Set for a Slowdown
History-minded manager likes gold, REITS, utilities and other unloved sectors
By SANDRA WARD
AN INTERVIEW WITH RICHARD ARVEDLUND – We at Barron's miss our friend and former colleague Erin Arvedlund, who is now writing from Moscow for the New York Times. If there's any good to come from her leaving it is that it made it possible for us to tap into her dad's 30 years of investment experience and share it publicly with our readers. Formerly with the DuPont Pension Fund, Arvedlund founded Wilmington, Del.-based Cypress Capital Management in 1984 and now shepherds more than $400 million in assets, mainly on behalf of individuals. A master of constructing balanced portfolios of mostly big-cap, dividend-paying, undervalued stocks combined with bond positions, Arvedlund has delivered solid gains for his clients through the years. Most impressive, while the stock market was sinking from 2000 to 2002, Arvedlund's clients saw their accounts appreciate nicely. Ever prudent and often prescient, Arvedlund is now braced for a sharp slowdown.
"The combination of rising short rates and rising oil prices has always jolted economic growth."
Barron's: Can the market keep delivering the goods here?
Arvedlund: We think the economy will experience a fairly sharp deceleration next year, most likely in the second quarter or so.
Q: Why is that?
A: We see GDP [gross domestic product], which has been running at around a 3%, 4%, 5% rate of growth, dropping to about a 1% or 2% by the middle of next year. We're not predicting a recession, but definitely a significant slowdown.
Q: What's driving that view?
A: Monetary growth has slowed down considerably. As of this summer the real M2 numbers, adjusted for inflation, were down to about 1% or so year-over-year, and the nominal numbers were down to very low levels, as well. In fact, they were down to rates of growth that were actually lower than we saw prior to the last recession. Secondly, the price of oil has experienced a very dramatic increase, and historically whenever you get an increase of this magnitude, 50% to 60% or so, it has always led to a drag on the economy.
Q: Even though prices have backed off their highs?
A: Higher prices are already baked into the cake. The price of oil a year ago was, say, $30 a barrel, and today it is just under $50. That kind of gain has always preceded an economic slowdown. It is a drag. But it takes time, about a year, to have an impact. The final leg of the stool is the Federal Reserve raising interest rates, and that takes about six to 12 months before it impacts the economy and the market. The combination of rising short rates and rising oil prices historically has always jolted economic growth. Examples of this were in 1999 and 2000, when the price of oil rose, the price of money rose and it led to a recession in 2000-2001.
Q: What will lead this slowdown?
A: We are now entering the fourth year of GDP recovery, and everything is getting long of tooth. What will lead the deceleration will be the sectors that have led on the way up. Automobiles will roll over. That's already started. Housing activity will simply stop increasing. When you take autos and housing and marry them with all their vendors and suppliers, that's about 10% to 20% of the economy that's going to be flat or down. Finally, consumers will start to slow down their spending because they are tapped out after their debt binge. Expect all the early cyclicals, and that includes retailers, to slow down or roll over.
Q: With that kind of forecast, what keeps us out of recession?
A: What keeps us out of recession would be the Federal Reserve's reaction. They would start to print money again and they would stop raising rates.
Q: But not necessarily lower them?
A: No. If you look at history, they always wait too late to lower rates. By next year, too, one would expect commodity prices and oil, in particular, to come down. Credit demand will come down. That provides some relief but it will still result in a very sharp slowdown. An earlier example of this would be early to mid-1995 when GDP slowed dramatically.
Q: Can the market do OK in the environment you're describing?
A: It will not be an exciting environment for the stock market. A slowdown in GDP implies profit growth will slow down sharply, particularly in the cyclical areas, which have been the market leaders.
Q: Doesn't demand from China provide an offset?
A: China will help buffer the economic slowdown, but it will not prevent it. Consumer spending will slow, housing will stop growing and automobiles could experience a 5% to 10% decline. This is not a good outlook for manufacturing and this is not good for cyclical industries, and corporate profit growth will decelerate.
Q: And corporate spending?
A: Corporate spending probably hit its peak rate of growth in the second or third quarter. Capital spending is a lagging indicator. It is always the last to come to the party and the last to leave it.
Q: This time it took a lot longer for it to come to the party.
A: It lagged dramatically until recently. It has lagged because there is significant excess capacity and corporations are still bent on cost cutting. At any rate, none of this is a major plus for the overall stock market. It should be OK for some industries, but for many that have done well, it will be the last hurrah. Yet if this forecast proves reasonable, it could be a phenomenal plus for the fixed-income market.
Q: Which no one is expecting.
A: No one is bullish on bonds. You are probably talking to one of the few bulls on bonds.
Q: Are we talking about the 30-year or the 10-year bond?
A: The 30-year. We generally invest in longer-term Treasuries as opposed to shorter maturities. Our outlook on bonds goes like this: The Federal Reserve raises short-term interest rates between now and mid-year, let's assume by 50 basis points [a half of a percentage point] and possibly more. They started raising rates late and they are clearly in catch-up mode. The long-bond yield probably holds here around 5%, the yield curve narrows to a more normal yield spread of 200 basis points, at which point the rise in short rates starts to have a breaking effect on the economy. At that point, short rates stop going up and long rates start to fall. The surprise market will be the bond market. Everyone is looking for long yields to go up to 6% or so, yet we think at 5% they are more than fully discounting our economic scenario. In the next two years, the 30-year bond will drop from 5% to a target of 4% somewhere in 2006, and in doing so deliver a nice rate of return.
Q: What about the dollar?
A: The direction of the dollar is down.
Q: How down is down? Is it necessarily a bad thing, or will it help the trade deficit? That seems to be the new line of thinking.
A: It is not helping the trade deficit very much at this time, and we suspect it is not going to help it in the future. I don't know of anything we export that would benefit very much, and we continue to be totally influenced by oil imports. I don't think Chinese imports will be affected at all by the weak dollar. The dollar is declining because of our loose money policy, our terrible fiscal deficit and our current-account deficit, all of which are heading the wrong way. What will happen at some point is that foreigners will stop buying our securities or at least buy less of them, and it will be witnessed in the short-term bond market, which represents the bulk of their purchases. That is where you will see the most damage.
Q: How are you positioning your portfolio?
A: Sectors at higher risk are the cyclicals and the commodities. Basic materials have had their run. Basic industrial-commodity prices are probably peaking. I'm referring to things like copper and nickel. The housing cycle is peaking. We would recommend people sharply reduce their exposure to those sectors and invest in companies that are far less economically sensitive. We started to reduce our exposure to oil because we felt the price probably peaked at $55 and that economic forces will drive the price down next year. We bought the oils in 2002 or thereabouts, and it turned out to be premature. The price of oil went up in 2002, but the stocks went down with the market. We've owned them now for two years or more and we've started to pare back, particularly those companies that are dependent on the price of the commodity. We've also reduced all our exposure to auto-related companies. We just sold our auto-parts position that we've held for years.
Q: What companies?
A: Genuine Parts, in particular. We noticed their basic automobile business had decelerated and the industry overall is facing a very difficult environment.
Q: What about the strength in the trucking industry?
A: We have not owned the trucking industry, but anytime GDP slows down meaningfully, you will see volumes contract quite a bit, and I would imagine energy costs will hit their margins. Transportation is a sector we think investors should leave. Over the last year or so, we've also reduced our weightings in financials because this is an environment where there will be a squeeze on net interest margins. From our perspective on the equity side, investors should stay with the steadier and less economically sensitive groups, which would be health care, food, utilities and real-estate investment trusts.
Q: REITs have held up well. Do you expect that to continue?
A: Yes. This is one of the few examples I've ever seen in my career where a sector of the stock market -- real estate -- has done so well for a very pronounced period of time and yet has probably the least sponsorship on Wall Street.
Q: Still?
A: Still. Very few funds own real estate. It is only 1% to 2% of the S&P. Very few people are advocating REITs, and yet the index has been compounding at around double-digit rates of return. They have fabulous yields. The average real-estate investment trust we own has a 6% yield, and many of them are raising their dividends. They are the only sector of the stock market today where you can pick up yields in excess of 4%. Their dividends, for the most part, do not qualify for the dividend tax benefit, but nonetheless we find it a very attractive sector and we have put quite a few of our equity assets in there. Most sell at reasonable P/Es, and in a couple of sectors the fundamentals are finally starting to improve.
Q: When did you start shifting your portfolio away from cyclicals?
A: The middle part of this year. Fixed income is now more than 50% of the portfolio. Stocks are down to the mid-40% range. Precious metals represent about 2% to 5% of equity assets. We started a precious-metals position in the second quarter of 2003. Our primary investment vehicle is Newmont Mining and our secondary one is Hecla Mining. It is based totally on the premise that the value of the dollar is in secular decline and that the direction between the dollar and gold is inversely correlated. Cypress has used gold only two or three times in our history. The last time we used gold it was as a classic inflation hedge, in 1987.
Q: Gold is still controversial.
A: Most investment folks on Wall Street refuse to acknowledge gold as an asset class. It is considered the realm of gold bugs and speculators. You also have to keep in mind that for more than 20 years, from 1980 to 2002, the price of gold did nothing but go down. During this period, sponsorship of the gold stocks dropped. The industry went into a massive consolidation. Mines were closed or simply depleted. The number of companies retreated and until 2002 the dollar was rising so gold had nothing going for it. Most people don't treat it as a valuable asset class, particularly in America. There is only one gold company in the S&P 500, Newmont Mining, and we find people would simply prefer to avoid the asset class. This is a form of denial. We think it is worthwhile. Given the decline in the dollar and the dramatic shortfall we see developing, we expect it to be our highest-return asset class.
We look for gold to appreciate demonstrably from here. Our near-term target is $500 an ounce, and our longer term target is $1,000. The stocks are incredibly volatile, which is another thing that scares people off. But there is a very close relationship to the price of gold per ounce versus the price of the shares. Also, a gold-bullion exchange-traded fund was just launched, and another one is expected to be available soon, and that will drive up demand for the metal considerably.
But again, very few people recommend gold, very few people recommend gold stocks. There is almost no coverage of gold equities on Wall Street. I suspect that will change quite dramatically. If gold breaks out to a material new high and the stocks have another lurch forward, the asset class will start to attract more interest. Thus far, interest has been incredibly modest despite the performance. Anyway, to summarize our view, we think the fixed-income market is far more attractive than people think and rates on the long end might drop by, say, 100 basis points in an economic slowdown, for a double-digit rate of return.
The outlook for stocks on our valuation model is now very limited, and we are finding it incredibly difficult to come up with reasonably priced equities. The expected return from both asset classes is fairly similar, roughly 4% or 5% over the next year, and in our view of the world, stocks should offer you a heck of a higher return than bonds.
Q: There is no risk premium on stocks?
A: No. Our models show a negative premium. The only sector that stands out as having really meaningful value is the drug industry. How is that for controversy? The big drug stocks, Johnson & Johnson, Pfizer, Merck. The prices are low. The P/Es are low. Everybody is liquidating them. The sentiment is terrible, and yet here is the largest industry in the country, representing 15% of GDP and growing at a faster rate than the GDP. The sector is very attractive. Generally, we are known as big-cap investors. We invest in companies that pay dividends. We particularly like companies that raise their dividend every year, and we particularly like companies that raise their dividends at a rate above inflation. That's another reason we like the drug stocks.
Q: What else looks appealing?
A: The defense sector is attractive. What you get with the Bush regime is more defense spending. I tell people they should own at least one defense stock as a hedge against all military actions that take place around the globe today.
There seems to be more new enemies against the U.S. every year than the year before, and defense is a sector you should have some exposure to. Our favorite is Northrop Grumman. We've chosen Northrop because of its programs.
Q: Do you expect bigger caps to do well in the environment you described?
A: Yes. Small caps, as they normally do, have outperformed in the early stages of a market like this. By our standards they now have the highest risk profile. This is a time to go from small to big. This is a time to get away from leveraged companies to less leveraged companies. This is a time to get away from commodity-price sensitivity. This is a time to take a look at companies that might potentially benefit from lower long-term yields a year or two from now, and that would mean REITs and utilities.
Q: Ah, another group people have forgotten about. What utilities in particular are you referring to?
A: Electric and gas utilities, which have no coverage to speak of, and are only 2% of the S&P. There's hardly any enthusiasm surrounding them, and yet the Dow Jones Utility Average has recently hit a new high, not a new absolute high but a new recovery high. The index bottomed at 170 and is now at about 330.
Q: What are some names you like?
A: Public Service Enterprise Group, Keyspan, NStar and Dominion Resources. There are lots of them. And they still offer reasonable value. Most of them have the ability to raise their dividends. Many got involved in some really crazy businesses in the bubble era but, for the most part, they are all getting back to their knitting. It is not a very exciting growth story. We're talking about basic energy production and growth rates of 3% to 4%. But they have dividend yields of 4% or 5%, and they are repairing their balance sheets. Several of them are buying back shares, which is a new phenomenon for the utilities. For years, all they did was issue shares and debt. Now they are starting to raise their dividends and buy their shares, and they are selling at very low P/Es. From our perspective, the total returns are quite handsome, and the group is underfollowed. In fact, in Barron's recent money-manager poll, the utility sector was listed as not applicable.
Q: How about some REIT picks?
A: I'll highlight two: New Plan Excel Realty Trust and HRPT Properties Trust. New Plan owns shopping malls anchored by grocery stores. Sound familiar? And HRPT's properties are primarily commercial and government office space. Each yields 6%-7%, and my guess is their dividends could be heightened by 3% or 4% each in the next two years. They are selling at very low multiples of earnings. If we can lock in 7% up front with dividends and get a 4% return on the price, we'll have achieved more than we need.
Q: Dick, thanks very much. |
