David Rosenberg, Chief Economist & Strategist of Rosenberg Research, doesn’t believe in the sustainability of the stock market rally, and warns that investors may be disappointed at the end of the year. He is bullish on energy stocks - and predicts that the gold price will surge to $3000.
Mr. Rosenberg is also the author of Breakfast with Dave, a daily distillation of his economic and financial market insights.
"At this level, many things have to go optimally so that the prices are higher at the end of the year," comments David Rosenberg on the growing complacency among investors.
The renowned economist and strategist is one of the most profound experts on the U.S. economy and one of the last remaining skeptics to warn of a correction.
His bearish view is based on exorbitantly high equity valuations and over-optimistic earnings expectations. He also thinks that the US consumer sector is in worse shape than the consensus believes.
Rosenberg, who recently launched his own economic consulting firm, explains in this extensive interview with The Market/NZZ why he is pleasantly surprised by the phase one agreement between the United States and China, why the Federal Reserve's balance sheet is currently the most important determinant for the financial markets, and why he is betting on gold, Treasuries, energy stocks and emerging markets.
Mr. Rosenberg, after a strong start to the year, equity markets seem to be somewhat more hesitant recently. What’s your outlook for the coming months?
This is a liquidity and momentum driven market. It’s been that way for the past four months where the correlation between the S&P 500 and the Fed’s balance sheet has expanded to a 95% relationship. This is a case of a very accommodative Fed policy. The double-digit growth in the money supply is bypassing the real economy and has entered into asset markets broadly, and specifically into equities. So as long as the Fed is in the game priming the monetary pump, shorting stocks is going to be a very dangerous game to play.
How sustainable is this rally?
I’m not bullish. Valuations are at extreme levels and the level of complacency is also a red flag. There are needles in the haystack, but this overall market rally is more a house of straw than a house of brick. You can rent liquidity rallies, and you can rent them for an extended period of time, but they’re very difficult to own. This is not a fundamentally based bull market like in the 1980s and 1990s. Back then, gains in stocks where premised on much better demographics and much more solid productivity growth.
What are your main concerns regarding the U.S. economy?
There’s this view that we’re going to have either a growth stabilization globally or a re-acceleration of economic growth. I don’t see that in any leading indicator. I think there’s going to be a lagged response in the U.S. economy to the sharp slowing that we saw abroad. Remember, twelve years ago it was the rest of the world that ultimately followed the U.S. This time around, the U.S. will follow the rest of the world.
Then again, concerns of a U.S. recession have faded since last summer. Are we definitely out of the woods?
People will claim that there is no recession. Statistically speaking that’s true as far as GDP is concerned. But we know for a fact that we actually had a four-quarter earnings recession. I never quite understood why GDP is so important to an equity investor who is buying an earnings stream. There’s no ticker “GDP” on the New York Stock Exchange. So it’s not about the overall level of GDP, it’s really about earnings and about the fact that if you look at the 30% share of the U.S. economy that is outside of the consumer space, we actually have been in a recession in the past two quarters.
Why would you exclude the other 70% of the economy from an investor’s point of view?
As an equity strategist, you look at the stock market from a breadth perspective to gauge the overall health of the marketplace. You should do the same thing to examine the breadth of GDP. On a median basis, the U.S. economy has stopped growing three quarters ago. Also, the U.S. consumer is not as nearly in good shape as people think. We see signs that the labor market is starting to show some fatigue. Moreover, there is a big split between spending growth on discretionary and non-discretionary items where things don’t look as robust. We surely saw that not just in the latest retail sales report but also in the CPI numbers this week. If consumer demand was really that strong the underlying inflation rate would be accelerating not decelerating. The Fed would not be cutting interest rates three times and then re-extending its balance sheet at a rate that even exceeds what they were doing with QE3.
How stimulative is monetary policy right now?
The most important correlation to the stock market today is the Fed’s balance sheet. The power of the Fed has become so acute that it has replaced the economy as a principle influence over the stock market to the point where there is only a 7% correlation between GDP and the S&P 500. Historically, in any given cycle that relationship was anywhere between 30% and 70%. The amount of easing that the Fed has done since the beginning of October by expanding the balance sheet is just about as strong in terms of basis points as the three rate cuts they engineered last year. They have cut rates almost a 150 basis points when you look at it on an equivalent basis.
How are the financial markets going to react when the Fed tries to wind down its “Not-QE”-program?
A lot will depend on what the macroeconomic background looks like, especially what’s happening with earnings estimates. But we have a template of what happened when the Fed provided a lot of liquidity juice to the marketplace with the Y2K special lending facilities in late 1999. At that time, the market strongly surged, and kept on rallying into the early part of 2000. Then, the Fed started to withdraw that liquidity and it wasn’t a pretty picture.
Keep in mind that the recession didn’t start until March of 2001, even though the problems in the stock market and particularly in technology started about a year ahead of the economic downturn.
What do you think will happen this time?
It’s tough to time when the Fed is finally going to sit back and say: “Ok, you know what: I’m not handing any more candy to the kindergarten class”. My sense is that the response to the Fed no longer priming the pump could be significant. We could end up unwinding almost anything we saw since last October. That wouldn’t surprise me at all. It doesn’t necessarily bring you a 20% stock market correction, but it certainly could bring you a 10% pull back.
At what level will the S&P 500 trade at the end of the year?
I would be surprised if the market is higher than today. The question will be how much lower, because earnings are going to be very challenged to meet the double-digit growth forecast based on the consensus view. Earnings will disappoint this year and I don’t think we’re going to get another 4-point multiple expansion. The question also will be the extent to which companies continue on this path of share buybacks. The principal source of demand in the stock market have been the corporations themselves. There is a big disconnect between the dollar level of earnings and earnings per share. The share count has been driven down to the lowest level in two decades, and that’s providing the support on a per share basis.
On a positive note, the U.S. and China have finally signed the long-awaited trade agreement. What do you make out of this deal?
The deal preserves the U.S. bargaining “stick” in the form of tariffs remaining on $360 billion of goods imported from China. But investors do seem impressed with this ‘Phase One’ trade deal, which did end up addressing IP protection issues, forced technology transfer, and termination clauses/dispute resolutions if either party reneges. Even skeptics like me have to be open minded to the possibility that there is more to this agreement than met the eye initially. At a minimum, the hostilities appear to be behind us for now and President Trump does have something tangible to campaign on. But the trade war is not over despite rising hopes that this trade deal with China is going to open up a prolonged period of appeasement. In fact, this is a much broader economic war between two clashing ideologies.
It’s not much more than two weeks until the start of the Democratic primaries. To what degree are the U.S. elections going to impact the financial markets?
Most market participants think that Donald Trump has a lock on the November elections. He may well, but I don't think the odds are as close to a 100% as people think. There is going to be political risk in polling, and that’s going to inject more volatility into the marketplace.
What should investors do in this kind of environment?
I believe in Bob Farrell’s 10 Rules for investing. He was a legend at Merrill Lynch & Co. for several decades, and his first rule is that markets tend to return to the mean over time. Whether you’re looking at price/earnings, price/book or price/Ebitda, we’re pressing against the valuation levels we saw at the peaks back in 2000. So at this stage, a lot of things have to go right for the market to continue to appreciate until the end of the year. It can happen, but there is going to be bumps along the road. So to me, it’s less about buying the index. It’s more about identifying the sectors and subsectors that will hold up well in that sort of environment.
What’s your advice for a Swiss investor coping with deeply negative interest rates?
You want to be investing in things that are reversely correlated to negative interest rates. Firstly, as a Swiss investor or a European investor, I truly would want to be invested in bonds that have a positive yield and liquidity. That means you want to be in other countries’ fixed income markets where Central Banks have the capacity to ease monetary policy. The United States fits that bill. That’s why I’m still a big fan of Treasuries. I think the U.S. Treasury market will be a very good refuge.
Where else do you spot opportunities?
Gold is inversely correlated with either near zero rates, zero rates, or negative rates which makes it an ideal investment. Mark Twain coined the phrase "Lies, damned lies, and statistics". But the thing about charts is that they don’t lie. Gold went through a long-term, multi-year basing period. Now, it has broken out and the chart looks fantastic. Also, gold is no country’s liability. For example, in the United States M2 growth is running at double digits. So when you compare the new supply of gold against the supply of money coming into the system from Central Banks, to me it’s a very clear cut case that you want to have very high exposure to bullion.
You’re predicting that the gold price will surge to $3000 an ounce. What are the fundamentals your forecast is based on?
It’s just a matter of when, not if. Gold demand is predicated on the final act which is going to be right-out debt monetization. When we get to the lows of the next recession, we’re going to find that these Central Banks that already have been extremely aggressive are going to engage in what is otherwise known as the “debt jubilee” or a right-out debt monetization which was actually the final chapter of the Bernanke playbook. Remember, Ben Bernanke got his nickname “Helicopter Ben” because in a speech in 2002 he suggested that helicopter money could always be used to prevent deflation. So we’re going to have helicopter money.
That doesn’t sound very encouraging.
Would you ever have thought that, at or near the peak of this cycle interest rates would be at the lowest level since the 1500s? Just imagine what happens to monetary policy in the next downturn.
What do you think?
This debt morass has been the principal reason why - notwithstanding how wonderful the stock market has done - this has been the weakest global expansion on record. What happens in the next recession is that the cash flows to service that debt are going to become significantly impaired and we’re going to get a destabilizing default and delinquency cycle. I know, that sounds absolutely horrible, but we’ve hit the end of the road on negative interest rates, and we’ve really hit the end of the road on quantitative easing. So the Central Banks are going to go into a new, non-conventional toolkit called debt monetization. They will lose control of the monetary base and then we will go into a situation where, even with technology and with aging demographics in the industrialized world, we will be talking about inflation again. That might come in the next 18 to 24 months, and gold is going to skyrocket.
Do you also see attractive investments in the stock market?
There is not a lot of visibility in terms of earnings. But defense and aerospace is an area where the earnings surprises will be on the upside for the foreseeable future. So you want to participate in that. Every single country is raising its defense budget, and Donald Trump has successfully pressured his NATO allies to ramp up their military spending. For the first time in the post World War II area, we see Japan doing the same thing. We’re not talking about classic warfare. We’re really talking about defense technology and cybersecurity. It’s just like the chart of gold: Even though multiples in this sector have been re-rated because of the earnings visibility, this is a chart you want to buy.
What about opportunities from a value perspective?
The energy sector’s market capitalization relative to the overall stock market valuation is the lowest it’s ever been. We’re down to almost a 4% energy share of the S&P 500. That’s lower than it was when the oil price was $11 a barrel back in 1998. We will not all be sitting in driverless electric cars three years from now. Fossil fuels are not going to go away that quickly. At this stage, there is a very firm floor. The energy sector is nowhere close to being priced for where oil prices are right now and there is justification for why the oil price will remain close to where it is for an extended period of time. So in a world where practically every asset class from real estate to corporate credit to equities is extremely expensive, energy offers very deep value. At peaks of the cycle this is where you want to be buying.
Are there also promising investments globally?
Sticking to the concept of mean reversion, I want to be taking my profits out of growth and moving into value. Part and parcel of that is taking profits in the US and moving them into other markets that are a lot cheaper and that have lagged well behind. Emerging markets are inherently riskier, but the valuations are very compelling. Moreover, I expect the U.S. dollar to go down rather than go up which is an additional benefit for the emerging market space.
What countries should investors look at?
You can’t get much cheaper than Hong Kong. But there are other markets that look pretty attractive. I would say Korea is another market that you would be focusing on as well.
And how about countries in the developed world?
The most positive story is Japan. I continue to believe that Prime Minister Shinzō Abe has emerged as a transformational leader. There has been a positive re-rating of Japan’s secular growth rate as a result of his policies. The back of deflation has been broken by the Bank of Japan. So Japan is a market that’s under owned and relatively inexpensive. There is going to be a positive re-rating, not just in terms of Japan’s GDP growth rate. There are also nascent signs of an equity culture being developed that reminds me a lot of what happened in the U.S. in the early 1980s.