SATURDAY, JANUARY 18, 2014
The Good, Bad, and Ugly: A Guide to 2014
By LAUREN R. RUBLIN
The year ahead presents challenges as well as investment opportunities, say our 10 Roundtable experts.
We wish we could share the official view of the Barron's Roundtable regarding the economy and markets in 2014. But it was impossible to find much common ground this year among our passionate, principled, and occasionally pugilistic panelists, whether the discussion veered toward interest rates, stock prices, GDP, or lunch.
The schisms were apparent from the start of our annual confab, held on Monday at the Harvard Club of New York, and they are likely only to widen as QE3 -- or is it QE4? -- makes its way fitfully back to port. Therefore, we feel obliged to offer two competing outlooks for the new year, which seems a tad more challenging already than its bubblicious predecessor.
The Roundtable's optimists expect the global economy to pick up, bonds to tick up, and stocks to mosey higher, notwithstanding the errant hiccup. The pessimists, emboldened perhaps by the return after a one-year absence of Marc Faber (wearing a woolen wonder of a hat that put hipsters to shame), see crippled economies here and abroad, rotten government policies, and a selloff in stocks that could rekindle fears of, yes, systemic risk. Yet, somewhere between these poles, all say, lie plenty of investments worth a wager, on the long side and the short.
After a morning of macro debate and discussion, chronicled faithfully in the pages ahead, Wall Street veteran Oscar Schafer walked us through the hidden charms of six lesser-known U.S. and European companies whose stocks, he said, could lift off in coming months. Also in this week's Roundtable issue, the first of three, Swiss money manager Felix Zulauf shares his forebodings about Hong Kong, Turkey, and Japan, and confesses to a newfound affection for gold.
Barron's: After a stupendous year for U.S. stocks, 2014 is looking rather different. Since the Federal Reserve and the bond market will be setting the tone, let's start with our bond maven, Bill. What will everyone be "Yellen" about this year?
Gross: Moves in the U.S. and global bond market have been directed in recent years largely by central-bank asset purchasing, or quantitative easing. These policies have kept interest rates abnormally, if not historically, low. In the U.S., the Fed is beginning to pull back. Yields on 10-year Treasury bonds are 120 basis points, or 1.2 percentage points, higher than they were 12 to 15 months ago. We've had a bear-market run, so to speak.
At Pimco, we don't expect yields to keep rising, even in the face of Fed tapering [the Fed has started curbing its bond-buying]. When its asset purchases end, likely in late 2014, government bond yields will be dependent on the policy rate [the Fed's target for the federal-funds rate, currently 0.25%]. That brings us to Janet Yellen, who becomes chair of the Fed on Feb. 1. She is dovish with a capital D, meaning she won't increase the policy rate, which is key for two-, five- and 10-year bonds. That will allow levered borrowers, banks, investment banks, and hedge funds to have a reliable source of funding at a reliable price. Absent higher inflation and a policy-rate change, the U.S. bond market, and other bond markets, will be stable.
Is the market overly discounting a rise in the policy rate in 2015 or 2016?
Gross: Yes. Eurodollar futures indicate a policy rate of 3% to 4% in early 2018, but that is a long way off. It's another way of saying that the market sees a rate hike in early 2015.
And what are the chances of that?
Gross: Slim to none. First, the Fed has to finish the taper. Then, as it has suggested, there will be a considerable amount of time before it raises rates.
Cohen: In her early academic work, Yellen spent a lot of time thinking about labor markets. Although the recession technically ended in the U.S. in mid-2009, we are just beginning to see better gains in employment. Her work indicated that the labor markets need to get much tighter before middle-income and lower-middle-income workers see the benefit in job creation and wages. Given current conditions, a rate change is unlikely.
We must also consider how the new leadership at the Fed, including the new vice chairman, Stanley Fischer, communicates with investors. The Fed has tried to be clear about its intentions, but the message isn't always received in a clear fashion. Often, investors focus on one or two words in a Fed statement and ignore the rest. People have forgotten that the Fed is data-dependent. It will make decisions not based on what it said it would do, but on what the data show.
Zulauf: Why offer guidance, then?
Cohen: It is just one tool to let the markets know what it is thinking, especially since policy rates are close to zero. In this case, the Fed has conveyed that it is a long way from wanting to tighten aggressively. Implicit in this conversation is that the bond market already has tightened, meaning that intermediate- and long-bond yields already have risen.
Rogers: Can I dispel the notion that the Fed can engineer precisely what is happening with interest rates? With the economy doing all right, some labor-market slackness disappearing, and the fixed-income market disappointing investors last year, it seems the pressure on 10-year yields is upward, not downward. I have trouble seeing how the 10-year bond could rally. I have trouble seeing bonds earning their coupon this year.
Zulauf: The U.S. bond market is mispriced relative to other major bond markets, except Germany's, perhaps. It doesn't make sense that comparable French government bonds yield 50 basis points less than the 10-year Treasury. If the dollar holds up or strengthens slightly against other major currencies, it will create an arbitrage situation that puts downward pressure on U.S. yields.
Gross: If the Japanese yen weakens even mildly, a Treasury bond denominated in dollars is an ideal investment for a Japanese investor.
Cohen: So there might be international demand for U.S. bonds. There might be corporate demand, mainly from pension funds. All this could serve to mute a rise in interest rates. Yet, I'm in agreement with Brian. Economic growth in the U.S. will be OK.
Demand will push rates somewhat higher. A major inflection point occurred in the bond market some months ago. The magic spell was broken. People had argued that rates would never, ever go up again. But they have, particularly on intermediate- and long-term bonds. They could drift higher from here.
Abby, what is your 2014 forecast for the economy?
Cohen: The Goldman Sachs economics team is forecasting gross-domestic-product growth of 3.3%. The sources of growth include less fiscal drag than last year, when the payroll tax was increased, and some improvement in domestic demand. We are seeing improvement in the labor markets and household disposable income, and spending has increased. This is evident in auto sales and housing. Also, U.S. companies with strong balance sheets are likely to divert money from dividend increases and share repurchases to business fixed investment.
Black: The most recent rounds of quantitative easing have had little impact on economic growth, but a salutary effect on financial markets. Unless we do something to improve fiscal policy, the economy will stagnate. From 2000 through the end of 2013, real [inflation-adjusted] growth in GDP has been 1.8% a year. It has been the slowest period since the end of World War II. I don't see how you get to 3.3% GDP growth. Looking at the National Income Accounts for the latest quarter, housing and an inventory build-up drove the 4.1% increase in gross domestic product. Government spending was down sharply. It doesn't seem possible that real GDP could grow by much more than a high-2% rate in 2014.
Gabelli: So what? The point is, the U.S. economy is improving at an accelerating rate.
Zulauf: Retail sales are a big part of the U.S. economy. In estimating GDP, it is important to gauge the outlook for consumer inflation. To the surprise of many, the consumer price index has remained low in recent years.
There is a change occurring in the world economy. Since the early 1980s, the U.S. has been running ever-increasing deficits, which released tremendous stimulus in the rest of the world. Now those deficits are shrinking, in part because labor is becoming more competitive here.
There has also been a domestic energy boom. This means surplus economies are slowing. I have problems with the consensus view that the world economy is improving or normalizing. People conclude as much by studying statistics, such as the purchasing managers index. But they are sentiment statistics, driven by how the stock market performs, and the stock market has been driven primarily by the Fed's liquidity provision.
What do you see, then?
Zulauf: The world economy will disappoint. The U.S. will perform best. China is slowing dramatically, causing contraction in the emerging world. Europe has seen an improvement in bond yields, due to arbitrage opportunities, but has virtually no economic growth. The U.S. could be the exception in seeing 2.5% or 3% growth, largely because consumer prices will remain depressed. If I'm right, commodity prices will remain soft, and the U.S. dollar could be stronger.
Marc, do you agree with him?
Faber: First, nobody could have a more negative view of the Federal Reserve than I. It is run by a disastrous group of academics, who have no clue about what is happening in the real world. They believe money-printing can create jobs. They are going to bankrupt the world. Mr. Bernanke [current Fed Chairman Ben Bernanke] said the intention of QE3 [the third round of quantitative easing], which then turned into QE4, was to lower long-term bond yields. As it happened, yields on Treasury notes and bonds bottomed on July 25, 2012, and have been rising since.
The policy was a failure.
QE also was intended to lower the unemployment rate, which has fallen.
Faber: After World War II, Hong Kong was in a depression. But the economy developed rapidly thereafter under the leadership of John James Cowperthwaite, a British civil servant and financial secretary of Hong Kong from 1961 to 1971. Asked later what he did to achieve this economic miracle, he replied, "I didn't do anything. I just prevented others from taking bad measures."
Employment would have improved even more without the money-printing of the past few years. The Fed acted correctly to save the financial system during the financial crisis, which it created with its easy-money policies in the late 1990s and early 2000s. But Ms. Yellen could be sitting on a barrel of gunpowder, pouring gasoline on top of it, and lighting a cigarette, and she wouldn't know the danger of bubble creation.
Gabelli: She doesn't smoke.
Hickey: When the Fed's easy money created the technology bubble in the late 1990s and the housing bubble in the 2000s, the economy was growing by more than 6% a year. Now we have 2% GDP growth, and bubbles in housing, art, farmland, junk bonds, fancy cars.
Faber: And government regulation.
Hickey: U.S. household wealth grew by $30 trillion, to an estimated $80 trillion or more, between 2009 and 2013. What happens if some of that $30 trillion disappears as the stock market declines?
Faber: Who got the $30 trillion? Not ordinary people.
Gabelli: That's not true. Ordinary people have 401(k) retirement plans. This idea of only the 1% having equity exposure needs to be fleshed out.
Black: Because of the intransigence of our political parties, we don't have good fiscal policies. By default, we had to pull out all the stops on monetary policy to get the economy growing.
As a result, the Fed's balance sheet has grown to $4.1 trillion from $850 billion. Tapering is a euphemism, because balance-sheet assets will top $5 trillion by the end of the year.
Faber: Ten-year and 30-year yields eventually will be much higher. But I bought some 10-year Treasuries when the yield rose to 3%, because in the near term, yields could retreat to 2.5% or 2.2% or even 2%. The economic recovery is in its fifth year. On March 6, the bull market in stocks will be five years old. That's long, by historical standards.
Sometime this year, the stock market could see a big tumble, as in 1987. Then the long bond will rally and reward Bill Gross.
What will precipitate this crash?
Hickey: Money-printing has been driving this elephant. After a four-year rally, the Dow industrials added 27% last year.
The Standard & Poor's 500 rose 30%, and the Nasdaq composite, 38%. Amazon.com (ticker: AMZN) trades for 538 times earnings. Google's (GOOG) market capitalization grew by $90 billion in the last three months of 2013. That's not normal.
Witmer: It looks like there's more greed than fear in the market.
Hickey: When QE1 ended, the market fell by 13% in a matter of months, which caused the Fed to launch QE2. When it ended, the market fell by 17.5%. If Bill is right that the Fed will stop buying assets by year end, somewhere between now and then we are going to blow the stock market up. Valuations are much higher today than when QE1 or QE2 ended. The market is far less stable.
Gross: Stocks also have rallied because of corporate buybacks. Corporations, helped by money-printing and more cash flow, spent $500 billion, or 2% of the S&P 500's market's capitalization, buying back their own shares in 2013.
That's 50% of what the Fed spent last year.
Zulauf: And 75% of corporate-bond issuance.
Gross: When companies stop repurchasing shares, it's up to other investors to keep prices aloft.
Hickey: Many companies borrowed to buy back stock. With higher interest rates, it gets harder to fund buybacks.
Gabelli: The global capital markets had $85 trillion of debt at year end, and $62 trillion of equities. Margin debt [borrowed money used to purchase securities] is at an all-time high. Regulators ought to lift the margin requirement [the amount of collateral required in margin accounts] to let the air out of speculative bubbles without damaging the economy.
Gross: I'm right there with you.
Rogers: I want to clarify the fixed-income situation. Bill can lead us in a tutorial of [bond] duration math. If the yield on the 10-year Treasury goes up by 100 basis points, you lose 8% on your principal and 5% on a total-return basis, right?
Gross: I'd say 6%, but let's not quibble.
Rogers: Conversely, if rates fall by 100 basis points, your total return will be 11%.
Jennifer Altman for Barron's
You don't need a tutor. Mario, give us your take on the economy.
Gabelli: The consumer accounts for approximately 70% of the U.S. economy. Consumer net worth was $77.3 trillion at the end of September. Debt has remained constant for five years. Housing values have gone up. Jobs and psychology are improving. Auto sales are flattening, but remain OK. The Wal-Mart shopper isn't doing as well as the Whole Foods shopper, but overall, the consumer is regaining confidence and will spend. Elsewhere in the economy, nonresidential construction is booming. Confidence in the corporate sector was hurt by the government shutdown last fall.
Government debt, not the deficit, is the long-term issue. But, on balance, corporations are also regaining confidence. State and local revenues are up, as is spending. Because of the F word, which Felix alluded to, the dynamics of the economy are changing.
We hope you mean fracking.
Gabelli: Hydraulic fracturing, or fracking, of shale [oil and gas] is changing the dynamics of the export market, and leading to job creation. The private sector is spurring job growth, while there has been no growth in the federal sector.
Another important point: With interest rates up, the stock market rising, plus accounting changes, corporations will put less cash into pension plans. That means corporate cash flow will be much higher than profits in 2014. Corporations' appetite for growth is starting to rise. You'll start to see more corporations forgo share buybacks and dividend increases in favor of doing deals. Companies will look to change their culture or business mix, spending more on research and development, starting greenfield projects, launching takeovers.
Witmer: They will have higher stock prices to use as deal currency.
Gabelli: Around the world, the German economy is improving; Bank of Japan Governor Haruhiko Kuroda is following Bernanke and European Central Bank President Mario Draghi; President Xi Jinping is making positive changes in China.
Hickey: Japan is printing too much money, which will cause import prices to soar. The average Japanese citizen is seeing his cost of living rise.
Zulauf: Japan will run into a disappointment in the first half.
Gross: The key is growth in manufacturing jobs. We can all give each other back rubs or wash each other's hair. We need to make things to sell to others.
Gabelli: U.S. energy independence is a game changer with regard to global competition and job creation, if we ever get policy support.
Hickey: If domestic energy was the be-all and end-all, Russia would be an economic powerhouse, which it isn't. The U.S. has lost two million manufacturing jobs since the recession began. We have added back only 500,000. Onshore drilling has created only 80,000 jobs, if that.
Zulauf: The U.S. economy is doing well -- relative to others, that is. But median household income isn't growing much. You're not getting the reacceleration you'd normally see at this point in the cycle. That's the point at which interest rates took off.
Faber: China has grown extremely competitive in the quality of its earth-moving and construction machines. What they produce is better than what Deere [DE] and Caterpillar [CAT] produce. The problem in America is that you have a lot of Facebook geniuses who sit around all day looking at their own pictures. They don't have competitive jobs. I met a diver in Shanghai the other day who repairs platforms and pipelines. He makes $180,000 a year and works half-time. The point is, there are lots of jobs that would pay well, but not many Americans are qualified to do them.
Gabelli: We have to retrain people to make sure no adult is left behind. BMW [BMW.Germany] is adding capacity at its South Carolina plant. It needs to train employees, and is doing so. It is a free market. You train employees for your own self-interest.
Faber: Yes, but how much capacity has BMW added in China in the past few years? Who cares, globally, about the U.S.? Whether it grows 2% or 3% or contracts is irrelevant for most people in the world.
Cohen: I disagree. The U.S. economy is the world's largest by far. The Chinese economy is 40% the size of the U.S. China is facing challenges. It was clear at the Third Plenum [a gathering in November of Communist Party leaders] that China's new leadership believes the economic model of the past two decades needs to change. The model was based on low-cost labor and exports and significant government investment in infrastructure. It will be replaced by something less liquidity-driven and tied not just to external but internal demand. That raises questions about future growth. Goldman believes China's economy will grow by 7.7% this year, a bit above consensus.
Returning to the U.S., share repurchases and dividends took 40% of cash on balance sheets, 10 percentage points higher than before the financial crisis. Where did the money come from? Long-term investment. The government also has cut its support for basic research in science and engineering. It was 4.5% of GDP as recently as the 1970s. Now, it is down to 2.5%. This has a negative impact on productivity, competitiveness, and economic growth. Nor have we held our leadership in education. The U.S. used to be No. 1 in the percentage of young people with a college degree. Now it is No. 12. The unemployment rate for people in the U.S. with a bachelor's degree or higher currently is 3.3%. We have to do a better job of creating educational opportunities for people in the middle-income category. In addition, many of today's manufacturing jobs require some college training. If state and local governments can't do it, as Mario notes, companies will step in.
One more thing: The Fed isn't perfect, but inadequate attention has been paid here to the many challenges it faced amid a horrendous economic situation, not just in the U.S., but around the world.
Zulauf: Which it created.
Cohen: Excuse me, I'm speaking. We have to look long and hard at U.S. history to find a similar situation in which the government made a deep recession even worse by creating fiscal drag.
Additional pressure was put on the Fed because other central banks and governments didn't step up to protect themselves. Early in the global financial crisis, the European Central Bank was more concerned about protecting the value of the euro than about economic growth in Europe. The Fed also has done a much better job, along with other U.S. banking regulators, of getting the U.S. financial system back on track. The balance sheets of U.S. banks are stronger than their counterparts in Europe and elsewhere. We are years ahead of other nations. The Fed deserves a lot of credit.
Hickey: Why? They haven't gotten a single forecast right. They said there would be no subprime-mortgage problem. They said there wouldn't be a housing bubble. They created the tech bubble. All of our problems were created by the Fed, including today's gigantic valuations on many speculative stocks. The crash that will occur will be the result of the Fed.
Cohen: You know a great deal about technology. I want to return to your comment that the Fed created the tech bubble.
Hickey: It did.
Cohen: Other factors contributed, including great investor enthusiasm for many things related to the Internet that didn't come to pass in 2000, but happened later. You are also overlooking government policy. The government gave a huge tax deduction to companies that invested in computer systems ahead of Y2K [the year 2000].
Hickey: The Fed was worried about a Y2K problem that didn't exist. [There were concerns that critical computer operations would fail with the calendar's rollover from 1999 to 2000.]
Cohen: Was it only the Fed?
Hickey: No, but by pumping $50 billion into the financial system, the Fed put a massive cherry on top of the stock market rally.
Can we please get back to 2014?
Rogers: Institutions sometimes do well and sometimes don't. Sometimes, in the back of the ambulance, you just have to stop the bleeding, and the Fed did that amid the financial crisis. Reasonable people would disagree about the Fed's behavior in terms of the housing bubble.
Zulauf: But, Brian, it's like a fireman who stops the fire he lighted.
Rogers: Sometimes, Felix, you have to stop the damned fire.
Black: One reason we're in this mess is that we had two unfunded wars. It's the first time the U.S. ever went to war and didn't raise taxes. When President Bush came into office in 2001, we had surpluses as far as the eye could see. He dissipated them, and debt rose quickly in relation to GDP.
Hickey: Behind every bubble, historically and forever, is easy money.
Zulauf: That's the problem with a fiat currency system. But that's the system we have, and we can't and won't change it. Over time, things will get worse, not better, for the average citizen. That's the history of fiat currencies.
Gross: I'm with Felix on that. Central banks are at the center of a fiat-based system. It is credit-based; credit is expanded, and hopefully will be used for productive purposes. In the past 10 or 20 years, it has been used for speculative ends, driving financial prices, instead of investment in the real economy. Now we're paying the price.
Zulauf: [Former Fed Chairman] Paul Volcker handed Alan Greenspan a clean situation. Greenspan blew it, Bernanke blew it again, and Yellen probably will do the same.
Enough! Meryl, what is your economic forecast for this year?
Witmer: The U.S. economy could grow by 3%, maybe a little more. Companies are doing well. Fracking is a help. Manufacturing companies are onshoring [bringing production back to the U.S. from other countries]. Stocks, however, don't look inexpensive.
There's a big debate in the market about profit margins. If they are unsustainably high, stocks could soon look more expensive. Will margins come down, or have they shifted to a higher level indefinitely?
Zulauf: About half the earnings of S&P 500 companies come from overseas. If the dollar goes up 10% against other currencies, profit margins will come down.
Black: Operating margins at S&P 500 companies were 9.69% in the latest quarter. For the full year, they were 9.63%, against 8.92% a year earlier. There could be room for some margin expansion this year, maybe by 20 to 30 basis points.
Cohen: In a normal cycle, margins come under pressure as inflation, labor, energy, and other costs rise. The way we've been talking, those don't seem to be big issues for 2014.
Gross: But this is a huge long-term issue. The profit pie can be split among corporations, labor, and the government. In the past 40 years, labor's share has declined. Ultimately, although perhaps not in 2014, there will be some reorientation.
Zulauf: The same is true for other industrial nations.
Rogers: Do you want to bet on continued margin improvement? I never want to bet on something when it is at a record level.
If margins fall, is there an offset that will prevent stocks from suddenly being exposed as overpriced?
Rogers: That exposure will occur, whether margins fall due to currency moves or decelerating economic growth.
Gross: Perhaps 20% to 30% of margin improvement in recent years was due to the benefit of lower interest rates. If you assume that interest rates bottomed in 2012, margins will be under continued pressure from current yields in the future.
Gabelli: The U.S. has among the highest corporate tax rates in the world, at 35%. Taxes could come down, enhancing profitability. Companies also could leverage up, getting a higher return on equity. There are lots of variables.
Are stocks overpriced now?
Black: Analysts' consensus estimate for 2014 S&P 500 earnings is $121.48, up 13.3%, year over year. That is ridiculous. My estimate is $116. At [its recent] close of 1842.37, the S&P was trading for 15.9 times expected earnings. Based on history, it is about fairly valued. The median in the postwar period is 16 times.
Small-cap stocks, as defined by the Russell 2000, are trading at 21.9 times this year's expected earnings. Mid-caps are trading at 21.1 times. As Mario would say, you can always find cheaply priced stocks. But large-caps are much less expensive today than small- and mid-caps.
I expect interest rates to stay low as Yellen will be accommodative. It isn't impossible that the S&P 500 could deliver a total return of 10% to 15%, with dividends reinvested. The market could be derailed if the Democrats and Republicans can't agree to raise the debt ceiling, or Israel unilaterally attacks Iran, or the Fed abruptly abandons quantitative easing. But, historically, stocks have done pretty well in years following an annual rally of 20% or more.
Oscar said here last year that he was extremely optimistic about stocks for 2013. Nice call. How do you feel this year?
Schafer: Economists and stock-market strategists suffer from an academic inferiority complex. I call it physics envy. That's when people try to be scientific and precise about forecasting things that can't be measured. So, although Scott has all the numbers, I'm much more bullish because labor costs are lagging.
Industrial production is going to be better than people think, and the stock market is going to do all right. No one here thought stocks would be up so much last year. Someone said they'd be up 5%. Stocks are more expensive now, but there are pockets of opportunity. We aren't in bubble territory because there is too much worry out there -- about the deficit, the Middle East, whatever. Once again, you rarely go to a dinner party where people talk about stocks.
Speak for yourself.
Hickey: Stocks can go up as long as money-printing continues. Volatility will return to the markets this year. It could be sparked by a geopolitical event, or an issue in emerging markets, where the technology industry is seeing lots of problems, or the end of the taper, at which point there will be a big decline.
Afterward, you'll see QE5, and the market will rally again. Normally, I would short stocks, given the valuations in the tech world, as I did in 2000 and 2007. I can't, because nominally, prices will go higher. There will be a big decline during the year, but the market could end the year about where it is now.
Rogers: I expect buyback activity to continue this year, which is good news for stocks. The problem is that CEOs historically have had a bad record of timing purchases; they buy when their shares are high. We saw investors tiptoe back into equity funds last year for the first time since 2006.
Speaking of cocktail parties, every place I go, people ask me about the next IPO [initial public offering]. There are pockets of irrational exuberance, including some IPOs, but in general, stocks could keep rising. Barring an expansion in price/earnings multiples, which I have trouble seeing, add a 2% yield and 5% earnings growth, and you get a 7% total return. Compared with other asset classes, that sounds OK.
Gross: Peaks are made not just by cocktail-party attendees, but also by institutional investors who get carried away with enthusiasm. With reference to stocks, the era of getting rich quickly is over. The era of getting rich slowly might be over, too.
What other eras are there?
Gross: That's the point. Equity returns could be 5%, plus or minus, and bond returns 3%, plus or minus. That is insignificant in terms of saving for college or retirement. It's not enough to pay the bills.
Cohen: Like Scott, we're expecting S&P earnings of $116 in 2014. If there is no P/E multiple expansion, that gets you to a level of 1900 on the S&P 500. If core inflation stays under control this year -- it could rise by less than 2% -- history suggests that stocks could trade for 18 to 20 times earnings. Assuming an 18 P/E, and running a simplistic scenario analysis, you get a target price of 2088. We are seeing enormous dispersion in relative valuation, not just between, but within, sectors.
Also, correlation [the degree to which stocks move with each other] has moved dramatically lower. A couple of years ago, the correlation within the S&P 500 was 0.65, which meant you had to decide to be in or out of the market. Now it is 0.27. This year, if people are moderately constructive on the market but spend most of their time on security selection, they will be better served. Equities will perform better than fixed income, but there will be variations here, too. I am not enthusiastic about government bonds. There may be better opportunities in corporate credits.
Commodity prices are a big question. In the U.S., natural-gas prices are under control, as are energy prices generally. But the global picture is challenging.
Commodity prices rose for many years, in part because of enormous growth in places like China and India. Growth there has slowed, leading to weakening demand for industrial metals. Performance in 2014 depends on the commodity.
To what extent has the drop in commodity prices resulted in the waning popularity of commodities as an asset class?
Cohen: Global enthusiasm in recent years led to demand for commodities by pension funds and active money managers. Now there is an unwinding, with the slowdown in emerging markets. We look at supply/demand balances. On a 12-month basis, we're not that enthusiastic about commodities as an asset class.
How do you feel about emerging markets? Their valuations are much lower than they were a year ago.
Cohen: There are also wide variations. We like some, such as Mexico, more than others. If the U.S. grows, our North American trade partners will benefit. Mexico saw weak economic growth in 2013. The currency depreciated and there were concerns about stock-market valuation. This year there is a reform story to be told.
Growth could re-accelerate toward the end of the year. An energy-reform story could take a few years to play out, but is just one indication that the new government is looking to take advantage of its energy assets in an appropriate way. [Among other changes, the Mexican government will now allow private investment in the country's energy sector.]
Zulauf: Just a minute. Mexico is a great story, but it has received the biggest foreign-capital inflows by far. Everybody and his brother is invested there, particularly U.S. managers. I don't question the long-term story, but if something unexpected happens in the world that prompts foreign capital to flow back home, the Mexican market will get hit badly. As capital flees, the currency could fall 10%, and the bond market could suffer. And I expect some bad surprises this year.
Cohen: Much of the U.S. capital that went into Mexico came in the form of foreign direct investment -- that is, companies building operations in Mexico.
Gross: The Tequila Crisis in the mid-1990s almost took Mexico down because the country had so much dollar-denominated debt. Now, 90% of the debt is peso-denominated, which, in addition to the reforms Abby mentioned, puts the country on sounder footing. It doesn't mean the currency couldn't come under pressure and precipitate a problem, but Mexico is a different country than it was 10 years ago.
Cohen: When the market sensed that the Fed would taper, all emerging markets fell. This year, we will see more selective investing, based on individual markets' fundamentals, not their inclusion in the benchmark index. East Asia and North Asia are looking better, too. Manufacturing is picking up and exports are improving.
Felix, where do you see markets going this year, in the U.S. and the world?
Zulauf: The U.S. stock market is highly valued on a historic basis, but valuation alone doesn't lead to a bear market. Bullish sentiment is also excessive, but it isn't a timing tool.
Professional money managers are well- exposed to equities. After several years of a bull market, your career or business risk is so high that, if you aren't in the market, you're in trouble.
Momentum is OK. The taper is akin to raising interest rates from a deeply negative level to a less deeply negative level. We don't know when the market will tip over, but the world has become more fragile. There is more sabre-rattling in Asia between China and Japan. The Chinese economy is slowing more than the world recognizes.
You can't believe China's official statistics; they're on automatic pilot. China will grow 3% or 4% this year.
Interest rates have popped up in China, not because of central-bank tightening but funding stresses. There is a credit bubble. If something goes wrong in China, it could set off a panic in other stock markets. The Russian and Asian crises in the late 1990s touched off a 25% drop in the U.S. in a matter of weeks. The market is building a top in the first quarter. In the following months, there will be a window for such a panic.
Can't the People's Bank of China engineer a way out?
Zulauf: If it supplies more liquidity to the market, the currency goes down. China also has a social problem. China's version of social security is that once a son marries, he receives a home or apartment from his parents, with the understanding that the newlyweds will take care of the parents when they get old. Now that real-estate prices have risen, fewer people can buy apartments. China can't let its money supply explode. The Chinese government is the smartest by far, and knows the country must go through a painful adjustment process. They like to do it in a controlled way.
Well, good luck with that.
Zulauf: If we have a market panic and the S&P goes to 1600, the taper will be over. All the central banks will provide liquidity. Some will buy stocks for the first time. They are afraid of systemic risk.
Gross: The global economy remains highly levered, with no margin of safety. Many policy options have been exhausted. Leverage permits the possibility that the flutter of a butterfly's wing could set off a global crisis.
Zulauf: You saw the butterfly effect when the Fed mentioned tapering. Emerging markets quickly became victims. Today's slogan is: There is no alternative to equities. Gold hasn't functioned for the past two years as an investment alternative.
Marc, are you warming your thoughts in that hat?
Gabelli: He's getting his bullish thoughts together.
Faber: I lean toward Felix's view of 4% growth in China. To clarify a point about the size of the U.S. economy and its importance in the world, China imported 12% of global metals consumed in 2000.
Now it imports up to 47% a year. China's growth has a major impact on emerging economies. The U.S. has no impact because it is a service economy. China has gone from sending less than a million travelers overseas in the mid-1980s to 100 million now. You hardly see American tourists in Asia any more.
Are you going to forecast the market or pick on America?
Faber: All asset prices are in the sky, whether it is Picassos or Warhols or the flat that Steve Cohen is trying to sell. [Cohen, founder of SAC Capital Advisors, has a Manhattan duplex on the market for $98 million.] We are in a bubble. We are the bubble. It is only a question of which asset is in a lesser bubble. The U.S. is expensive, compared to the European market and especially emerging economies.
Based on the level of today's secular adjusted P/E, returns in the next seven to 10 years will be minor, if not meaningless. The Mexican stock market went up 343 times between 1984 and '87 because of money-printing. Then the currency collapsed. The dollar can't collapse, so gold will come to the forefront. Or Bitcoins.
Gabelli: Let's discuss Bitcoins on the Brooklyn Bridge. I want to sell you both.
Faber: It is possible that a well-run bond fund will do better this year than the stock market. The market hasn't had a correction of more than 11% since October 2011.
Enthusiasm about the U.S. market reminds me of the talk I heard nine months ago in Indonesia and Thailand. Subsequently, those markets fell 35%. While it is too late to buy the U.S., it is too early to buy the emerging markets. They aren't incredibly cheap, except for Vietnam and Iraq, and capital could still flow out. I agree with Abby on Mexico, although I would rather buy property than the stock market.
Speaking of Iraq, to what degree have investors factored in potential geopolitical crises?
Faber: Geopolitical tensions are rising. You can't hold the Fed responsible for that, although without money-printing, the price of energy would be lower. I was in Ethiopia and Egypt at this time last year. The Asians have a future; they can advance, and tighten their belts. But a country like Egypt is much worse off today. The Nile Valley can't feed the people. Many countries in the Middle East could go up in flames.
Zulauf: The U.S.'s step-by-step withdrawal from the region is increasing the risks and dangers.
Gross: History will record that during periods of slow or negative economic growth, geopolitical problems always grow more intense.
Faber: Pretend you are the leader of China's army. The Americans are enlarging their bases in Australia, trying to stir up trouble in the Philippines and Vietnam, and lifting an embargo against Burma. America also has a defense pact with Japan. The Chinese depend on oil, copper, and iron, all imported commodities.
What would you do to protect your border? The tensions in Asia are real and rising, and could cause a market panic, just like the financial crisis Felix discussed.
The Chinese have decided to shrink their government's share of the economy and make markets freer. Everywhere in the industrialized world, you find the opposite.
China has a dark side, too. In the U.S., someone can be highly critical of the government and stay alive. If you write something negative about the leadership in China, you can be put in jail for a long time. There is only one Nobel Peace Prize winner behind bars -- Liu Xiaobo, in China.
Thank you for reminding us. Let's move on to this year's investment picks. Oscar, you can start us off.
Schafer: Since the U.S. equity market is one of the most expensive in the world, I have three companies overseas, and three in the U.S. I recommended several rental companies in the past, including Hertz Global Holdings [HTZ] and United Rentals [URI]. While these businesses are cyclical and capital-intensive, their balance sheets are often more resilient than investors believe. When the economy slows, they can generate a lot of cash by deferring purchases and de-fleeting. Buying rental companies when they are shrinking can be rewarding. It is a good time to replicate this investment across the pond.
Northgate [NTG.U.K.], based in England, has a market capitalization of £740 million [$1.2 billion] and is a dominant provider of light commercial van rentals in the U.K., Ireland, and Spain. With a fleet of 53,000 vehicles, it is three times as large as its nearest U.K. competitor. Its shares trade for about four times 2014 estimated Ebitda [earnings before interest, taxes, depreciation, and amortization; the fiscal year ends in April.] The company pays a 2% dividend and has a conservative balance sheet.
What type of customer does it serve?
Schafer: Northgate operates a network of retail depots renting vans to a range of corporate customers. The average rental time is three to four months. The company serves the needs of seasonal businesses including landscapers and florists, as well as governments and corporations undertaking special projects. It went into the financial crisis with nearly 60% of its revenue from Spain, mostly exposed to the construction industry. Fleet utilization in Spain dropped to 83%, and Northgate breached its gross debt covenant. A new management took over, restructuring the debt and raising equity, causing substantial dilution. The company's two largest competitors went under, liquidating their fleets.
In the past five years Northgate has focused on returns on invested capital. It shrank its fleet considerably to maintain a 90% utilization rate. It also cut fixed costs and finally integrated a few decades of acquisitions, going from 20-plus brands run by local dealers to a single brand operated with standard processes and strict quality controls. The balance sheet was de-risked and a refinancing cut the company's interest rate in half. Now, management is focusing on growth.
The company is expanding into southern U.K. It has six new locations, with 20 more on the way. Even in a flat economy, new locations could add £50 million of incremental Ebitda. Operating efficiencies and an improving macro environment could boost Ebitda to more than £350 million by 2016. We value the shares at £9, versus £5.63 now.
Gabelli: Are you buying this because you think it will be a takeover target?
Schafer: No. We are buying it for the operational turnaround. But, given its dominant market share, a company wanting to get into the business ought to buy it. We are paying only 1.5 times tangible book value and the business has a free-cash-flow yield of 10% on a steady-state basis.
At the midyear Roundtable ["Shifting Winds," June 17, 2013], I mentioned Interxion Holding [INXN], a European data-center operator. The stock declined, and I like it even more at today's $24.63. Information technology continues to transform the way we work, communicate, and play. I have no idea which hot start-up will be the next big thing, but all this innovation is driving demand for the cloud, streaming video, mobile chat, and more bandwidth and computing power. The best way to play these trends is to bet on the data centers. Their stocks declined in the second half of 2013, as investors worried about oversupply and competition from companies such as Amazon.com [AMZN]. They need to differentiate between commodity wholesalers and unique operators, and identify companies that can compete on more than price.
Such as Interxion?
Schafer: That's one. It is a cloud-neutral, pan-European data-center operator based in Amsterdam. It owns excellent real estate that will allow it to collect growing rents over time.
The company recently announced a €100 million [$136 million] expansion in Amsterdam. Yet, despite superior organic growth, Interxion trades at a discount to its closest peers, Telecity [TCY.U.K.] in the U.K., and Equinix [EQIX] in the U.S. There is an overhang, in the form of a large private-equity holder that could sell shares. By my math, Interxion trades for 10 to 11 times core recurring free cash flow. The stock has 50% to 75% upside. It could compound in value for a long time if it remains independent.
Mario mentioned my other data-center pick, Internap Network Services [INAP], at a previous Roundtable. It has a $400 million market cap and is based in Atlanta. Its legacy bandwidth-resale business generates a lot of cash but is in decline, masking the company's overall growth rate.
If you look under the covers, there is a hidden but growing data-center business that caters to midsize customers and offers a broad suite of services. Since 2010, this business has grown by 13% a year, compounded annually, while segment operating margins have expanded by 13 percentage points.
There is still room for margins to expand, as new company-owned data centers are less than 60% utilized. The data-center business now represents more than 50% of revenue. It could make Internap the target of a large telecom or information-technology services company. Internap trades at less than seven times my estimate of 2015 Ebitda. Historically, such transactions have occurred at 10 times Ebitda.
Gabelli: Eric Cooney, the CEO, is terrific.
Schafer: Do you still own the stock?
Gabelli: We are the largest shareholder.
Hickey: There have been many acquisitions of such companies.
That could continue. My only concern is that tons of money poured into Internet-hosting capacity expansion in the dot-com bubble years. Companies thought they had carved out niches, but when the bubble burst, prices fell across the board. Now there is even more investment. If the economy weakens sharply, what happens to excess capacity and pricing?
We'll find out.
Schafer: My third European pick is Orkla [ORK.Norway], a Norwegian consumer-packaged-goods company in the middle of a multiyear selloff of noncore assets and operating-margin improvements. When the restructuring is complete, the new Orkla will be the dominant consumer-brand company in the Nordic region, making everything from frozen pizza to laundry detergent to toothpaste. It will be a regional peer to global companies, such as Procter & Gamble [PG] and Nestle [NESN.Switzerland]. The shares sell for 46 kroner [$7.43] and yield 5.5%.
The driving force behind the transformation is Chairman Stein Erik Hagen, a Norwegian billionaire who owns 20% of the company. Hagen made his fortune building and selling the region's largest discount grocery store, which was Orkla's largest customer. Since beginning the transformation in 2011, Orkla has sold off or listed a number of business lines. Most recently, it announced a joint venture with Norsk Hydro [NHY.Norway] for its global downstream aluminum business. The venture will yield significant synergies and could issue shares in a few years. Orkla also has purchased two consumer-products competitors in the region in the past two years.
How has the stock done?
Schafer: It has performed poorly. The transformation has been slower than expected and the core branded business is deteriorating, having lost share to private-label and international competitors.
Earlier this month, the company announced that the CEO will step down. This is a compelling time to invest. Orkla will continue selling assets, and there is a tremendous opportunity to improve margins in the core business. The company's brands dominate the Nordic market with a No. 1 or No. 2 share in almost every food and personal-care category. Excluding amortization, Orkla earns an 11.4% operating profit margin, while most global peers are 200 to 700 basis points higher. Consolidated margins eventually could reach the mid- to high teens. A global consumer-products company might be in the best position to extract these margins from Orkla. We wouldn't be surprised if the company was acquired in the next 12 to 24 months at a substantial premium. Absent a deal, the shares are worth at least 70 kroner three years from now. We are happy to collect the dividend while we wait.
We recently bought a large stake in BioScrip [BIOS]. In the past few years CEO Rick Smith has radically transformed the company from its retail and mail-order-pharmacy roots into one of only three national providers of home-infusion-therapy services.
BioScrip stumbled last year in integrating four major acquisitions, creating an opportunity for us. Demand for infusion therapy is growing at a mid-teens rate as a result of aging demographics and a robust pipeline of specialty drugs that need to be delivered intravenously. Infusion therapy traditionally was administered in a hospital, but has shifted to an outpatient setting in the past two decades. Home therapy is more comfortable for the patients and much more cost-effective than hospital and in-patient settings.
Who delivers the therapy?
Schafer: BioScrip operates a network of state-licensed infusion pharmacies and employs nurses to visit patients, administer treatment, and coordinate care.
This is a highly fragmented market, and 70% of infusion pharmacies are independent. The large managed-care companies are pushing the industry to consolidate, to ensure consistency of care. The other national consolidators are Option Care, which Walgreen [WAG] acquired in 2007, and Coram, which was purchased by CVS [CVS] in November. Government reimbursement isn't a big risk for BioScrip.
Medicare doesn't cover home infusion, which forces patients to get treatment in the high-cost hospital setting. Eventually, the government will fix this issue.
The stock fell more than 60% last fall, and now trades at $7.52. Management revised its annual guidance three times last year. It now is focused on finishing the integration, cutting corporate expenses, and improving gross profit margins in the infusion business. Current margins dramatically understate the earnings power of the franchise.
BioScrip could generate $120 million of Ebitda and 85 cents of free cash flow in 2015. We value the shares at $13. CVS paid 16 times Ebitda for Coram. We wouldn't be surprised if Walgreen, CVS, or another strategic acquirer pays north of 15 times to buy BioScrip.
What else have you got?
Schafer: One important advantage to being in the stock-picking business for more than 50 years is that you have a context for evaluating companies within an industry. I never had big positions in the large pharmaceutical companies because there was very little in their drug pipelines that could move the needle. That wasn't true in the 1980s and '90s for generic drug companies, especially when they had six months' exclusivity. We did well in generics. Then two things happened. Big pharma stopped looking down its nose at generics and brought out its own 'branded' generics, doubling the players and reducing profitability. Also, the number of blockbuster drugs coming off patent dwindled. Recently, generics companies have merged, creating giants that have jettisoned their smaller drugs. This brings me to ANI Pharmaceuticals [ANIP].
What's to like about ANI?
Schafer: The market cap is only $200 million. ANI came public in June via a reverse merger with Biosante Pharmaceuticals. It makes an estrogen product to treat menopausal symptoms. Until mid-2013, there were two players in this market, but the competition was forced to withdraw, leaving ANI alone and allowing it to increase prices. As a result, first-quarter sales could double from 2013's $5.6 million. To reduce dependence on its key product, the company acquired 31 generic products from Teva Pharmaceutical Industries [TEVA] for $12.5 million and a percentage of gross profit. Current sales of these generics and the branded versions are about $500 million.
ANI's earnings per share could be well north of $1 this year, rising over time to $2. The key is to grow the portfolio from seven drugs to more than 30, and buy additional drugs. The stock is $22.79.
Thanks, Oscar. Felix, you're next.
Zulauf: I have great respect for China's achievements, but its credit and investment boom, which started 10 years ago, is overdone. Many have predicted its demise through the years, but they were early. Now it is more obvious that it's in a terminal stage. China became the world's second-largest economy in a short time. It went into overdrive after the 2008 financial crisis. In-the past five years, total credit outstanding more than doubled, growing by $14 trillion, to $24 trillion. That growth is equivalent to the size of the U.S. commercial-banking sector. The balance sheet of China's central bank has expanded more than any other since 2000. This is the biggest monetary expansion and credit boom in modern history.
The classic signs of an end are now visible. They include an acceleration and expansion of credit not matched by GDP growth; the aggressive expansion of a shadow-banking system, in China's case, via wealth-management products; massive investments in property, and weak risk management at financial institutions. Sixty peer-to-peer lenders went bust in recent weeks. Finally, at the end of a credit boom, you see a heavily state-directed financial and corporate sector. In the U.S., Fannie Mae and Freddie Mac had government oversight. In China, the banks are partially or totally government-owned. In December, the seven-day repo [repurchase agreement] rate shot up to 9% from 4%. A credit boom needs more capital to keep growing, but it isn't available any longer. That's why borrowers are bidding up rates in the money market.
Where are you going with this?
Zulauf: The Hong Kong banking system is heavily exposed to mainland China. When things finally go belly-up, there could be a banking crisis in Hong Kong. Its dollar is pegged to the U.S. dollar, and the Hong Kong monetary authorities will defend it.
Interest rates will shoot up. The Hong Kong economy is rate-sensitive because it is based on finance, real estate, and construction. I recommend shorting the Hong Kong stock market, which you can do by selling short the iShares MSCI Hong Kong exchange-traded fund, or EWH.
Gabelli: Why not short gambling companies like Las Vegas Sands [LVS]? Macau [a Chinese gambling mecca] will be challenged.
Zulauf: I stick to exchange-traded funds. The EWH trades for $20.44. It peaked at $24 in 2007 and fell to $13 in 2009. If I'm right about China, emerging markets will fall further. Commodity prices will weaken. Resource economies, such as Canada, Brazil, and Australia, will suffer. U.S. CPI will remain low. Bond yields of quality borrowers will decline, contrary to the consensus.
Felix Zulauf's Picks
|i Shares20+Yr TreasuryBond/TLT||$104.41|
|Market Vectors Gold Miners/GDX||$22.01|
|Buy U.S. Dollar/Sell Turkish Lira*||$1=2.19TRY|
|*Feb. 2014 contract|
Zulauf: That's true. Equity markets aren't homogenous. The strong markets are overbought and could decline. The weak markets haven't finished falling. The whole situation reminds me of the late 1990s, when the Asia, Russia, and Long-Term Capital Management crises hit. [LTCM's master hedge fund collapsed.] The important lesson is, there was no recession outside of Asia at the time, but investors panicked around the world.
With the 10-year Treasury bond yielding about 3%, I want to buy Treasuries. I'm not constructive on the bond market after 30 years of declining yields, but the 10-year yield rallied to 3% from 1.4%, and could easily fall by 75 to 100 basis points. I'd buy the TLT [the iShares 20+ Year Treasury Bond ETF] at $104.41. The U.S. dollar will strengthen against most other currencies, and it is a good time to buy gold, which is completely washed out. It is the most-hated asset class. If a panic hits, gold will rally.
Black: In the absence of inflation, why should gold go up?
Zulauf: Gold can protect you against many things. Inflation is just one. There will be a panic that brings back systemic fears. Those who wanted to sell gold have sold it. China last year bought the world's total production of physical gold. Western investors, asset-allocators, exchange-traded fund players have all sold their gold.
Hickey: The GLD [ SPDR Gold Trust ] saw four years of inflows depart in one year.
Zulauf: It was a dramatic liquidation. Physical gold moved from Western to Eastern hands. I haven't recommended gold stocks for seven or eight years. Now is the time to buy the GDX -- the Market Vectors Gold Miners ETF. I got my feet wet at the mid-year Roundtable, recommending a cheap option strategy to buy gold stocks [see mid-year scorecard at barrons.com].
In general, risk positions will get reduced by the market. Everybody is short the yen and long Japan's Nikkei index. The yen could suddenly jump and wipe out the shorts. The dollar will strengthen this year, so buy yen against another currency. It's best to sell Swiss francs and buy yen, which were at CHF115.42 [$126.55] Friday [Jan. 10]. This trade could work for six to nine months. I'll have to review it at midyear.
My last recommendation involves a bearish bet on Turkey. In June, I recommended shorting the Turkish lira against the dollar and euro. A dollar bought TRY1.88 then and TRY2.19 now. Among developing markets, Turkey was one of the main beneficiaries of foreign capital, No. 2 after Mexico.
Since 2010, Turkey has received $85 billion of capital. There was a big economic boom. The iPhone cost more than $1,000 in Istanbul. Turkey is the seventh-largest economy in Europe. It had hyper-inflation in the 1990s, and reformed its currency in 2005, which encouraged capital inflows. In the past five years, credit grew 2.5 times faster than GDP. Credit growth peaked in 2011 at 50% of GDP. It's now down to 20%. Consumer inflation is 7.4%.
Turkey also has big political problems.
Zulauf: The corporate sector has $125 billion of short-term debt and $32 billion of medium-term debt. At the same time, the central bank's foreign-exchange reserves have fallen below $40 billion. This covers less than two months of imports. Turkey is short U.S. dollars. This makes for an explosive situation.
As if this weren't bad enough, Prime Minister Recep Tayyip Erdogan introduced more Islamic rules in recent years, and the mostly secularized people, particularly in Istanbul, became unhappy. There were street protests, especially over his plan to close a park in the middle of the city. Erdogan reacted in the worst way possible; he started to fight the people in the street.
Then the country's president began criticizing him, which split the ruling party. Erdogan's support is beginning to crumble. The president wants to be prime minister, and Erdogan can't run again. So he did what Russian President Vladimir Putin would do: He gave the presidency more power because he wants to run for president and stay in the game. The presidential election is in August.
Erdogan reduced the military's power and influence. He put 300 officers in jail. Recently, there was a corruption scandal. It's a mess. Most important, Erdogan told the central bank that it can't raise interest rates, which would spark a recession. Thus, the system gets adjusted through the currency.
What do you expect to happen?
Zulauf: The dollar/lira trade could go much higher [the number of lira to the dollar could soar]. You can buy dollars and sell the lira using the one-month forward contract.
Another way to sell the currency short without paying the forward costs is to sell short the dollar-denominated iShares MSCI Turkey [TUR]. It's trading for $47.23. It has come down a lot, but the low was $18 in 2008. By selling it short, you sell the currency at the spot rate but also sell the stocks. At some point, the stocks will benefit from a lower currency, but that is a long way off. In the near term, the currency could go to TRY3, and the ETF could fall substantially.
Thank you, Felix.
Copyright 2013 Dow Jones & Company, Inc. All Rights Reserved