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What will drive the markets in 2015?
In this Outlook Masterclass, two experts with over 75 years of combined investment experience talk what forces will impact markets the most in 2015
Hersh Cohen - Co-Chief Investment Officer, Managing Director, Portfolio Manager at ClearBridge Investments
James F. Keegan - Chief Investment Officer and Chairman at Seix Investment Advisors
Duration:
00:51:36
Transcript:
Courtney: Gentlemen, welcome. Hersh, given that The Fed has begun a transition from easing to tightening credit, Japan is ramping up stimulus and Europe is maintaining an accommodative stance. How do you assess the current macro situation?
Hersh: [00:00:14] I assess it in the same way that I’ve assessed it for a number of years which is incredibly slow recovery. We had an asset collapse in 2008 around the world. And I think it wasn’t your garden variety recession where the Fed tightens money, housing slows, the Fed comes in and eases and you start a recovery. This was a collapse of credit, of banks, of stock prices, of debt and so we’re not surprised that it’s been sluggish. I think the Fed moves were designed to save us from a depression. And I think they were and maybe still are more concerned about deflation than inflation as they should be. And I think that the European governments are not doing what they need to do to stimulate the economy. And Japan has been slow on it. So China, I don’t know, what’s happening in China in terms of, you know, how fast they’re growing or slowing. So I think things are slow and so I guess and will remain sluggish.
Courtney: [00:01:19] Jim, the dollar is rising, we’re poised to see the Fed take liftoff in summer of next year, how do you assess the current macro situation?
Jim: [00:01:28] Well, we’re actually in the camp that the Fed’s going to be later with respect to the tightening cycle. If you think about where we are today it seems that the Fed is data dependent. But the data that’s dependent on the stock market. So if you think about the Fed having tried to exit quantitative easing now three times, you have to look at what’s brought them back in. And what’s brought them back in every time has been the stock market. So I would venture to say that the Fed’s inflation target is probably important. But what’s probably more important and they won’t talk about it is the stock market. And the reason why we think that’s critical is because if you look back to the October 15th/16th time horizon, the stock market had gone down 7.4% from the September 18th all-time high. And we haven’t had a 10% correction in the stock market since 2011, so most … defer to Hersh, but most equity strategists would tell you that, you know, having a correction is actually good after you’ve run the way we’ve run. And the Fed…
Hersh: [00:02:34] Until you’re actually in one.
Jim: [00:02:36] Until you’re actually in one. And the Fed panicked, and Jim Bullard who we consider to be the Anthony Kennedy of the Fed if you will, he’s the weathervane. He was an early proponent of QE. He’s been on the more dovish side and about a month before his October 16th comments he actually was of the view publicly stating that the Fed should conduct its first rate hike in the first quarter of 2015, stock market goes down 7.4%, global growth weakening, commodity prices doing what they’re doing;, Bullard comes out and says, “Hey, maybe we should consider tapering the taper and consider doing QE4.” So I think the stock market’s the key here for Fed policy.
Hersh: [00:03:19] You know, it’s interesting … sorry, what’s interesting is I think people have really had trouble … the average person has had trouble reconciling a sluggish weak economy with a very strong stock market. And I think that’s why from 2009 when the market made its final bottom in March until 2013, you had very little individual addition to the market. You had PEs that were … price earnings ratios that were 13 or so, having come up from 10. The market was really still washed out. I think that people discovered last year that there was … what they should have … would have liked … we would have liked them to have discovered four years earlier that stocks were kind of being given away in 2009, 10 even into 11. And that they took prices up, money came out of fixed, came out of money funds into stocks to price earnings ratios up to 16 or 17 last year. And I think it might finally be settling in on people the idea that over a third of the stocks in the S&P yield more than the 10 year treasury, every call … I don’t know about you, every call we were getting from wealth advisors, from individuals was how do I get more income with no risk? How do I get more income? I have a CD maturing. And the answer is, well you can’t get more income with no risk.
But in the stock market you can get materially more income with a little more risk when stocks were so cheap, you know, it’s maybe leveled off a lot now although you still, you now have a lot of stock still yielding 50%, even 100% more than the 10 year treasury, which is what’s keeping … ties in with what you’re saying. The Fed is definitely … I don’t know if The Fed is causing rates to be 2.10 or 2.20 on the 10 year treasury. But they … right, if they’re not, but they are at that rate and were flight the safety blah, blah, blah. So it’s certainly an aid to the stock market.
Jim: [00:05:09] To know where we are today you have to know how we got here. And Hersh made the point about what happened back in 2008 and 9. We had a massive debt super cycle. We’ve been in a secular decline in growth in the United States going back to the 60s. And if I showed you a chart, the average business cycle’s about five years. And back in 1960 the five year moving average of GDP was about 4½%. In the last five years it’s been 2.3%. And yet we’ve had a massive leveraging up of the US economy. It manifested itself in the largest debt, credit and housing bubble that we’ve ever had in this country. It popped; we’re dealing with the aftermath of the popping of that credit bubble. And I think to understand where we are today you have to understand the policymakers, and Hersh alluded to this earlier, the policymakers had a choice. They waited too long and in the summer of 2008 they were looking at great depression two or something worse and they opted for what we call the amortization strategy or the Japan strategy. And Bill Dudley who ran the market’s desk-Executive Vice President of The Markets Desk at the New York Fed actually gave a speech where he talked about, We can’t change what’s going to happen but we can amortize the losses over as long a period of time as possible. That’s what they’re doing. And so I’m not surprised that growth has been this weak. Demographics are such that you’ve got a balance sheet repair process that we believe we’re only in the middle innings of, that’s going to go on for an extended period of time. And when you overlay the demographics which were a tailwind in the 80s, 90s and earlier this decade are now turning into a headwind. And people have to save more. And you know, I think when the textbook is written it should be known as crisis of unintended consequences because economists like to talk about the paradox of thrift. And simply stated, what that means is savings is a good thing unless everybody does it. Well, when you have zero rates for six years and Hersh alluded to the insatiable demand for income, people do what people do, baby boomers have experienced two 50% stock market crashes in the last 14 years we’ve had zero rates for six years, they need income. So what do they have to do? They’re earning zero in the bank, they either have to take risk in higher risk fixed income assets and/or equities or as you approach retirement they have to save more. So The Fed is actually creating what we call the paradox of thrift, not intentionally.
Courtney: [00:07:39] Do you agree, Hersh?
Hersh: [00:07:40] I totally agree and it’s interesting what you say about the whole debt bubble breaking. And people say, “Well, debt is down, debt is down to individuals.” I could be wrong on this number but I think I’m right, it used to be, I think personal debt … household debt is a percentage of disposable income, used to run for decades at about 60%, mostly mortgage debt. It got up to 125% with all the defaults and the mortgage default and credit … paying of credit card down … paying down the credit card debt ostensibly. It’s still over 100%. So we are way above historical, I mean the consumer who used the house … the home equity as a piggybank, who took on credit card, they’re not in a position to drive this economy up. So again we come back to the idea, slow growth, the Fed going very slowly and that, yes, I agree.
Courtney: [00:08:36] Jim, between Isis, Ebola the devaluation of the ruble, a 40% slide in oil, we saw a lot more volatility in the latter half of 2014, do you think this is a portent of things to come in 2015?
Jim: [00:08:49] Well, I think you know, if there’s a bubble it’s probably that we’ve been in a complacency bubble largely because everybody looked at the Fed and said, “The Fed’s not going to let anything go down.” And what was very interesting, we had been of the view towards the end of last year that, you know, rates were actually going to go down rather than up. What’s interesting is that the narrative of Fed and QE is that when the Fed is buying bonds and conducting QE, rates go down. Well, in fact if you look at the record when the Fed is printing money and doing QE, rates have actually gone up. It’s when they announce that they’re slowing down or stopping that rates have actually fallen more than they have gone up when they are printing money. And it gets to this whole first derivative, second derivative. And the second derivative is when the Fed is putting liquidity into the system they’re telling people that they want them to go into riskier assets. And people are very rational. And they view that there is effectively a put option to the Federal Reserve. And so when you remove that liquidity, and the liquidity cycle is rolling over at this point, what happens is people then get nervous because they no longer have that liquidity being supplied by The Fed and they start to sell the risky assets that they went into largely because you’ve had such a big move in all risky assets.
Courtney: [00:10:09] Hersh, we’re nearly six years into today’s bull market that was born in March 2009 and it’s the fourth longest in history so far. Do you believe it’s poised to continue through 2015?
Hersh: [00:10:21] I heard a quote by Leon Cooperman, was a good quote, he said, “Bull markets end from excesses and not from getting tired.” So you don’t have to have a bear market, let’s put it that way. I’m off a little this year at the beginning, last year we had the big markup, you had earnings go up 6%, you had stocks go up 30%. And so you had stock prices go up five times as much as corporate earnings. I came into this year thinking that we’d have kind of mid-single digit returns because you wouldn’t get a repeat of a big revaluation upward. And PEs, I’m off by … I’d rather by off and have it move higher. But I wasn’t looking for a decline because you do have this backstop of interest rates that really do keep things from falling in a material way. And every time the market goes down somebody from the Fed comes out and says something, says something bullish or you have a meeting that comes like yesterday. And so no, I don’t think we have to go under a bear market next year. But I would repeat kind of my forecast which is I think the market will go up in line maybe with corporate earnings and dividends. So maybe you’ll see, you know, kind of a 3-7% increase. You know, I hope it’s … I hope it’s more. The ingredients for a big spill are not there. You had complacency but not ebullience. People are not running around bragging how much money they’re making.
The market’s treated people unequally you know, the people who have been in stocks and have really benefitted from it, a lot of the country hasn’t. And so there’s definitely not too much enthusiasm about the market. Geopolitically, you know, who knows if, you know, if [unclear 00:12:03] unpredictable and if he blows up the Saudi pipelines, I’m not predicting, I’m just saying. There are things that could happen.
Courtney: [00:12:11] So do you believe it’s really contingent on the geopolitical [unclear 00:12:13]?
Hersh: [00:12:13] Then you would have … then you would have, you know, or you know, you have a series of terrorist events in this country, you’d have a pretty good … pretty horrible correction. So you can’t forecast that. But on an interest rate basis, earnings basis, I think the market is okay.
Courtney: [00:12:29] Okay. So okay unless we see a black swan event, terrorist attack, a geopolitical event, it sounds like that.
Hersh: [00:12:34] Right. Right, it’s interesting. Someone referred to [00:12:38], a market commentator referred to oil as this year’s black swan event. It really did come out, I don’t know who was talking about, you know, $54 oil, it seemed … it seems as if oil had its selling climax this week when it was down 4%, 3%. So it’ll bounce around. So I think maybe we’ve seen the worst case there. And we still don’t know the fallout on the credit markets and as people have … I haven’t even thought of the implications on the credit markets of oil. You could probably make some comment on that.
Jim: [00:13:07] Yeah. Well, yeah, absolutely, I’ve heard people talk about oil in the context of it’s the equivalent of a house back in 2007 and 8. And what we mean by that is the fact that, you know, when you have zero rates for six years now, you’ve had a Fed that’s increased its balance sheet from 800 billion to 4½ trillion. You’ve had 13 trillion dollars in quantitative easing of some sort globally in this cycle. And you have to really wonder where there has been misallocation of capital. We used to joke in our business that two guys and a Bloomberg would start a hedge fund. Well, now two guys and a fracking drill could start an energy company. And so we think, you know, that’s the weakest link if you will. There’s been about 500 billion dollars that’s been raised, capital that is to go to the energy sector. And if you think about the economy for a second, you know, in the C + I + G + net exports consumption investment, government spending and net exports. I read a study that said the energy industry has been spending on average 300-400 billion dollars a year in CAPEX. Well, if you do the math on a 17 trillion dollar economy; the economy’s grown about 2.3%; take 350 billion, the midpoint, that’s about 2% of GDP. So if you strip that out, the economy really hasn’t grown much in the last five years. Now, that’s not exactly the right way to look at it.
But I think, you know, Hersh talked about the consumer not being there. The consumer still has quite a bit of balance sheet repair left to go. Investment companies have been able to borrow money but they’ve not been investing in people, plant, property or equipment. What they’ve been doing is financially engineering share buybacks, dividends and return on capital to shareholders. So on the margin and this’ll take a while to work its way through the economy, but if we have lower energy - sustained lower energy prices and sustained is the operative word here, it’s going to clearly hit capital spending. And two of the biggest industries for cap spending are… [energy, metals and mining]
Hersh: [00:15:30] Yeah, it’s been the growth engine, the only growth engine, it was healthcare several years ago, now energy, so you know, it’s a two edge sword. And it helps the consumer but also impacts job creation. Also one of the things I’ve been concerned about and I don’t know if I should be or shouldn’t be, subprime auto loans, oh my heavens, I mean they’re, you know, we’re selling 16 million cars a year, not all of them being bought for cash, you know, so is that a risk to the … to, you know, asset backed securities and stuff like that, is it? But as big as mortgages but…
Jim: [00:15:57] No, it’s not as big as mortgages, it’s a risk. It’s absolutely a risk but it’s a risk that’s dispersed to investors. And the key thing there I think is leverage. And I don’t think you have the same leverage…
Hersh: [00:16:06] It’s a [unclear 00:16:06].
Jim: [00:16:08] I don’t think, yeah, I don’t think you have the same leverage in the ABS like you did in the CDO market back in with the CDO or the market.
Hersh: [00:16:15] But there a whole host of things that if they happen to coalesce, you could get problems. I mean so there are, you know, you keep your eye on things, so.
Courtney: [00:16:23] Given your expectations for continued lower rates, what can the fixed income investor expect for their returns?
Jim: [00:16:30] Well, I mean just look at this year. I mean we were of the view that rates were going to go lower and stay low for longer. So we’ve been of that view for the last four or five years. If you would have said to people, “Where do you think long treasuries would be at the end of 2014” when we started this year, they probably would have said, “You’re going to lose 10-15%.” Well you know 30 year treasuries are up 29% year to date. And so even though we’re in a low rate world there’s still the potential for capital appreciation. People buy bonds for income obviously. But given where global yields are, we can’t look at the US fixed income market in a vacuum anymore because global investors don’t look at it that way. And when you’ve got a 10 year treasury, when I left the office it was trading about 2.21 today, okay. But you’ve got Japanese yields at 35 basis points. You’ve got German yields, 10 year yields that are at 62 basis points. When you can get 2.20 in a US treasury where the dollar is rising, and then you could put a spread on that to buy corporate bonds, mortgage backed securities, we’re of the view that, you know, the market is going to probably return, you know similar to Hersh, 4-6%. But we’re in a low growth environment. And in a low growth environment asset returns are low and interest rates will be low. And if you’re a good security selector, you can make money.
Hersh: [00:18:08] Agreed.
Courtney: [00:18:09] Hersh, agree. Hersh…
Hersh: [00:18:10] In a word.
Courtney: [00:18:11] In a word. Hersh, you wrote March 2013 that we’re in the golden age of dividends, do you still agree with that today?
Hersh: [00:18:18] Totally. I love it. The companies have more cash on their balance sheets than they’ve had in decades. They’re not spending on capital spending as much as they used to. We prefer dividends to buybacks. And companies are listening to shareholders. Dividends went from 50% of after tax profits prior to the 1990s. Companies would earn money, they’d pay taxes. And 50% of the after tax earnings would get paid to shareholders on average. It went down to 25% by 2000 because of a variety of factors, mainly having to do with companies stuffing their pockets with stock options and using the free cash flow, instead of dividends to buy shares to support the stock prices, 25% payout ratio, way too low. And then when the tax law changed on dividends in 2003 as part of the tax bill. I think corporate directors started to get the idea that maybe it will be a good idea to shift the mix from more buybacks, less dividends to more dividends, fewer buybacks. And that’s continued but really gathered steam a couple of years ago as I think individuals were crying, begging for income. And so companies, you know, got the message, board of directors got the … board of directors became much more responsive to shareholder desires.
And so yes, I believe the golden age of dividends is in effect … the S&P dividends in the 2000 through 2000 and … end of 2009, that decade I think were up on … a little over 5%. I think last year they jumped materially. I know our dividend program, the dividends were up … not here to tell the whole thing but I mean they were up 13% dividends. You just had 3M last year; 3M has been a dividend raiser every year for call it 50 years. And they raise … but it used to be 6/7% dividend increase, now it’s steady, last December they announced a 35% increase, huge, this December two days ago they announced a 20% dividend. A 20% dividend increase, where is somebody going to get a raise like that? Amgen, a biotech company just announced a … the numbers run into each other, over 20% increase today for their next dividend. So companies are, yes, this is the golden age of dividend. I think it will continue. Dividend payout ratios just to close the circle are still only 33/34%. So I’m not saying they’ll get back to 50%, but I don’t think they’re going back to 25% either. So I think dividends are … and the growth story for dividends is definitely intact.
Courtney: [00:21:02] Jim, where are you currently seeing opportunities for investment in the fixed income space?
Jim: [00:21:07] We’re seeing opportunities right now and have been this year, we’ve been taking profits. We thought that things got a little bit ahead of themselves. And so came into this year overweight, corporate bonds and mortgage backed securities and have taken that down to a more neutral allocation relative to our benchmarks. And so we still see opportunities in the investment grade corporate sector. The securitized assets, whether they be agency mortgage backed securities, commercial mortgage backed securities, certainly some in the asset backed securities area. But believe it or not we’ve been increasing our treasury allocation throughout the course of the year. And that’s been a good opportunity. I am not concerned about rates heading up any time soon. We think we’re going to largely stay in a 2-3% trading range for the 10 year treasury. I’d probably lower that, that’s where we came into the year. I’d probably lower that now to more like 2-2½. But I believe there’s a one in three probability that we will take out the July 2012 1.38 lows on 10 year treasuries. There’s a gravitational pull by yields in Europe and in Asia. And there are eight European bond markets where their two year yields are negative. You saw overnight that Switzerland adopted negative deposit rates. You know, we’re going to be in a lower rate world and fixed income still has not only the income characteristics, but it still has some potential for capital appreciation.
Hersh: [00:22:47] The real problem … the real problem is for people who are risk averse and need income and who don’t want a high proportion of their assets in stocks because of the volatility. And if people would just focus on the income from stocks they’d be fine. But of course it’s hard because you see online every day if you want, every month, and you get a 10% correction and it’s hard for people to take even though the dividends may go up during that period. I have a stupid line that I use when the market goes down beginning of day, I say, “Well, gee, not one of my companies cut their dividend today” you know. And it’s true but that isn’t the way people tend to look at it. So it’s a real problem for, you know, you talk about 2.2% on 10 year treasury, I’m not knocking it, I mean but it’s hard for people to build wealth with 2%. It’s tough. It’s a tough environment for the saver, really tough. I mean I don’t think … I don’t think we have any quarrel about that one. We don’t have a quarrel about anything, but there’s certainly no quarrel about that one.
Courtney: [00:23:53] Hersh, where are you currently seeing opportunities for investment?
Hersh: [00:23:58] It’s the question and you know, stocks are still okay. What I’m having trouble finding are companies where the reward … potential reward is materially greater than the potential risk if something does go wrong. And the problem now is that there are so many … it’s the money at the margin, the fast money that move stocks up in huge gulps. And so I hold my breath every earning season. If a company misses by a penny the stock can get killed way out of proportion, if a company beats by a penny or two the stock … got me, I can cite you an example, I’ve forgotten what the rules are about citing individual stocks, examples of it. But you see it every day, you know, company beats by a penny, everyone knows what the expectations are, it’s all over Bloomberg, it’s all over everywhere. And if a company beats, the stocks go up a lot; if they miss they go down. It’s … so when markets are really washed out then it doesn’t matter what the earnings come out. If they miss because it’s all in the stock, I would say the only group that really got washed out here would be the big oils and maybe even the smaller ones, I tend to follow the bigger ones. You know, you had Chevron down the other day to $100 yielding 4.1%. And I’m thinking, you know, that’s a pretty secure dividend and likely to be the dividend raiser. And so that’s the only area that got really cheap.
Other than that it’s tough to find, I think you have to be broadly diversified, the markets are pretty well correlated across groups. I don’t see any compelling industries and nor do I see any really overpriced industries. That’s where I come down on it, so you know kind of a broad based approach. I love the dividend sector, so I look for a broad based portfolio of companies with the ability to raise their dividends. That’s not necessarily for everybody. The, you know, biotech stocks have had this massive run and they change peoples’ lives and that’s a good thing. You look for companies that change peoples’ lives and those are…
Courtney: [00:26:04] They do, yeah. Jim, when looking back on the 2014 debt market, what will the history books write?
Jim: [00:26:10] Surprise. Yeah, I mean I remember this time last year when we were out there saying that rates were headed to 2%. And the looks that I got from people were, are you kidding? Every year we go through this narrative. And the narrative for the last five years has been, you know, back in 09, 10 and 11 it was all about green shoots and the last couple of years they’ve changed green shoots to escape velocity. And we’ve grown 2.3% in spite of all of the stimulus that we’ve thrown into this economy. Our view is the most stimulative thing the Federal Reserve could do is raise rates. And you know, just some very simple numbers, there’s 13 trillion dollars in zero maturity money or cash. That’s, you know, sitting in banks and money market funds earning nothing, okay. If the Fed had just gone to a short term rate of 1½% the last five years, we would have thrown off about a trillion and a half in income. And I guarantee you there would have been a multiple [00:27:21].
Hersh: [00:27:21] No, but it’s all … it’s transfer, I mean that’s transfer from one pocket to another, from going to savers out of, you know, more debt, I mean it costs them more to service that.
Jim: [00:27:32] Costs who more?
Hersh: [00:27:32] Costs the government more to service that so it’s…
Jim: [00:27:35] Yeah, but…
Hersh: [00:27:37] You’re borrowing more and going to save … I’m not saying that’s wrong, but it’s not a zero…
Jim: [00:27:43] My point is, so what you’ve done is, you know, we ask ourselves and we often get asked, you know, “Has QE been successful?” And I said, “It depends how you define success.” If you define success as creating asset inflation, it’s been hugely successful. If you define it in terms of economic growth, income, jobs, no, it’s been an absolute disaster. So…
Hersh: [00:28:07] But what could have created economic growth and jobs, that’s … so I think the odds are so stacked against … have been so stacked against growth because of the collapse that we talked about earlier. It’s going to take time and so…
Jim: [00:28:19] No, you’re right it’s going to take a lot of time.
Hersh: [00:28:22] They’ve prevented the worst case from happening and I think that was, you know, Bernanke having understood what happened in the 30s, that’s my view.
Jim: [00:28:32] I think you know, I would venture to say, you know, it’s like rewarding the arsonist for calling the Fire Department after the fire has been set. So you know, I think … I think the Fed waited too long, they kept rates too low for too long. They confused back in 2003, good deflation with bad deflation. The deflation that they were afraid of in 2003 was productivity led deflation, okay.
Hersh: [00:29:01] But it was a search for income, there’s a point there about keeping rates too low. There was a search for income back in 06/07 by pension funds. And so that’s why they were enabling firms to package these junky mortgages and … because they were getting these mortgage backed securities at higher rates than normal market rates. And so that led to a pile up of, I think, you know, and all these things interrelated, so. But I can’t blame the Fed for the mortgage backed security crisis, so.
Jim: [00:29:32] Well, you know, the Fed’s the regulator, right. And therein lies a conflict, the central bank should never be the regulator because you have those conflicts that are obviously apparent. I think you know the Fed could have done something in 07 and early 08. But by the time we got to the late summer of 08, you know, they did the only thing that they could do. Look, Wall Street learns very fast, you can go back and you know, history and 2020 hindsight, but I would venture to say that if the Fed had let Bear Sterns go for instance, yeah, that would have been painful. But I think the financial industry would have gotten religion and I’m not sure that we would have been in this situation if the Fed would have allowed the losses to occur early enough, I think the US would be growing very nicely. We wouldn’t have had to do QE1, QE2, QE3, Operation Twist, the extension of Operation Twist.
Courtney: [00:30:40] Hersh, do you agree?
Hersh: [00:30:40] Bear Sterns had 31, I couldn’t believe it, I didn’t know how much leverage was being used in these mortgage backed, they’re hedge funds, you know, the market was down three percent and they go broke because they had 30 to one leverage.
Jim: [00:30:55] They’re the brokers at 35 and 40 to one leverage on their own balance sheet.
Hersh: [00:30:57] Yeah. And so had they let it go maybe it just would have hastened what happened later. A lot of money funds, I don’t know what would have happened, Lehman had, you know, Lehman had the junk on their books. When Bear Stearns went under it wasn’t … like that wasn’t a new phenomenon because the Fed had kept things low. They had all kinds of marginal real estate projects and I’m sure they had the leverage of their own … people didn’t want to know it. And so I don’t think had they let Bear Stearns go, I’m not sure if the story would have been a bit different, so.
Jim: [00:31:30] Yeah. No, I mean look, Hank Paulson was Treasury Secretary. But earlier than that when the brokers used to be subject to what they’re calling a Net Capital Requirement Rule and the big five went and got an exemption from Congress, okay. So what used to be 12 times levered became the sky’s the limit. And it was, the balance sheets were becoming more and more complicated. And I remember looking at the brokers back in 2006 and 7 and they were 35 and 45 times levered. And the complexity of these balance sheets was off the charts. And make a very simple observation, if you’ve got a balance sheet of 35 to one levered, all it takes is a 3% change in that balance sheet going down and you’re effectively insolvent.
Hersh: [00:32:22] But having Bear Stearns equity go to what should have been a dollar and they worked out a thing, did that give anybody religion? I don’t think so.
Jim: [00:32:31] No, absolutely not.
Hersh: [00:32:31] And that’s what [unclear 00:32:32], nobody got religion. They didn’t want to know, they were still, you know, thinking they’re making money and so you know, it’s an obviously sorry episode. But I’m not sure, I can’t blame the Fed, I blame greed and [unclear 00:32:46] leverage.
Jim: [00:32:46] Well, fear and greed and leverage.
Hersh: [00:32:49] Every collapse is fuelled by that. That’s why when you asked earlier, to come back to that, you know, is the market going to a bear market, I don’t think, certainly on equities, I don’t see the greed factor that has kicked in. You don’t have the people, you know, there’s not the cocktail party chatter, it’s not on the front pages of the newspaper, how great the market, all those classic signs that you saw in 1968 and 1972 with the Nifty 50 and 1999 with internet. I don’t think there’s any of that now, actually after the internet break, I never thought we’d … I thought we wouldn’t see a stock market bubble for 20 some years. And we haven’t. We’ve suffered a housing bubble, it’s incredible – it’s incredible.
Jim: [00:33:39] We’ve had one bubble, we had a tech, telecom, internet bubble. And again the Fed kept rates to a low too long to try.
Hersh: [00:33:46] Are you talking 1999/2000?
Jim: [00:33:48] 1999/2000, yeah, and so the Fed, you know, wanted to amortize the pain there so they keep rates too low for too long. What did we get? A credit and a housing bubble. Then that pops and now all of a sudden they’ve kept zero rates for six years. And they’ve taken the balance sheet from 800 billion to 4½ trillion. You can’t tell me that there aren’t going to be implications for that. And when the history books, you know, Hersh and I can have different views on this, and that’s what makes markets. But when the history books are written and it’s not going to be for a while, I don’t think they’re going to look favorably upon the contribution to this crisis from the Federal Reserve.
Hersh: [00:34:31] It’s interesting, I’m just not sure, once it unfolds and I’m not sure what the choice is. But what would you say to Bernanke if you met him today, what would you say? I know what I would say.
Jim: [00:34:41] Well, I would say that they waited too long so they needed to do QE1, okay. But that they need to do QE2, Operation Twist, QE3 no! The patient had long left the emergency room, is out of intensive care. And you know, I think Bernanke said it all back in his November 2010 editorial in the Washington Post, he was going to create a wealth effect, okay, by keeping rates low and printing money. And he was telling people, “We want you to take risk. We want you to go into stocks, high yield bonds, bank loans, commercial mortgage backed securities.” And that, the theory, in theory, you know, it was going to lead to a trickle down, okay. Well, if you look at the academic research that’s come out over the last two years, there is no wealth effect. And so Janet Yellen steps in to replace Bernanke and Janet’s a labor economist so all of a sudden we’re not talking about a wealth effect anymore now, we’re talking about income inequality and employment. Not bad things to be talking about, but we’re still pursuing the same policies. And I just believe that there are going to be ramifications for these policies.
Hersh: [00:35:59] Interesting. Interesting.
Courtney: [00:36:00] Hersh, when we look at just specifically the equity markets for 2014 what will the history books write for the equity markets?
Hersh: [00:36:07] Good returns, not exactly unfolding the way you would think it would, which is a steady grind upward without a major pullback. I think from a broad perspective it’ll say, yeah, pretty good year, unknown going forward for energy. But I don’t see how you can call it anything but a good year.
Jim: [00:36:35] And you had good earnings.
Hersh: [00:36:36] Mm.
Jim: [00:36:36] You had good earnings.
Hersh: [00:36:37] We had good earnings, good, yeah. Good expectations have been ratcheted down. I’m not sure how great earnings are. I think they’re better…
Jim: [00:36:44] They were managed.
Hersh: [00:36:45] Yeah. Yeah.
Jim: [00:36:47] Expectations were managed.
Hersh: [00:36:48] So, right, expectations were managed well. And I think they’ll … very few companies guiding upward on their earnings, I mean everybody’s nervous about … companies are nervous about guiding upward, about the world and Latin America and China. So there’s definitely … people are being very careful about their earnings guidance, which is good. So when companies come in and beat it and their guidance is not negative and stocks tend to do pretty well. So yeah, it’s been a good year, you know, a good year. I’m feeling good about, you know, what we’ve accomplished and what the market has accomplished, definitely.
Courtney: [00:37:27] And speaking of emerging markets - emerging markets, commodities, have really taken a beating. How do you see them going forward in 2015, Jim?
Jim: [00:37:37] Well, I think the way you have to look at … there’s an interesting debate. If you listen to economists and you ask them why oil prices are down, they tell you, “Because there is too much supply.” And if you actually listen to people in … that know energy, the energy analysts they’ll tell you, “It’s because there’s a lack of demand.” I think all you have to do is look at the revisions in global GDP. And let’s take the IMF estimate which was the most recent one, the IMF has reduced the global GDP forecast for 2015 from 3.9% to 3.2%. Everybody’s ratcheting down their growth estimates. And I think if you look at when those growth estimates have gotten ratcheted down, it coincides with the decline that you’ve seen in oil prices. So I think that the decline in commodities is driven by a slowdown in global growth. China has been the marginal buyer of every commodity. So whether you look at copper, oil, iron ore, you know, these things are in bear markets. And I was just looking at the CRB Index before I came, the CRB Index is back to 2009 levels, which you know, I would have said, okay, are we back to 2012?
Hersh: [00:38:59] Well, things overshoot on the upside, they never shoot on the downside. And is it an overshoot? As you say, China’s the kind of the swing factor there. It’s interesting, about cars, you know, Americans are driving more miles and using less gasoline, as these new cars come on and are more fuel efficient. And so yeah, demand is higher, I think it’s a demand issue. I don’t know what Saudi Arabia’s trying to do. I think there are all kinds of conspiracy theories, that they’re trying to hurt Iran, Russia, shale, I don’t know. I don’t know, I’m not sure, only they know.
Jim: [00:39:35] Emerging markets are in better shape than they were in the 98 timeframe. But the issue with the emerging markets this time is not necessarily going to be in the sovereign, yeah, the fringe weaker, parts of the emerging markets like Venezuela, who have their own unique issues in addition to oil. They’ve got problems. But where most of the borrowing has occurred in the emerging markets has been in the corporate sector. So if there’s a problem it’s going to be the corporate sectors in a lot of these emerging markets who have borrowed a lot of money in the dollar markets and are they going to have the ability to pay it back and/or refinance it? And unless the markets become more hospitable the answer right now looks like they’re going to have some trouble.
Courtney: [00:40:22] And, Jim, what specific fixed income strategies would you recommend to an investor in this zero interest rate policy environment?
Jim: [00:40:30] You know, again, I think it’s…
Hersh: [00:40:32] It’s a good one.
Jim: [00:40:33] It’s a function…
Hersh: [00:40:34] I want to hear the answer to this one.
Jim: [00:40:36] It’s a function of your risk tolerance and your time horizon, with any investment it’s always a function of you know, how much risk and what your time horizon is. And we’re of the view that we are in a below trend growth environment, where trend growth is being revised down. So the potential growth rate of the US economy, which for 40 years was assumed to be 3-3½%. In our view is closer to 2 and maybe slightly lower than that. And the potential growth rate of any economy is a function of two things, the growth in the labor force which has clearly slowed and demographics will tell you that it will slow even further, and in the productivity of the labor force. And the productivity growth has slowed and the Fed, the Bank of England, the ECB, they’ve all talked about productivity and why they don’t understand why we’re not more productive. But to come back to your question, so in a slower, lower growth environment, interest rates are not going up. And while 2.2% can seem extremely low, again, we had less than 4% on 30 year treasuries coming into this year and yet they’re up 29%. So in a low rate environment you don’t need massive moves in rates to generate some capital appreciation. If you have a long time horizon you can take more risk. So you can buy things like corporate bonds, mortgage backed securities, high yield has gotten cheaper. Hersh talked about energy, well the energy sector in the high yield market which has been a big issuer of bonds and so the high yield market’s gotten very cheap. And that contagion has cheapened up the entire high yield market. We reduced our exposure to non-investment grade credits or high yield credits back in May when we started to see high yield bonds trade through 5%. You can now get more than 7%. So you know your dollar cost average in that might not be a bad place to be.
Hersh: [00:42:56] You do it through … would you do it through a fund?
Jim: [00:42:58] Hersh, that’s a really good point. I think any bond investing that you do outside of treasuries, if it’s going to entail any security specific risk, whether it be credit risk, mortgage backed securities risk, certainly corporate bonds and high yield bonds and/or bank loans, do it through a fund. And the reason for that is diversification, liquidity and you’ve got somebody else doing the credit work.
Courtney: [00:43:23] Right. That would be quite tough for the average investor to just cherry pick the right bonds.
Jim: [00:43:28] And buy enough of them.
Courtney: [00:43:29] Right.
Jim: [00:43:29] To have a diversified portfolio.
Courtney: [00:43:33] Hersh, what’s changed in the equity markets over your 45 year investment tenure?
Hersh: [00:43:39] Well, the speed with which things move, the idea that people are entitled to get out of zillion share positions in milliseconds, it used to take a long time to accumulate stocks, a long time to liquidate stocks and that’s not a bad thing. I think it slows things down. It would only be at the extremes when you would get the panics. But basically human behavior is still the same. You go through cycles of despair and you go through, so like we had in 2002 and then again in 2008, early 2009 and then you go through … then you get recovery and you go through where people become exuberant then the market starts to rollover and it begins it all over again. And so what’s changed, I think just the volumes and the … well, derivates have made it a lot … in some ways a lot scarier, the moves are bigger. Those would be the things I would say. But you know, the human behavior hasn’t changed, it hasn’t changed at all. The 70s, I mean you had the market fall in half between 1969 and 1974 when I came in. And so you know, that colored my judgment about risk. And then you had all these [unclear 00:45:01] Dodd and [unclear 00:45:02] situations where stocks would literally be … you could get them for … you could get companies for less than their cash value. You don’t have those anymore. But that’s … you had many of those again in 2009. So things, you know, things come full circle.
Courtney: [00:45:17] Jim, what’s changed in your 30 tenure in the fixed income markets?
Jim: [00:45:22] Oh, the bond market’s a lot bigger because of the debt super cycle, liquidity, you would think that as markets have gotten bigger and bigger, that liquidity should increase. But in fact, and Hersh, alluded to it, the liquidity is not there anymore, largely driven by … again, unintended consequences of the last crisis, regulations, whether it be Dodd Frank, the Volcker Rule, Basel III, capital requirements, the sell side firms are not providing … they’re not getting paid to provide the balance sheet.
Hersh: [00:45:57] Exactly. Could I just say…
Courtney: [00:45:59] Yeah, yeah.
Hersh: [00:45:59] The unintended consequences of mutual fund boards pushing to get commissions down to fractional cents per share has caused Wall Street research to, I think, become much less broad, in some cases they can’t afford to pay as many analysts. I think you’re not getting the same quality of research that maybe you once had. And that is an unintended consequence and people can press a button and trade 50 stocks for no cost. And it’s, to me, I don’t know, that’s kind of not the way the stock market was not meant to be. That doesn’t aid capital formation and it doesn’t aid, you know, companies raising money, it’s pushing, you know.
Courtney: [00:46:47] The current US business cycle is the longest we’ve seen in the post-World War Two period, do you think it’s getting a bit too long in the tooth, Jim?
Jim: [00:46:53] Yeah, I think it’s a bit, it’s a little bit longer than the average in the sense that it’s … we’re now at about 66 months the average, in the post war period is closer to 60. So yeah, it’s a little bit long in the tooth. And the argument is that because it’s been such a slow recovery that it’s going to be elongated and extended. I would venture to say that the next recession is likely not to be caused by an economic event. It’s probably going to be because of a financial market event. Why? Because I think, everything’s been focused on asset prices. And the real economy is growing as I said, just a little bit over 2%. So you know, to use that, you know, you’re flying at about tree level, so it doesn’t take a lot to cause an issue. The way we look at the cycle, so you have the economic cycle, you have the credit cycle and then you have the liquidity cycle, so in the grand scheme of things the liquidity cycle is clearly rolling over here in the US, not … as I said, not of the view that the Fed’s going to raise rates in 2015. But not doing QE has diminished the liquidity that’s going into markets. The credit cycle peaked about two years ago, so balance sheets as Hersh said earlier, are in very good shape but it’s peaked. And then the economic cycle will be the last one to roll over here. And as I said, it’s not going to take a big shock to potentially cause the next recession. And we’ve got to remember that recessions are a normal part of the business cycle. And what recessions do is expose and expunge the excesses in the previous business cycle. And it’s fair to say that I think there’s been a fair amount of excesses built up in certain asset prices and certain sectors.
Courtney: [00:49:01] Hersh, do you agree? Yes. Your final takeaways?
Hersh: [00:49:06] I think people need to be diversified. I think … I wouldn’t be at the ranch on any one sector. I wouldn’t keep all my money in money funds. I wouldn’t necessarily put all my money after the age of 50 in equities, in a fund, to the extent, I mean equities which I love equities, I’d want to be … well, I’ve not been in the ranch on energy, I’ve not been at the ranch [unclear 00:49:30]. And I think you have to be pretty well diversified. As far as fixed income, I struggle with it when I’ve had balanced accounts over the years and honestly, I don’t know what the heck to do with the fixed income. Right now I’m actually interested to hear your views, I think are very insightful. So, diversification and patience and with dollar cost averaging, always a good thing when markets have had big moves.
Courtney: [00:49:54] Great. Jim, your final takeaways?
Jim: [00:49:56] Well, I think, you know, Hersh hit on it, which is diversification’s a really important part of investing. And I’m reminded of something Peter Lynch said many years ago, where he said, “It’s a market of stocks, not a stock market.” And I’ve taken that into the bond world to say, you know, it’s a market of bonds, not a bond market. So if you’re a good investor, if you’re a good security selector, I don’t care whether you’re in stocks or bonds, there’s always opportunities, sometimes they are more obvious, sometimes you have to do more research, do not be frightened by this narrative that we’ve been listening to for the last five years. And I could take you back even further, that interest rates have nowhere to go but up because they don’t, they can stay low for a very long period of time.
Courtney: [00:50:43] Gentlemen, thank you. From New York and Asset TV, this has been the Asset TV 2015 Outlook Master Class.
DISCLOSURES: All investments involve risk. Comments and general market related projections are based on information available at the time, are for informational purposes only are not intended as individual or specific advice, may not represent the opinions of the entire firm and may not be relied upon for individual investing purposes. Information provided is general and educational in nature, provided as general guidance on the subject covered and is not intended to be authoritative. All information contained herein is believed to be correct but accuracy cannot be guaranteed. This information may coincide or conflict with activities of the portfolio managers. It is not intended to be and should not be construed as investment, legal, estate planning or tax advice. RidgeWorth does not provide legal, estate planning, or tax advice. Bonds offer a relatively stable level of income, although bond prices will fluctuate providing the potential for principal gain or loss. Intermediate-term, higher quality bonds generally offer less risk than longer term bonds and a lower rate of return. Generally, a fund’s fixed income securities will decrease in value if interest rates rise and vice versa. Past performance is not indicative of future results. For performance data current to the most recent month end visit our website at www.ridgeworth.com. An investor should consider a fund's investment objectives risks and charges and expenses carefully before investing or sending money. This and other important information about the RidgeWorth Funds can be found in a funds’ prospectus. To obtain a prospectus call 1-888-784-3863 or visit www.ridgeworth.com. Please read the prospectus carefully before investing. ©2015 Seix Investment Advisors LLC. Seix Investment Advisors LLC is a registered investment adviser with the SEC and a member of the RidgeWorth Capital Management LLC network of investment firms. ©2015 RidgeWorth Investments. RidgeWorth Investments is the trade name for RidgeWorth Capital Management LLC, an investment adviser registered with the SEC and the adviser to the RidgeWorth Funds. RidgeWorth Funds are distributed by RidgeWorth Distributors LLC, which is not affiliated with the adviser.
The opinions and views expressed herein are of Hersh Cohen as of December 18, 2015, and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results, or investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments nor its information providers are responsible for any damages or losses arising from any use of this information.
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MASTERCLASS: 2015 Outlook - January 2015
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