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David Rosenberg: ‘Excessive Valuations Will End in Tears’
“I believe we are in a type of depression that has not yet been recognized — not a recession. And the difference between the two is seismic.”
Some of the world’s top financial minds hold economist David Rosenberg and his extensive body of work in the highest regard. As such, his well-reasoned warnings are worth heeding.
Baupost Group CEO Seth Klarman describes Rosenberg’s “willingness to take a contrarian view, always backed up with hard data, valuable for anyone interested in seeing around corners.”
“With the breadth, depth, objectivity, usefulness of his research,” explains Doubleline’s CEO Jeffrey Gundlach, Rosenberg provides “actionable investment advice.”
And economic historian Niall Ferguson, who RIA Intel interviewed last year, calls Rosenberg’s work “meticulous with an uncanny sixth sense” that will never be outdone by algorithms in spotting “the next crisis before it engulfs us.”
President and Chief Economist & Strategist of Toronto-based Rosenberg Research, Rosenberg and his 10-person team provides in depth macroeconomic analysis to 2,600 institutional and high net-worth clients, sovereign wealth funds, and family offices across 40 countries to help them better understand current trends, future shifts in the global economy and financial markets.
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For the decade through 2009, Rosenberg was Chief Economist and Strategist for Merrill Lynch Canada and Merrill Lynch in New York. The following decade he held the same position at the Toronto boutique wealth management firm Gluskin Sheff before starting up Rosenberg Research in January 2020.
As a natural contrarian, Rosenberg is often viewed as being exceedingly cautious as the market has soared with the support of aggressive central bank intervention. In this interview, he speaks expansively about the troublesome division of a roaring stock market and a pandemic-shocked economy, Biden’s win, the Democrat-controlled Congress, and the insurrection at the Capitol —which the market has shrugged off so far.
Hi, David. This year started with the country more ravaged than ever by the pandemic with daily death rates topping 4,000, rioters occupying the Congress, and the Dow climbing 400 points on the same day. What in the world is going on here?
I’m not surprised the market didn’t respond to the Capitol riots or the Covid death rates. The market is in overdrive, continuing to respond to ultralow interest rates, massive fiscal stimulus, and approved Covid vaccines that are rolling out across the country.
How are you handicapping the forward effects of a Democrat-controlled government on the economy and investing?
Near term, I would expect the market to continue to rally. But further out, if anticipated explosive second half growth doesn’t materialize, the markets may begin to turn south. Remember, also, while the Democrats have taken over Congress and the executive branch, the November elections were not by any means a “blue wave.” The Democrats lost seats in the House and President Trump received a large minority of votes. Yes, I do expect more aggressive spending to confront the damaged economy and essential infrastructure needs, which should be good news for Main Street, improvements that may not necessarily bode well for the market. One likely outcome: Taxes will likely revert to what they were before the Trump tax cuts, which will help government begin to restore its fiscal health, and this will likely translate to lower after-tax earnings for corporations.
Are you concerned the current market disconnect from Main Street, which has sent stocks rising, could reverse when we see the economy begin to recover?
Yes. That’s actually likely to happen because we may see interest rates begin to recover and the amount of economic stimulus will eventually slow. Just as falling interest rates push up market multiples, rising interest rates will have the reverse effect. This suggests increasing risks for broad index buyers. And as I just mentioned, the market is expecting strong growth in the second half of 2021 based on a variety of scenarios that may not play out — including a material reduction in the scale of the pandemic and a sharp rise in consumer and corporate spending.
With the spread of Covid-19 out of control and the likelihood of soaring bankruptcies, when do you anticipate the pandemic will no longer significantly weigh on the economy?
I think we will be largely out of the woods by this time next year.
OK. Back to the present. Gold has been hovering around $1,900, markets are setting records, there’s high and rising unemployment, negative GDP growth for 2020 and an uncertain outlook — how do you square all of this?
The best way to understand what’s going on is in terms of liquidity. I think what we’re witnessing is one of the most impressive liquidity bubbles of all time. Fundamentals or valuations don’t really count for much in this massive money creation environment.
So the story is mostly about Jay Powell and his colleagues at the Federal Reserve. We have seen unprecedented monetary growth. In 2020, M1 was up 66%; M2 rose 25%. We’re expecting the economy to have contracted by more than 4% in 2020. (Editor’s Note: On Jan. 28, after this interview was conducted, the Commerce Department’s initial report about the U.S. economy stated that it shrank 3.5% in 2020, the most since 1946.) That means the gap between money supply growth and economic growth is around 30%.
Over the past 40 years, that gap has been only about 1%. Historically, money supply growth runs about 1% faster than GDP growth. Excess liquidity that’s not being absorbed by the economy is finding a home in the financial markets. And I believe these excessive valuations will end in tears. This is a castle built on sand.
Now let’s look at the fiscal side. In 2020, the combination of quantitative easing and direct government stimulus is close to $7 trillion. As of late summer, the loss in GDP due to the pandemic and lockdown was somewhere near $2.5 trillion.
For the first time in any recession we saw personal income growth running at a 12% annual rate during late summer, double the rate it would’ve grown by without the pandemic and Uncle Sam’s generosity.
So when one tries to figure out how to make sense of this steep economic downturn and financial assets hitting record highs, one needs to realize no recession has ever seen a government cash plug of this scale only a month after a crisis hit.
Seems you’re suggesting retail investors — with excess liquidity provided to them from the government to survive — are largely responsible for driving up stock valuations beyond what’s rational. But we’re not seeing institutional investors selling in response to a rally unsupported by fundamental investment sense.
Half my clients are retail investors, half are institutional, and I can tell you that the retail investor is far more bullish than my more circumspect institutional clients. So if you don’t have any serious selling going on by institutions and 25% of the marketplace is largely retail investors who are buyers (especially of ETFs that are weighted to large caps), that would be enough to move the market.
I think the explanation about institutional sentiment is informed by former Citigroup CEO Chuck Prince’s infamous quote: “you have to keep on dancing until the music stops.” I think investment professionals think they know when to get out, although that has never happened before. Even though actions should be dictated by valuations, fundamentals, liquidity, market positioning, fund flows, technicals, and sentiment, fear and greed seem to always trump these clear metrics. Put another way: institutions are simply afraid to sell while retail investors are piling on.
What are your thoughts about value versus growth stocks?
While they have rallied from their summer lows, value stocks are still below their pre-Covid prices while blue-chip large-cap growth stocks have soared. Many of the latter cater to the homebody economy. The longer the pandemic runs amok and social distancing goes on, the longer the economy remains sluggish, the better these growth stocks seem to do. So large firms with a prominent online presence and those connected to delivery services or home computer networking will continue to do well.
Keep in mind while 10% of the economy is not working, 90% still is. Combine these numbers with the massive inflow of liquidity that central banks and government have infused into the economy. Markets are flush with cash.
Extraordinary expenditures are driving segments of the economy and that’s what’s carrying the load. The stay-at-home economy is a lot of technology companies that are rerated as essential utilities — like Microsoft and Google and Amazon. These are phenomenal companies with great balance sheets and business models that cater to what people feel they need to buy.
In contrast, as of year-end, financials and energy comprised only 12.7% of the S&P 500’s market cap — one-third less than their index weight just two years ago and nearly half of their index weighting five years ago.
Are you worried about bank failures?
I’m worried about bank earnings, not about the banking system.
What are the main risks investors are facing?
If we can extensively rollout an effective vaccine that can put a lid on the virus, we may see support for the mega-cap, stay-at-home economy stocks start to peel off. I don’t think you would want to be in those stocks when such a sell-off hits. At the same time, likely beneficiaries of this scenario would be banks, airlines, cruise lines, hotels, and dining establishments.
Despite rotation that has occurred into these value stocks during the fourth quarter, they are still relatively cheap because they still lack near-term earnings visibility.
Bank shares, for example, are being punished because we’re in a zero-rate environment with no yield curve from which they can profit. But I expect big banks will survive because they have a ton of regulatory capital. And once the vaccine proves itself, banks will be a great place to be. The shadow banking industry, however, may not be so fortunate.
With bank profitability hinging on the slope of the yield curve, what has happened to the yield curve throughout 2020?
The 2- and 5-year Treasury spread has remained pretty much flat throughout the year, hovering around 15 basis points. The 2- and 10-year spread peaked around 60 bps when the pandemic struck. By August it fell toward 40 bps. But now in early January, it has curved above 90 bps. But keep in mind the normal spread is 150 to 200bp.
Even if the vaccine begins to normalize the economy, can we really expect the Fed to bump up rates sufficiently to drive rate spreads and bank profitability?
The Fed is not going to allow overnight interest rates to go up dramatically. But if we start on a real recovery, the bond market, on the medium and longer end of the yield curve, may start pushing interest rates higher, mindful that inflation would likely accompany recovery, especially with so much liquidity sloshing around the economy. That steepening of the yield curve is all the banks would need to become more profitable.
Do you specifically advise investors as to what to do?
Yes, every day in my newsletter. I talk about the credit market, the government bond market, equity markets, specific countries, and currencies. I don’t tell you about specific investment plays, but I will discuss industry, sector, and macro plays.
How have your recommendations changed over 2020?
During the early period of the crisis, I wasn’t happy about most individual sectors because I was seeing a number of companies with cross-sector characteristics. The best example is Amazon: is it a retailer, a technology company, a delivery company? Clearly it’s a hybrid. So in response to the blurring of lines between many sectors, we created our own indices that are responding to the crisis: Stay-At-Home Equity Index, Recovery Index, Reopening Index, Vaccine-Hope Index, and Payment Stress Index.
How have your own indices performed over 2020 and are they still all relevant as investments?
Using a pro forma approach where we started performance on Jan. 1, 2020 the Stay-At-Home Equity Index rose +39% for the year, Recovery Index gained +23%, Reopening Index declined -15%, Vaccine-Hope Index increased +18%, and Payment Stress Index fell -8%.
What were your other recommendations?
Through August, I was recommending 30-year Treasury bonds, which had risen 25% during the first eight months of the year. Since then, as long-rates have risen, that gain was cut back to 18% by year’s end.
I’m still bullish about long-dated Treasuries as portfolio insurance that help stabilize overall performance. Keep in mind, over any rolling five-year period, Treasuries have never lost money. For equities, over the same time cycle, stocks have been down 12% of the time.
I’ve also been recommending gold and gold mining stocks. For the entire year, the former rose 22% and the latter 26%.
I’ve also been advocating e-commerce, cloud services, computers and accessories, and delivery services as great holds during the pandemic. For the full year, these industries were up 68%, 42%, 74%, and 47%, respectively.
I’ve also been promoting tech stocks. The problem I see with the group of these hot FAANG stocks is that their valuations are in nose-bleed territory.
Analysts promoting these stocks are treating them as long duration plays. So as interest rates go down and you discount earnings stream to the present, their valuations get inflated, notwithstanding the fact that we’ve had a huge plunge in GDP.
I was bullish on value stocks during the summer. Many have since rallied back to their pre-pandemic levels. They still are suffering from low earnings visibility as the pandemic keeps a shroud over recovery. I don’t think you will get penalized rotating into value stocks at this point. But there’s not as much clear upside in them as there was in mid-summer.
Are value stocks getting support from those that pay healthy dividends?
Not really. I found it very interesting that Warren Buffett sold his banks and went into gold. I believe this was a bet that interest rates were going to stay low, making it harder for banks to make money. Low rates are also a boost for gold, whose historical performance has been inversely correlated to interest rates.
Also keep in mind gold mining companies like Barrick are paying 1.6%. This is more than what you can get from 10-Year Treasuries. Mining companies are increasingly being run by businessmen, not geologists, and they are paying dividends. Further, such gold stocks have the appeal of being a form of currency, which governments can’t manipulate like their do their own currencies.
If gold is inversely correlated to interest rates, and we’ve been in a low-rate environment since the Great Recession, why didn’t gold take off in earnest until 2019 when stocks soared? Fear is typically another driver of gold prices, which made the advance notable.
Remember, the bull market in gold actually started six years ago. Meanwhile, real interest rates have been negative for a while, a likely trigger of inflation and likely higher gold prices. If inflation starts to rise with recovery and the Fed keeps a lid on nominal rates, that means real rates will turn more negative. This makes gold an even more attractive investment as a stable store of independent value, especially with gold production typically running no more than 1% a year. In stark contrast, the world is printing money like there’s no tomorrow.
What are you most afraid of?
First, I’m afraid of rising social tensions here and abroad. Second, I’m worried about China’s relationship with the rest of the world, which is likely to undergo a major transformation after the pandemic has passed. And third, we’re facing massive public deficits and debt and government regulation, and how all this is going to play out for the rest of the economy is also very unclear.
What government regulatory shifts are you concerned about?
I’m worried about new regulations pertaining to the financial, energy, and technology sectors. And we’re also uncertain about what fiscal policy is going to look like. Who is going to pay for these massive public deficits and debt? How will bloated government and Federal Reserve balance sheets get resolved? I think this means we’re going to have to move to a world of higher taxation, and this will likely pinch future economic growth.
How do we begin to address the country’s debt that’s now more than GDP?
It remains to be seen. It will involve a debate about how we redress rising fiscal pressures that will be exacerbated by the demands of retiring Baby Boomers, which is on top of the cost we’re paying to fight the pandemic. This swings back to the issue of income and wealth disparities that’s also fueling social tensions. And the pandemic has only widened that gap.
I think the debt problem partially gets resolved with the Fed forced to monetize the country’s debt. This means the eradication of $7 trillion in debt, forgiven by the central bank. This would be a transaction between the Federal Reserve and the Treasury, not be confused with quantitative easing, which was a transaction between the Fed and the private sector. And that will bring a new era of inflation.
Anything else keeping you up at night?
I believe we are in a type of depression that has not yet been recognized — not a recession. And the difference between the two is seismic. Recessions are forgotten within a year after they end. At a minimum, depressions entail a prolonged period of weak economic growth, widespread excess capacity and a fundamental shift in attitudes towards spending and credit. Simply put: a depression invokes a secular change in behavior.
Over at least the near- to intermediate-term, working from home is certainly going to be a more dominant practice. This will have obvious negative implications on commercial real estate and all goods and services complementing office activity, but positive implications for internet infrastructure, computer hardware, and video conferencing. Urban working and living will also undergo a profound shift.
We are also going to see a much greater appreciation of open space. There is going to be a sharp reduction in travel to work and travel in general — nothing here that is very good for the auto or office real estate sectors.
With the Fed having a long-term record of mitigating economic declines and bankruptcies, do you think the concept of moral hazard has been lost on business and investors?
It was lost a long time ago. This current crisis wasn’t brought on by reckless corporate behavior that triggered the Great Recession. We had a pandemic no one was prepared for and then we locked down the economy. We told people you can’t work; you can’t shop.
However, bigger picture: We went through a whole cycle where companies gorged themselves on debt, not for capital formation purposes, but to buy back their stock to generate the illusion of a bull market in earnings per share.
Nobody talked about stagnant real corporate profits over the previous five years because earnings per share was rising as share count dropped to its lowest levels in 20 years. Financial engineering created the illusion of corporate earnings strength, which simply wasn’t there.
Companies went into the pandemic with no liquidity of their own and with the overall corporate debt-to-GDP ratio at 50%. So to think that we are now risking moral hazard because we’re opening up a Pandora’s box with all this new borrowing is really missing where we’ve been all along. The die was cast a long time ago.
You’re saying policy makers and business have collaborated (knowingly or unknowingly) in undermining the economy. Please explain.
Sure. Back in 2018, Jay Powell talked about the need to normalize interest rates somewhere around 3%. When he took the Fed Funds rate to 2.5% in December 2018, the markets puked and everyone started fearing recession. And then we had the President tweeting almost everyday about the need to cut interest rates. The last cycle in which the fed funds rate peaked at such a puny level was in the 1930s. So we became Japan a long time ago.
We found out trying to normalize interest rates in an abnormal environment produces abnormal results. The reasons why interest rates peaked at such a low level in nearly a century is that we’re choking on too much debt at almost every level of society and we’re not allowing markets to clear the dead wood that would eventually produce a healthier corporate environment, one that could manage with normalized interest rates of 3% or higher. Remember, having such rates would help investors better gauge the true value of risk assets, taking some of the air out of asset bubbles.
Companies now are again appreciating the concept of working capital as they try to stay alive. So whether in the personal or business sector, there will be a fundamental shift toward liquidity, savings, and cash on hand.
Bottom line: Every financial decision we make requires us to consider that the Fed is distorting risk markets on a scale that we’ve never seen before. We’ve been bailing out bad actors in the name of the greater good.
What other secular shifts concern you?
Global supply chains could shrink and, in some cases, we might see the full repatriation of manufacturing in certain industries, for instance, pharmaceuticals, food, and high-tech such as semiconductors — areas deemed to be in the realm of national security.
Before the pandemic, the emphasis was on just-in-time production, with parts being delivered when they were needed in the manufacturing process. In the post-pandemic period, the emphasis could shift, to some extent, to “just-in-case” supply chains, emphasizing proximity and certainty of delivery.
You’ve been telling people to start liquidating their portfolios. Please elaborate.
The most successful investors never bought at the lows and sold at the peaks. They participated in the middle 60% and we are way beyond that middle 60%. I think it would be prudent for investors in the highly valued growth stocks to start taking profits. I’m now 20% cash, which will enable me to add to market exposure if there’s a significant selloff.
Nobody ever got hurt by booking a profit, and I don’t live in a counterfactual world of what would’ve been, “if.” I live in real time. I don’t worry about money I left on the table. I’m happy where I am right now and whether I will continue to liquidate is purely situational.
What chances are there for another massive selloff that goes well beyond 10%?
The market has become a casino where Jay Powell is a blackjack dealer handing out chips for free and you can’t really fight the Fed. I totally get it. Once the Fed started buying high yield debt, the equity market resides right next door in the capital structure so the odds of another precipitous decline are low. Will we see another correction in the near term? I’m not sure. But it would be normal and healthy to clear out a lot of the froth. I think a selloff of 10% would be easy to see.
I guess you’re then feeling cautious about the market.
The market was plateauing during toward the end of last year, not much above where it was before the pandemic struck. But over that time, we’ve traded forward PEs of 19 for 23. That’s awfully optimistic given all the potholes I’m seeing. There’s more downside risk than upside. That’s why I’ve been raising cash.
Thank you, David.
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