Earlier this month, I interviewed famed investor Felix Zulauf on his professional background and investment outlook (Audio here). As per popular request, here is the interview transcript.
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BARRY RITHOLTZ: Tell us about your background…
FELIX ZULAUF: I grew up in Switzerland, in a small town, I went to all the school. After college, I decided to go [with] a banking career. I regretted it after a year or two because it was so boring — commercial banking, then I finally hit the investment department. It became more attractive. I asked my bosses why stock prices moved up and down, and from their end — I could very soon tell that they had no clue. So I tried to figure out if there were some other people who knew why the markets were moving. And I found some leading opinion people like Bob Farrell. They were all in the US, there were no opinion leaders in Europe. And I decided that I wanted to learn that business and foresee market moves in big ways.
And then I went step-by-step. I started in the equity stock market department in a Swiss Bank in Zurich. And then I transferred to Paris to a stockbroker for a year. There, I really developed my speculative activity. As a young chap, the owner of the shop gave me a credit of half a million dollars. Which was a dramatic amount for a 23-year-old guy, and I started speculating. Went short on the market in the fall of 1973 and you know what happened thereafter into the end of ’74. So that year I made the first big money.
What was your actual first employer?
The Swiss Bank Corp. I was there for 2 years. And then I was sent off to Paris and to acquainted more with the French language and see another country and another culture and I didn’t want to go to a bank because I wanted to learn more about the investment business. So I went there, came back after a year, moved then to portfolio management (or what they thought was portfolio management), and then went to the US. So in 1976, or 1977, I stayed in New York, put together a trainee program for myself using all of the concept of Swiss Bank Corp. and I trained with Charlie Maxwell in energy and Bob Farrell in Market Analysis and Ed Hyman in Economics and trading in a shop called Salomon Brothers at that time. So I went through Wall Street and all of those firms and it was like paradise.
I’m still friends with many of those people.
It was fantastic. And then the bank called me back to Switzerland in ’77. And then I changed horses and joined UBS because I wanted to learn money in a more aggressive way, and Swiss Bank didn’t offer me that job. That was ’77 — I joined UBS and the mutual funds management department and research. And I ran the US equity funds and global equity funds and a raw materials fund and became a global strategist for the whole UBS group. And later I ran the institutional portfolio management department at UBS and then came 1987. I was very instrumental to push UBS equity allocations to the highest in all of Europe. At that time, 65% equity in balanced accounts was extremely aggressive in European standards. And in ’87, during the summer, I tried to reduce that because I was also part of the investment committee, and I convinced the committee but general management then vetoed it and that upset me so much that I stopped there and liquidated all equities ahead of what thereafter became the crash of ’87.
And it didn’t make many friends. By hindsight, I think it was the most difficult thing I ever did because I never got the credit for it. I got the blame because all of my friends and colleagues looked terrible next to me. You know, from a political point of view, it was not a good move. But from a trustee point of view, it was the right move and also from a professional point of view, it was the right view.
Then I decided I needed to join a smaller money management operation where I had more freedom and I joined a subsidiary of Credit Suisse at that time as an executive vice president in charge of the whole investment policy. And then came ’89. The leading portfolio managers were very successful with Japanese equities and I turned very bearish on Japan and they took it as a personal insult that I turned very bearish on Japan.
At 39,000 and something, and I think it was January of 1990…I turned very bearish and pulled… And it then happened and it made it clear to me that I had to go on my own to manage money the way I thought was right.
Before you launched your firm, you had essentially rotated at some of the biggest banks in Europe and you had come to New York and worked at some of the biggest banks in the city. And the takeaway from all of this is that there are institutional impediments for a money manager and a trustee to operate on behalf of the clients.
So I became an entrepreneur and started a new financial management firm. I was 40 with two small kids and no client so the first six months were very tough because I could not attract any clients…which was very nerve-wracking. But after that, the ball got rolling and I managed individual accounts. i just wanted a limited number of individual accounts that I could manage in my own fashion so I could go long and short but not leverage. Which was basically the ways I ran my own money in earlier times. But later on, I moved away from leverage because too much leverage is where you make the most mistakes.
And did you set this up as a hedge fund or as a managed assets account?
It was managed assets for several years and then it was just too much work with individual accounts. I decided to channel everything into a fund and we launched Zulauf (Europe) Fund, the fund for Europe equities (long short) which became very successful. And later we launched a natural-resource related equities [fund] and later a global macro fund. And then I was very exhausted in the year 2000 because I basically did everything myself. I had a few employees — two portfolio managers and analysts but they left at 5 o’clock in the evening and they went on vacation. And if something went wrong, you know, the old story. Basically, you’re married with the company and you’re married with the markets and you cannot let go.
So at 50, and I have to mention that my father died at age 50. I made enough money so I decided to go slower and wanted to phase out really. I feared that I would kill myself. And then I started to sell my company and sold the majority of it to these two employees and for awhile it worked out very well. I was more the senior advisor and giving my advice and my input but I was not running the day-to-day business. They moved into a direction that was further and further away from my philosophy and that created problems because I had raised basically 90% of the asset. And then we decided to split the company and I took my share — one fund, one small global macro fund and kept the name and they changed their name. And we are totally unrelated these days. And so I have just a small shop where I run a conservative global macro fund and advise some large clients and institutions and family offices.
I have to mention that these times are so fascinating that I don’t want to give up running money but I don’t want to be glued to the screen 24 hours a day. And I am the senior advisor to a newly launched global fund in northern California — 300 North Capital run by a gentleman who is a very successful equity manager. He wanted to go global and macro and he asked me to help as a senior advisor and I will advise him on a weekly basis and, if necessary, on a daily basis. I will give strategic input and be the partner in terms of discussing any of his ideas.
This is a hedge fund.
So it’ll be global macro, and you’re going to be the senior advisor. Long/ short and not a lot of leverage. That’s the approach?
That’s right.
Let’s shift gears and talk a little bit more about global macro and your approach. When you’re doing your day-to-day work, what are you looking for? What is a day in the life of Felix Zulauf when he gets to the office?
Well, I’m a believer in cycles. I strongly believe that an economy — all economies — do not move in linear but in cyclical fashion. And so do financial markets. And my goal is to catch most of the up cycles and most of the down cycles, because assets are priced based on where we are in the cycle. So I do a lot of cyclical work. I do not moon cycle but the classic business cycle. There is the 3-5 year inventory cycle that they teach in basic economic theory, then there is the investment-related cycle which lasts 9 years. And then you have the 18-20 year real estate cycle and etcetera. I try to get a big picture of where the major economies of the world are moving and where the risks and pitfalls will be in the next six to 12 months. That’s my work — to find out where we are in the business cycle. And then I apply classic tools like monetary analysis, I do valuations because capital markets go from one extreme to the other. They never go in between and reverse to where they come from — that’s important to understand.
Once it hits an extreme (like in 2000), it does not go to a new level in the historical range in terms of valuations and then goes back to overvaluation again. It always goes from overvaluations to undervaluations.
Is that true for the housing market in the US?
The housing market has been a linear affair, particularly since the gold standard was abandoned. When you overstay a cycle by these aberrations like two expansive monetary policies, you could a stretch a cycle for a long time. But when you do that and overstay a cycle, you create more excesses and the correction, when it comes, will be happening in a much-altered time frame than normal. And it will be much sharper and much more painful.
Felix, you may be the first person I’ve heard who is blaming the US housing bust on Richard Nixon.
Well, in a way, you’re right. It all started with that [Nixon’s taking the US off of the gold standard] but it added. The down cycle is usually here to shake off the weak participants in the system and to correct the successes that have been built up during the up cycle. When you do not let that happen, you take more and more excesses with you, which over the long term and over many cycles will build up to extremes — and that’s where we are now.
Would you say that the ultra low rates that we saw…after the US crash when the US fed took rates down to 1%…so in other words, we never saw the cleansing effects of the 2000 crash, we just kicked the can down the road?
The 2000 excess was really the result of the bailing out and the easy money after the 1980’s long term capital and the Asian Crisis and the Russian default.
So ’97/ ’98 begat 2000, which begat the 2003 crash which set up the ’07/08/09 collapse.
That’s right.
So we end up with these cycles where intervention from the Fed and elsewhere, in an attempt to prevent the pain, just make worse and worse.
Yes, and now, we are at the point where over the last decade, the regulators for the banking industry allowed the banks to reduce their equity capitals step by step, which really was another element creating the boom and the bubble in real estate and other sectors. And now we are here suffering from the fallouts of that bubble bursting…In Europe, it is even worse than in the US. And the problem then comes that the banks have to be bailed out. And bailing out the banks in the system pushed government debts to much higher levels. The question is, what will we do next time when the governments need to be bailed out.
Because the problem is that we are living in a fiction that we can enjoy a relatively high level of prosperity for our average citizens in industrialized countries by going more and more into debt. And Greece, in a way, was a stopping point. The markets said, “There is a limit, we are not financing it any longer.” And then the European Union was changed to a transfer union all of a sudden. Now, the next thing to drop is Spain, where we have a real estate problem that is bigger than in the US. There are more homes for sale in Spain than in all of the USA. And prices have so far only gone down 10 percent because there are no transactions. But once transactions are forced by the banks, because the banks are forced by the government to clean up the situation — then prices will come down 30 to 40 percent and probably end at 50 percent down and then the banking system is bust. And the insurance system is bust. And then the government has to bail them out and the government is bust. And then what?
So I see this problem of over-indedtedness moving from the periphery of our global credit system to the center. The center is the US. And believe me, the US has its own problems. Half of the US states are running deficits that are bigger than Greece.
I think this whole process will run another few years until it reaches the center. And the point is that at some point in time, the Central Banks [will] have to bail out the governments. And maybe on the way to that point, there will be some countries that will default, and then restructure — which would be the right thing to do, actually. But at the present time, Greece should have restructured. They should have claimed default and then the debt should have been restructured. But the problem was that the banks could not take that hit. So bailing out Greece was bailing out the banks.
I do not know what the final outcome will be. I think that historically, when you look at governments that are highly indebted, you have either defaults or you have printing money. I would assume that most of the European countries [aren’t party to the latter] because they have the Euro and it is harder to run the printing press than if you had one country and one government that has sovereignty over its own currency. They [the European countries] will probably go towards restructuring. And within the group of sovereign countries (I would include the UK, Japan, and the US probably) — they will probably try to run the printing presses up and go into massive debasement of the currency. This will, of course, create a payoff later on in the currency markets and currency controls.
Do you think that members of the EU are at a disadvantage because they do not have the ability to inflict these loans upon themselves or does it work to their benefit that they’re forced to take unpleasant-tasting medicine to avoid much worse tasting medicine down the road?
Well, I don’t believe that a country like Greece can, through conventional steps, heal its situation. That’s impossible. They have a program to heal deficits…but they will kill themselves by doing it. It will push the economy into a massive deflation. And I do not think that it is politically possible for a long time — people will revolt.
So, in a way…the Euro acts like the gold standard in the 1930’s for the weaker economies. And in the 1930’s, those countries [the weaker nations] came out of the Depression first (that debased and devalued their currency relative to gold). And then they could recover. And I think that will be part of the solution. We have never had a situation like that — all of the major industrialized countries were hitting the fan at the same time, basically. This is a unique situation, and I would be lying if I told that I knew exactly what the outcome would be.
What’s your take on the obsession over every open, every close — especially now that you’re more of a weekly advisor than a daily tethered to the machines?
I’m one of those poor guys who never lives in the present but always lives in the future. In a way, I draw like a sine curve for a cycle. And according to my analysis of the big picture of a monetary factors of market prices and trends and momentum and valuations/ sentiments, I try to place on that sine curve where the economy and the different markets are at the time.
And then, based on that, I read reports and glance through the newspapers and I try to think whether the news today confirms what I think is where the markets are in the cycle. If they do, then [I] go on to the next thing. If they don’t, then I have to check it out and see if this is noise, or an aberration, or a delay, or whatsoever. That’s the way I look at the short term.
How do you avoid the classic investor foible of confirmation bias? Especially with the internet, you can very easily only read the things that agree with you and nothing else?
Every human being tends to be lazy, and tends to like people and opinions that tend to agree with him. My situation is that I really grew up in the whole industry as a maverick. I was never a mainstream guy. I can see best when I can see lonely. And the majority is on the other side. But I reason, I look at them, and I check it [their stance] out. And you know that the markets are horrible. The markets tell you, relatively quickly, when you’re wrong. So I’m very risk-averse. I like to make money, but I hate to lose money. So I’d rather make a little bit less and not lose money. That is something that I learned from my youth on. I wasn’t born with a golden spoon in my mouth, so I had to make my fortune first all through hard work and suffering. And I don’t want to lose it.
I’ve found that some of my bad calls have taught me a lot of lessons. Any in particular stand out for you?
In my younger years in ’74, when I was bearish on the markets, I turned bearish on Japan and didn’t understand that market for some years. And that was a horrible mistake. It was a mistake by a missed opportunity and not by losing money, but it was a horrible mistake.
And how about more recently?
In March ’09, I turned bullish for a rally. I saw that in 2 to 4 months it went up 25 to 40 percent and I didn’t expect that rally at the beginning when it started to last that long and go that far. Once it never corrected, I had to go back to my drawing board and do the homework and I sought a bet that was very similar to two previous cases in the history. One was in the US — that was in 1938 — that rally had the same characteristics in terms of fundamentals and in terms of technicals. And the other case was in Japan in 1995, ’96. Both rallies lasted one full year. Both rallies were eventually fully retraced and that’s what I think will happen here too.
So now, here we are, it’s 2010. What stuff catches your attention? You mentioned before this is a fascinating time to be investing. What makes it so?
We came out of a time when monetary policy worked extremely well for quite some time. It worked well for the economy because when the Fed banks cut interest rates and stimulated the system, you had good growth following through later on with a time lag. You had chemical markets rallying and equity markets and credit markets and commodities and etcetera.
This time is different, because we have such a high level of debt that monetary policy has become very inefficient. And in ’09, monetary policy alone would not have worked if the Fed and other central banks did not go out and buy, for trillions of dollars and Euros, financial assets in the market directly. Because monetary policy alone did not work. We have basically zero interest around the world in the major industrialized economies and that alone is not working. In a situation where you have too much debt and the private sector begins de-leveraging, monetary policy doesn’t work. It’s similar to the situation in Japan, although the problems there were even more severe. What works is fiscal policy, and fiscal policy gave us this kick in ’09 and carrying through the economy up to this day. But these fiscal stimulus programs will have run their course very soon. And then we are back to final demand.
So we have three factors moving the market. One was the stimulus demand, the other was the re-stocking of inventory throughout the manufacturing sectors of the world, and the third was financial banks manipulating financial markets up to the point where they got the prices where they wanted them. And I think quantitative easing to that degree is not possible in the current environment without first having a crisis again because you run into political problems. And the same is true for government spending of the size we have seen last year. Because the political framework is such that some people are very concerned with the debt that we are piling up virtually everywhere. And therefore, the markets are now forcing the hand and you see that markets are beginning to break down. The deflationary forces are gaining the upper hand and the western world is really hoping that China will bail us out by buying all the goods that we want to sell.
I just came back from a three-week trip to China and my view is very different. I think China is in the early stage of a decline with economy weakening that will turn into a hard landing.
So you’re in the Jim Chanos camp that looks at China as another boom about to bust.
I’m bearish cyclically. I’m not sure about the secular framework, but it doesn’t matter at this point in time. At this point in time, the cyclical forces in China are bearish, and the biggest problem for the Chinese people are the run-up in home prices over the last 18 months of about 100%. Private sector debt in China is almost the same as in the US relative to the size of the economy. And the people cannot afford housing anymore so the government wants to bring housing prices down. And they will be successful with all of the tightening steps they have undertaken. The problem is — you cannot just hurt housing. The economy is a mechanism that is inter-linked. If you hurt housing, you hurt many other sectors too. I’m very bearish cyclically for the next two years or so. It could be also that we will never see 10 percent growth again. Maybe we will see 4 or 5 percent, that’s possible.
Ten percent growth in China?
That’s over.
By the way, I’ve been sort of critical about the consistent data that we get from China. How seriously do you take the numbers that we see from the Chinese central authorities?
You should take them with a grain of salt. I think they are trying to improve the numbers, I don’t think they are cheating intentionally so. You have to look at some statistics and compare them to other statistics and you see some flaws and you should take those numbers with a grain of salt.
Any areas of the globe that are looking reasonably attractive?
Well, never before has the world economy been as globalized as it is today. I have recently looked at GDP growth and I have looked at the growth of equity markets around the globe. And these are, historically, the highest correlation metrics. That’s why, being bearish on one major economy — you have to bearish on all of the other equity markets as well. They all move together. And being bearish on equities on a cyclical perspective over the next 2 years or so. I’m also bearish on commodities because of what I said about China.
Including gold?
Gold is not a commodity – gold is a currency and it is the only currency without liabilities and cannot be mismanaged by its own central bank….so gold is different. Gold, I think, can get hit here to around $200 on the downside and about a thousand or 1050 in a shakeout. There was recently too much noise in the gold market, but that was another opportunity to buy, because eventually gold is the best store for your savings over the next five years or so.
And let’s talk about the gold standard again. Can we go back to being on the gold standard in the future?
I don’t think we can go to a gold standard again, because if we go to a gold standard, there is not enough gold around to cover all the needs of all the companies to cover their currency. But gold, in one form or another, will play an important role in the next currency system once it is born out of the ashes of the current currency system. Therefore, I do believe that gold will be the best way to move your savings from the old world, that is in short of a final game until it breaks down completely and we have a new system.
So it sounds like you’re looking for something to be replacing the EU, and the US Dollar, and the Chinese system. Are we looking for some brand new restructuring or are we going to still see the old political lines? How does this play out?
I really do not know. I don’t think that our systems are functioning and we need a new generation of politicians who are completely free of the old thinking and Europe will be disintegrating. We will be going through a lot of pain and changes in the coming years and at some point in time, a new generation of politicians will arrive and they will tell the truth and they will tell the people – “We have a problem, it’s going to be painful to fix it, but we have to do it for the sake of our future and our children.”
In the US, we only have politicians who tell people what they want to hear, and very few who say “Here’s some medicine, it’s going to be uncomfortable, but you got to suck it up because the alternative is far worse.”
That is the case everywhere, but I’m hoping that can change. It doesn’t change just by saying things. You get strong leaders only after a period of pain and hardship. You don’t get them in a world of high prosperity.
So do you ultimately see the EU breaking up?
The EU may not break up, but the Euro…will most likely break up. I don’t see how that can survive. You have a currency for economies with completely different economic structures, and one size fits all in terms of monetary policy, and currency policy and fiscal policy just does not work. Because over the long term, the productivity differences are such that you build enormous imbalances and stress and currencies are here to balance imbalances. And if you take that factor – the currency – away, then you have to balance through the real economy adjustments and that’s much more painful.
What else do you think is interesting, what might you look into buying 1,2,3 years from now?
I think equities in the very long term are interesting investments. But we are not at the point where we should buy them long-term yet. We are in a structural bear market that started 10 years ago. I talked about the valuation cycle and we have gone far away already in valuation declines in Europe. We have gone from four times book value to about 1.2 times book value. We will probably go under book value. In the US, book value is 500 in the S&P. Usually, secular bear markets end slightly below book value, so there is still some way to go.
So that sounds like you think we’ll break the March 2009 lows.
I think we’ll see it again in the next 2 years, yes.
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