Top money manager says bear market still has a long way to go.
'By midyear, markets will be at
new lows.'
A pundit speaks: 'By midyear, markets will be at new lows.'
Once a pundit always a pundit? The case of Felix Zulauf, president of Zulauf Asset Management
AG in Zug, Switzerland, may provide a clue. Zulauf, who with his partners, Daniel Koeppel and
Nicholas Mathys, manages Zulauf Europe Hedge Fund, used to get a lot of media exposure.
Besides his ongoing annual appearances in Barron's Roundtable of top financial pundits, Zulauf
often appeared from the mid-1980s through 1998 on CNBC as well as Louis Rukeyser's "Wall
Street Week" and a variety of financial television programs in Germany, Switzerland, even
Portugal..
A month before the 1987 market meltdown, Zulauf, then head of Union Bank of Switzerland AG's
institutional portfolio management department, decided to liquidate his clients' equity portfolios..
In 1998, Zulauf decided to leave the limelight and avoided all media appearances save Barron's. "I
saw that things would get ugly. I saw many, many people investing in a way they should not.
Eventually they would turn out to be big losers," he said, adding, "If you had warned them at that
time, they would have thought you were an idiot, and you would lose your status.".
While the past two years have left many investment advisers red-faced, Zulauf Europe Fund, which
goes long and short on equities, has gained 80 percent after expenses since its August 1998
debut. So far in 2002, it is up 3.9 percent; the Eurostoxx 50 index is down 4.8 percent. In his first
non-Barron's interview since 1998, Zulauf spoke with Sharon Reier as one of his top short
positions, Zurich Financial Services AG, revealed its weakness..
What is your overview of the economy and the stock market now?.
The consensus is that the United States economy has bottomed, is turning around, and the
market hit a low on Sept. 11. That analysis puts us in a bull market that will carry over the next
few years..
I do not believe that. I do not think we are in an economic situation that allows for a sustainable
recovery. Last year there was a refinancing opportunity where interest rates were lowered and the
consumer could cash out and spend. But long-term interest rates have risen, and therefore the
window for lower interest rates is spent. Moreover, energy prices declined and left more money to
spend for other goods and services. But energy prices are rising again. Thirdly, there was a [U.S.]
tax cut last year that will not be repeated this year. There will be a big disappointment as people
realize the recovery is spent. The market is smelling it and selling off. I think by midyear the
markets in the U.S. and Europe will be at new lows. There will be another big rally in the second
half, then another decline. That is the way markets decline..
How low do you see it going?.
I think we are in a structural bear market that will last for five to 10 years. It is not a nice picture.
But it will not go straight down. From time to time there will be fiscal and monetary stimulus.
Markets will get oversold and will rise for awhile. Markets will zigzag downward. It will not be over
until stocks trade at attractive valuation levels..
Don't forget that the norm for the U.S. stock market over the past 80 years is a price/earnings ratio
of about 15. The current reading is in the 40s. Most structural bear markets usually hit a low where
stocks trade at book value. When the stock market trades at book, you get a lot of stocks that
trade below book and are good values. Book value [for the S&P] right now is $220 and the S&P
index now [is] at about 1,100. It is still trading at a valuation level higher than in any historic period.
People are looking back and saying the market has come down 20 percent to 30 percent. We had
a rally from September to January. Then down we go. It may go up again next fall, and then there
will be another decline..
What strategy do you suggest for investors in this market?.
What is important for the investor is that the winning formula of buying and holding is not working
any more. In fact, it is working against him. If you cannot be successful in the current environment,
get out. Leave it to those who can. This is a market for opportunistic investors who can play rallies
and can also play the short side. But it is important to know what you are doing if you short
stocks..
What is your fund shorting?.
We see lots of losers. At present we are more short than long. For instance, we are short financial
asset gatherers and managers because the bear market environment will slow their business
sharply. Also insurance companies. These are companies that made money on their financial
asset portfolios and now are suffering losses. You will see more and more disappointments in
these sectors. Stocks are not the only problem. Corporate bond yields have actually gone up, and
quality spreads have been widening. Many professional investors have moved to the higher yields.
But we now have a corporate environment with the weakest balance sheets ever.
It is like this in Europe also..
Remember the 1990s was a period where companies bought back stock, and took out loans to do
it, to boost the stock price. By contrast in the past, when equity prices were high, people issued
new stock and strengthened their balance sheets. These weak balance sheets are coming home
to roost..
We are also shorting banks. We expect loan losses will continue to rise in commercial banking.
Investment banking is hurting as the capacity built up during the boom time proves too big to
support the very low revenue flow in the future. In general, we are also shorting any industrial
company with a weak balance sheet and high valuation of its equities..
What are you long on?.
Companies with low equity valuation, strong balance sheet and a dividend yield. One finds more
like these among the midcap stocks, particularly in industries where there has been consolidation.
That would mean basic industries. We also like metals and mining stocks; energy stocks and
gold stocks. We are long Newmont Mining Corp. and Goldfields Ltd., a South African company
listed over the counter. Gold and energy - sounds like you expect inflation. But people are talking
about deflation, as in Japan..
There are a number of crosscurrents at play. It is true that globalization has lowered some prices.
So we have deflation in tradable manufactured goods. But the local service sector is inflationary.
And credit creation has grown at an extremely high rate in the last decade and has produced
inflation there. The U.S. economic boom was created by a consumer spending boom interlinked
with a financial asset boom. The financial asset boom was made possible by an aggressive easing
of money, the accounting gimmicks we are beginning to see - and a lot of hype by the investment
community. It came from the belief that we were in a new age of productivity and innovation. At the
end, it all has created the weakest balance sheets in U.S. corporate history. Weaker even than in
1929, and now the boom is over..
And due to the financial asset boom, you had the savings rate collapse. So in order to keep the
consumption boom going, you have to keep the savings rate declining at the same rate. For that to
occur, you need the stock market booming as in the past. If not, the savings rate will most likely
rise, which means a lot less consumption and a weaker economy. Governments will compensate
for this in part by going into deep deficit. I think governments will go into deficit and there will be
deficits of 3 percent and 4 percent and still very little growth. Central banks all over the world will
not be able to stay a stable course. If the economies are weak, the central banks will not limit
money supply to 2 percent growth. They will go to 10 percent or 20 percent or 30 percent growth,
whatever it takes to support the system. And that will mean a devaluation of paper currencies.
Investors will turn to gold, as they are already doing in Japan..
Our enthusiasm for energy stocks is based on another premise. Oil reserves are depleting at a
rate of 6 percent a year, and demand is growing 2 percent a year. Just to keep reserves even, the
industry should find 8 percent new reserves per year. That is not happening. Because prices have
been low, there is little incentive to find reserves. Oil prices a year from now will be higher - and five
years from now will be much higher. That should benefit oil companies with lots of reserves in the
ground.. Does the prospect of inflation make real estate a good investment?. Real estate with a
decent yield will do well. So will undervalued assets. But I would not go into financial districts or
fat-cat houses in Greenwich, Connecticut. They are certainly overpriced..
Americans have become obsessed with the stock market. You see CNBC and other financial
programs at bars, airports, restaurants. Are Europeans equally interested in financial media?.
Today virtually everyone in the United States owns equities, and now nearly all Europeans do. And
until two years ago, everyone was enjoying it. Now they have calmed down a little, but the stock
market is now quite important in Europe. There are three reasons. Firstly, investors are investing in
equities on an individual basis. Secondly, savings plans through life insurance tax incentive
programs and insurance companies have never been more in equities - until a year ago - and now
are having trouble meeting performance criteria. Thirdly, pension funds have become important
players in equities, and they are now entering a more troubling era. People are concerned whether
their pension funds are well invested. |
