Don’t buy stocks – for real, this time. That was the message Jeffrey Gundlach delivered to investors last Tuesday.
Among riskier asset classes, only equities have performed well since February 14, the date of Gundlach’s previous remarks to investors, during which he advised investors in his Doubleline funds to avoid those assets – Including equities. In his most recent conference call with investors last Tuesday, he reiterated that forecast, this time singling out equities in particular.
“I really think we are not going to be making money on stocks bought at this level,” he said.
Gundlach identified two “triggers” that could set off a decline in stock prices – a worsening of the fiscal crisis in Europe and the ongoing inability to confront debt problems here at home, regardless of who is elected president this fall.
Gundlach, who is the founder and chief investment officer of DoubleLine Capital, titled his remarks to investors “To QE3 or not QE3 – That is the Question.” A quote from Shakespeare accompanied each slide in his talk, all of which are available here.
I’ll review Gundlach’s concerns about the equity market, but first let’s look his forecast for monetary policy and interest rates.
Expect the Fed to act aggressively and rates to be stable
The title of Gundlach’s talk points to the recurring question of whether the Fed will engage in further quantitative easing. But that question, Gundlach said, has already been answered.
“We are already doing QE3,” he said, through the Fed’s bond-buying program called Operation Twist. He called that action a “risk party” – a Fed policy designed to incent investors to move into riskier asset classes – including equities.
The Fed has achieved its goal. Each episode of quantitative easing has moved equities to higher prices, and when those measures stopped, prices declined:
The more important question, he said, is if the Fed throws another such risk party, will anyone show up? A monetary easing by the Fed that fails to have its desired effect represents the “real downside case” that Gundlach and his team at Doubleline fear, and it underlies the conservative positions of his funds. For example, his Total Return fund currently has 20% in cash.
Gundlach, though, is confident the Fed will act aggressively to stem a potential economic decline. “We believe at Doubleline that the Fed stands ready to do whatever you want to call the stimulus” if nominal GDP growth threatens to go negative, he said.
The danger of rising rates is not imminent, according to Gundlach. He said the current environment is dominated by stable rates. “They may rise over the long term,” he said, “but the Fed cannot even think about a preemptive strike on inflation, given the deficit problem.”
He said it would be “insanity” if the Fed were to raise rates, because it would suppress income in nominal terms. Such a move would increase the government’s borrowing costs and shortchange its ability to service debt.
“I don't think the Fed tightens unless inflation comes in at 4% and looks like it is headed to 5%,” he said, “because that is the only way you could really think about servicing your debt. I don't think that's going to happen.”
The outlook for equities
When managing across multiple asset classes, as Doubleline’s does in its Multi-Asset Growth Fund, Gundlach said investors will make 80% of their money 20% of the time.
“It is all about buying in at opportunity points,” he said. “We are not terribly fond of the opportunity point.” Indeed, Gundlach’s criterion for putting “big money” into US equities is that P/E ratios must be in single digits on major indices. That last happened in March of 2009, when Gundlach was a strong advocate for equities.
He said that the S&P is at a “high level.” That may bode well for the economy, Gundlach said, but the reverse is not true. When positive economic data are released, they are typically already priced into the market.
“Can one desire too much of a good thing?” Shakespeare asked in As You Like It. The answer is “yes,” Gundlach said, because when fiscal stimulus measures end, investors should expect weakness in various asset classes, including stocks.
Fiscal pressures are one of two triggers Gundlach said could send stock prices lower. He chided the government for failing to heed Shakespeare’s advice to “neither a borrower nor a lender be.” The government, he said, has borrowed in order to support household incomes. Since 2008, real personal disposable income has been holding steady, Gundlach said. But once you take out transfer payments – funded through stimulus measures – it has declined.
“I am absolutely convinced that this cannot be a long-term strategy,” he said. The government is engaged in a “failed scheme” to use debt for non-productive purposes like transfer payments, while it has been neglecting public investment.
A very ugly election season could lead investors to conclude that neither candidate offers viable solutions to those fiscal problems, according to Gundlach. Neither an “austerity program” under Romney nor a “tax program” under another Obama administration is likely to please the market.
Obama’s side comment to Russian president Dmitry Medvedev that he would be “more flexible” after the election was “scary,” Gundlach said, because it could apply to economic matters as well – such as the potential for tax increases.
Gundlach returned to a theme he has presented in the past – the tension between the “taxes are too darn low” and the “spending is too darn high” advocates. He presented a chart which appeared recently in the New York Times:
It shows that, since 1950, the effective tax rate (reflecting ordinary income, payroll taxes, estate and other taxes) for the top 0.01% of the population has declined from 71.4% to 34.2%. The top 0.1% and 1% have benefited from similar but smaller percentage declines. Taxes increased only for the second and middle quintiles, albeit very modestly.
Those data support the rhetoric coming from the Obama team. “It sure looks good for the taxes are too darn low party,” Gundlach said. Gundlach said that Treasury Secretary Tim Geithner presented data similar to the chart above in a recent 60 Minutes appearance.
For the top 1%, Gundlach offered this warning from Shakespeare (Julius Caesar, act three, scene two): “If you have tears, be prepared to shed them now.”
The other potential trigger to an equity decline is fear over Europe, Gundlach said. “The situation in Europe is getting much worse much faster than people had hoped,” he said. He called the recent LTRO financing program a “scam” that, at best, might forestall problems in the short term.
Gundlach said that Spain’s fiscal situation is much worse than its bond market reflects. In Cymbeline, Shakespeare wrote that “fortune brings in some boats that are not steered,” and Gundlach said that the Spanish “boat” is not steered, as its interest rates of roughly 5% reflect. Those rates, he said, are “absolutely inappropriate relative to the risk of the haircut that we have already seen in Greece.”
Central bank policies have not been strong enough to avert a crisis, according to Gundlach. “Is the central bank really steering anything, or are they just shoveling money into markets?” he asked. The answer, he said, seems to be the latter.
Read more articles by Robert Huebscher
