, I’ve got $50 million to spend; what do I do?” we wouldn’t have a problem putting that to work.
WHAT ARE YOUR TOP THREE PICKS?
I’ll give you names that I think are defensive in nature but have the potential of doing well over the long haul. Most of my career I never owned Berkshire Hathaway – we added that almost two years ago. It’s done pretty well; it’s done really well in 2012. Any time you have the chance to buy a high-quality name at a very reasonable price, be thrilled to do so. That was one of those things. I know there are people who have drunk the Buffett Kool-Aid: that’s not me. To me this is just a broad company with exposure to a lot of areas.
We don’t want to own any of the money-center banks; the Citis, the Bank of Americas, the JP Morgans. We are afraid of them partly because we can’t see what is in their balance sheet and partly because they are just all so mismanaged – including the vaunted JP Morgan, which we owned a small piece earlier in the year and managed to just get a little dinged up when the whale came out. We gave back all our profits and a little more than that. I’m not happy about that. So we’ve been staying clear of that, but we want some exposure.
The insurance aspect of Berkshire gives us some exposure to that. The other company in the finance space that we’ve had for a long time is Visa; that’s worked out very well. In terms of defensive names – and by the way, the nice thing about Visa is they are a tollkeeper on Internet transactions, on other credit transactions, and they have no credit risks. It’s up to the banks to actually assume the risk to determine whom they want to give a card to. Visa just takes a little bit of a transaction fee each time, and it’s highly profitable.
When we look at the sector of health care, you could go broad ETFs. XLV gives you the top forty or so names in that space. If you want something with a little more potential, take a look at Merck, which is an interesting name in that space. Lastly, if you want to have a foot in consumer staples with a little bit of healthcare aspect to it, we also like Johnson and Johnson. So again, big, deep names. None of these names are going to quadruple by Thursday, but they are also very unlikely to implode the way some of the high flyers might. In this environment, we’re playing our cards a little tight. We’re looking for up-side, but we’re not looking to hit the cover off the ball. In a secular bear market you want to take advantage of opportunities, but not take on a lot of risk because as we see, once the market begins to roll over it can head down pretty quickly without a whole lot of notice.