Part One Mike:
June 8, 1998
Deserting the Bulls
Why one erstwhile big money manager has started a hedge
fund
By Kathryn M. Welling
An Interview With Joseph L. Toms ~ The proprietor of Hilspen Capital
Management isn't running a bushel of money. At least not yet. Only about $30
million. Joe's private equity partnership, based in rainy (blame El Nino) San
Mateo, California, officially opened for business only at the beginning of the
year. And his performance, well, it pretty much matched the major indexes in
the first quarter.
So why are we talking with Joe? For openers, his hedge fund notched those
numbers while being heavily net short amid the roaring bull-market rally.
What's more, being a bear is a huge departure for this Joe. His previous
professional incarnation was as director of research at Fisher Investments,
where he ran $2 billion in institutional portfolios alongside founder Ken Fisher.
After joining Fisher in 1985, when the fledgling firm was managing just $4
million in institutional assets, the onetime small-cap analyst for boutique broker
L.H. Friend played a myriad of roles and "gained a wealth of experience," as
he puts it. Joe also established for himself a record of almost unflinching
bullishness during the market's long march upward -- except for a couple of
brief, and exceedingly well-timed, detours to the dark side -- in '87 and late
'89.
The beauty of the whole experience, says Joe, was absorbing the essential
attributes of Fisher's thoroughly thought-out, rigorously researched and cannily
contrarian approach to investing.
We'll say this, after chatting with Joe recently about his new business and the
market: The lessons took. Which makes his conversion all the more
noteworthy. See for yourself, in the Q&A that follows.
Barron's: Why did you leave Fisher to strike out on your own, Joe?
Toms: I ultimately came to the point of deciding that I don't want to manage
billions of institutional dollars in specific, defined styles. I'm a big believer that
investment styles come into and go out of favor. It's important to have
flexibility, to be able to go back and forth -- and that's hard to do in the
institutional world; institutions don't like it.
Q: In fact, don't permit it -- and hire consultants
to keep managers in line.
A: Absolutely. That's a whole separate subject.
The structure of the institutional world, in my
opinion, guarantees mediocrity -- and that the client
pays high fees for that mediocrity. The committee
structure means you go to the median, whatever
that is. You have people who have to report to
other people, so they are always covering their rear
ends. You have a consulting structure that says you
must fit into a certain box and you shouldn't change.
Yet the investment world does change. So as a guy
managing money for these people, you're stuck if
you see the world starting to change and think you
should do X -- because doing that is suicidal to
your interest in managing the account.
Q: You lose it.
A: You got it. It becomes a very bizarre game. But
I realize that's the way the world works. I can't change it very easily. So I
decided to go off and concentrate on managing money where I could have the
flexibility to switch styles.
Q: You don't believe all the academic studies saying it's all but
impossible to make money by market-timing like that?
A: No, they're fundamentally right in terms of how most pension plans, say,
approach the market. But I use investment styles, in essence, as a barometer
to tell me what kind of business model will succeed in a given macroeconomic
environment. I look at big-cap value, big-cap growth, small-cap value,
small-cap growth as representing essentially unique business models. So the
styles become only a proxy for me to try to decide what kind of companies
make the most sense.
Another reason I decided to set up my own shop was that I wanted to be
able to go short. I am a very big believer, to use the old analogy, in using both
forward and reverse gears. Especially because, over the next three to five
years, there could be some good potential for downsliding. My goal is to
make money in both bull and bear markets. Which is hard to do in an
institutional money-management firm.
Q: Your move is a market call, then?
A: I would argue that we're at a significant inflection point in the marketplace.
Potentially, the most significant since the beginning of the bull market in 1982.
Certainly since the bottom of 1990.
Q: Why?
A: Let's stand back and address a couple of things. First off, obviously, by
definition, inflection points are rare. In my view, whether it's an inflection point
leading to a bull market or to a bear market, what makes it an inflection point
is that you have four or five major factors converging together, pointing in the
same direction, and that direction is the opposite of the current trend. Today,
these factors are clearly pointing in a direction that in my perception is
negative -- while stocks are telling you things are great. Ultimately, the way I
look at the world, that's a rubber band -- and the rubber band does snap.
Q: This old bull market has shrugged off tons of bad news in its time.
A: In the short term, anything can happen. But in the end, if these
countertrend factors continue to do what they're doing, they will pull stock
prices lower.
Q: This bearish stance is quite a departure for you, right?
A: Right. The only time we were bearish as a firm at Fisher was before the
crash in '87, which worked out nicely for us, and in '89 -- only temporarily. I
turned strongly bullish in 1990 as the market fell apart, and I've been bullish
since then. In fact, I wrote a piece in '94 arguing that the market would do
very well over the next couple of years -- because of positive trends in many
of the same factors I now see as negative. Granted, I didn't predict the
rip-roaring three years of spectacular returns that we had. But I'm definitely
not a perma-bear.
Q: So, why are you bearish now?
A: It's the convergence of these four or five factors, all pointing to a reversal
of what have been very happy economic and market trends, that have turned
me from a pretty ramped-up bull into what you see -- a dyed-in-the-wool
bear. The Asian situation is the catalyst that started to change the
macroeconomic trend -- which is the most important factor influencing the
market in the intermediate to long term, in my view. I am a firm believer that,
over the long haul, stock prices directly correlate to the underlying economic
trend.
Q: But this Goldilocks economy is not too hot, not too cold -- and Asia's
downturn has actually helped keep it that way.
A: That's where we differ from everybody else. It's true today. But we both
know the market will move on expectations about what will happen over the
next year and a half. It does discount the future. And while it has not done so
yet, I argue that it will begin to discount a couple of key elements that are
clearly pointing to a negative trend in GDP growth in the U.S. -- and the
world -- over the next year and a half. No. 1 -- which people have talked
about recently in a more fearful way than they did just a couple of weeks ago
-- is the Asian crisis. In my view, the Asian crisis does count. The reality is
that what happens over there is a predictor of what's likely to happen here,
albeit not to that degree. When significant segments of the world's economy
suffer from a downturn, it's only a question of time before the rest of the world
gets sucked in. No economy is an island.
Q: Ah, but Southeast Asia isn't all that significant, we hear.
A: Let's look at the historical record to see what's significant. One source is
David Hackett Fischer's 1996 book, The Great Wave, which does an
excellent job of charting ancient historians' accounts of economic activity,
using things like prices and the cost of capital done in whatever terms were
current, all the way back to ancient Babylon, Greece and Rome. Obviously,
the data aren't perfect, but what's interesting is that, in any given period,
regardless of what places you look at, the trends in prices, or in whatever
economic measures were recorded, were very tightly correlated. In other
words, the spotty historical records seem to indicate that there was a
synchronization, if you will, between economies that by definition probably
didn't have a lot of trade between them, due to transportation, distribution
issues, etc.
Another source is Wesley C. Mitchell's piece, "Business Cycles: The Problem
and Its Setting," which was published by the National Bureau of Economic
Research back in 1927. Mitchell was a pre-eminent economist in the early
part of the century who spent a lot of time thinking about business cycles. He
put together a beautiful chart [reproduced in part nearby] that initially looked
at the business cycles in the U.S. and England between 1790 and 1925. Later
he added the cycles between 1890 and 1925 for a host of countries, including
India, Japan, China. He showed that if you look at the cycles of prosperity,
recession and depression in those disparate places, amazingly, they line up.
The key to reading the chart is observing how the heavy black segments line
up vertically. The late 1800s were tough economically in the U.S. and
England. Well, guess what? They were tough all over the world. The data
show many periods in which all the major economies suffered contractions --
together -- demonstrating that the interlinking of economies has existed for
hundreds of years.
The key to reading the chart is in observing how the purple segments
line up vertically, showing that in many periods the disparate
economies suffered contractions together; thus, the linking of
economic cycles has existed for years.
Q: You mean globalization ain't news?
A: People who believe in this big new trend of globalization argue that today
we have more interchange between countries than we've ever had, that we've
become this global village because of advances in telecommunications and
transportation. Yet the historical record, I argue, provides incomplete
evidence that there has been a sychronization of economies going way back.
And while the duration and magnitude of each country's downturn varies, it's
clear that a major country rarely escapes the impact of a global slowdown.
Q: What causes these cycles -- sun spots?
A: That's a good question; I'm not sure it can be answered. It's almost akin to
"Why does everybody show up at the grocery store at the same time?" If
retailers could ever figure out how to smooth out their traffic flow, it would be
wonderful. But they haven't been able to do it. I know people want to argue
that only a tiny percentage of our GDP is exposed to Southeast Asia. My
point is that if history is any guide, it has mattered in the past, and it matters
now. We are seeing a recession in Asia, which will spread. You can see signs
of one in China. In Taiwan, in the U.K., Latin America. It will eventually
impact our economic growth rate. Another point, tied to that, is that the
yield-curve spread is an excellent predictor of future economic growth rates.
Q: You'd better define "yield-curve spread."
A: It's simply the difference between the three-month Treasury-bill rate and
the 10-year Treasury-bond rate. It just closed the flattest it has been since
April 1989. Which was, again, not a very good time to invest, considering the
subsequent bear market and recession. Actually, when you look at the
yield-curve-spread data going back to 1953, you find that when the spread
gets into this zone, which is 45 basis points or less [a basis point is 1/100th of
a percentage point], the probability of a subsequent recession or slower
economic growth jumps dramatically. Secondly, if you look at how the stock
market has performed in the 12 months subsequent to the times when the
yield curve has gotten this flat -- except in the midst of a recession -- what
you find is that the stock market has its worst performance over those
stretches. It's actually down about 195 basis points as a median calculation.
My point is, if the yield curve spread is predictive of economic growth, and
there is a whole bunch of logic that says it is, and if it is flattening, it's telling
you that the U.S. is going to be slowing economically. Which means you
cannot sustain stock market prices and valuations at current levels.
What's more, this is a global phenomenon. If you look at the U.S., Germany,
the U.K. and Japan -- which I'm willing to argue constitute 95% of what's
truly the global currency -- their combined yield-curve spread is the flattest it
has been in the last six years. That says economic growth is falling worldwide.
Which means you can't sustain earnings growth and you can't justify
valuations. So the notion that everything is great, I'd say, is based on past
evidence. Future evidence, the yield curve and Asia, point to much slower
economic growth, perhaps even recession.
Q: That prospect really spooked the market around the beginning of the
year -- yet the first quarter turned out great.
A: I wrote at the time that I suspected we would get a good rebound, and
why.
Q: Which was?
A: Simply because it would take a lot of time for Asia's troubles to spread.
And because our slowdown won't be due just to Asia. Other contributing
factors, like the yield-curve spread and money-supply growth, also take a
while to kick in. The U.S. economy is unquestionably the strongest in the
world today. But trends in place today clearly point to slower growth in the
future. As I anticipated, the U.S. continuing to show good economic numbers
-- for a while -- has soothed investors' fears. Yet the evidence continues to
mount on a worldwide basis that somewhere out here -- three months, six
months, nine months -- the economic news is going to turn bad. |
