If the sequestration is allowed to occur on March 1, it would be a “big hit” to GDP, he said. Gundlach has consistently warned that federal deficits are the major threat to the economy. “This problem just never seems to want to be seriously addressed,” he said. “Pretty soon, the snake is going to strike, because this cannot go on very much longer.”
Gundlach noted that he was hardly alone in his pessimism, citing the recent decline in analysts’ earning estimates visible in the figure below:
2013 S&P Revenue Estimates
March 3, 2011 through January 1, 2013
Source: Bianco Research, LLC, Week of January 2, 2013
Analysts were optimistic in late 2011, and equities performed well last year, Gundlach said. But if estimates fall much further, he said, “it will be very difficult to see what would be the support for the equity markets.”
“It is very difficult to see how we are going to get the type of economic acceleration that some people are hoping for,” Gundlach said.
Gundlach warned the market technicals were unfavorable. He cited Richard Russell’s Dow Theory letters, which argue that if industrial companies are doing well, then so should shipping and transportation companies. The Dow transportation index had its high at 5,618.25 last year, Gundlach said. But even though the S&P 500 reached a new high very recently, the transportation index is still below its prior high, indicating a non-conformation of the recent market rally.
Gundlach said investors should watch to see if the transportation index exceeds 5,618.25 in 2013. If that happens, and the industrial index reaches a new high as well, it would be a “bull buy sign.”
But if that fails to happen, he said, it would signal trouble ahead.
For now, Gundlach said US equities offer a poor risk-reward tradeoff, and he said investors stand to lose more in equities than in an intermediate-duration bond fund. He wants to see lower prices before US stocks become attractive.
Japan, China and other non-US markets
Gundlach’s distaste for US equities was offset by his enthusiasm for Japanese and Chinese stocks.
He acknowledged that the 26% rally in Japanese stocks since they reached their bottom made those stocks less attractive than when he called them his best high-conviction investment idea in December. They are probably due for a correction, he said, “but I love the Japanese stock market for long-term investment.”
Gundlach said the S&P 500 has grown 18-fold since 1979, but the Japanese market has gone up only fourfold.
He said going long the Japanese market and short the S&P 500 is a “great trade.” In the event of inflation, Gundlach said he was virtually certain the Japanese Nikkei would outperform the S&P 500.
The Shanghai stock market is similarly attractive, he said, adding that China may be able to avoid a hard landing in its economy.
“I would certainly own the Shanghai and the Nikkei in lieu of developed stock markets,” he said. He recommended a similar pair trade as he did for Japan – shorting the S&P 500 and going long the Shanghai.