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THE DOW JONES BUSINESS AND FINANCIAL WEEKLY
www.barrons.com
JUNE 4, 2007
$4.00
Interview With Steven Leuthold
Chief investment strategist, Leuthold Group
Downshifting Into Neutral on Stocks
by Sandra Ward
ALL IT TOOK WAS AN E-MAIL ALERT FROM
the folks at Leuthold Group informing us
their major trend index, which takes the
pulse of all sorts of market measures, had
slipped to neutral after deteriorating from
a peak in mid-March. That gave us a good
excuse to check in with the grand poobah
of the renowned Minneapolis research
and money-management outfit to see
which way the investment winds are blowing. Gas prices be damned, what better
way to kick off Memorial Day weekend
than by paying a visit to Leuthold at his
summer home on the Maine coast and
hearing what’s on his mind.
Barron’s: A year ago, you and I were discussing how a new bear market might
have just begun. It hadn’t. Now where do
we stand?
But your work on market trends is flashing
a warning sign again.
Our market work remained positive, on
balance, until a few weeks ago, when it
downshifted to neutral. We’ve got 180
components in the major trend index and
what has caused it to shift has been an
acceleration of inflation, in commodity
prices, and the very recent increase in
rates. That’s occurring against the back-
“It looks like maybe the consumer, for the first time in my lifetime,
might actually be tapped out. I’m not expecting a new secular bear
market…But we certainly could see a 25% to 30% correction.”
drop of an economic expansion that is
long in the tooth by post-World War II
standards of duration and magnitude.
This cyclical bull market has now run
about 14 months longer than the typical
cyclical bull market. The S&P 500 is up
95% from trough to peak, versus an average of 80% [see chart on facing page]. As
a result, we’ve moved to neutral. We are
50% in equities, compared with 70% at the
first of the year.
Steve Leuthold
How do you balance this with the flood of
liquidity that keeps coming into the market? Is that a factor in the major trend
index?
I went back through our Green Book and
read what I wrote in 1987.
Why ’87?
Because we also turned negative in 1987
prematurely, about two or three months
prematurely, and people thought we didn’t recognize a new era of valuations. The
(over please)
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Kevin Brusie for Barron’s
Leuthold: Our disciplines turned negative
a year ago and we became defensive and
moved our asset allocation down to 30% in
equities and we stayed with that for about
3µ months. We got back into the market
when our indexes improved. The original
signal was a false alarm. It’s the price you
pay sometimes for being defensive. Our
whole credo is making it and keeping it,
and we try to get out of the way if we
think we’re headed for trouble. It was
premature and, in retrospect, it was
wrong.
“Private equity isn’t going to sink the stock market. The negative stuff is going to come
when, down the road, private capital attempts to regurgitate these companies and sell
them back to the public after they have stripped all the assets out of them.”
two things Wall Street was talking about
to support the market before the terrible
October decline was the huge amount of
liquidity and the big shrink in equities.
Then liquidity was coming from Japan
because Japanese brokers had started
selling U.S. stocks. The big equity shrink
was partly the result of LBOs, but mostly from companies buying back their own
stock. There were other parallels.
Breadth was deteriorating and investors
were gravitating to big-cap stocks from
small-cap stocks. There was an acceleration of inflation, which we are seeing now.
There was an acceleration of interest
rates, and the market kept going up in
the face of higher rates, although, back
then, the rise in rates was greater. There
were a lot of similarities.
There was also a real-estate boom.
Yes, there was. More to the point, though,
this is an old market. It is mature by historical standards since World War II.
We’ve had two economic expansions of 8
and 10 years under Reagan and Clinton,
and people have come to believe that
those are normal. But the average economic expansion has actually been about
five years since World War II.
Here we are at five years from 2002.
In terms of magnitude, the cyclical bull
market has overshot.
the 81st percentile, so it’s modestly overvalued. We are starting to see a shift
where large-caps are winning by a small
margin over small- and mid-caps. That is
also typical of what we saw in 1987.
What about sentiment?
What happened then philosophically was
also very much like what might be happening today. At the end of 1986, institutions thought the market was overvalued
and they became cautious. Then the market had a big move up in January 1987
and people were sitting there with defensive positions and thought, “Uh-oh, the
market is going up.” And it kept going up.
Finally, there was a point of capitulation
as managers who were lagging behind the
S&P 500 and their peers threw in the
towel and bought stocks. We haven’t seen
that happen yet this time around. We
could see it happen pretty soon. We’ve
already seen it happen with the hedge
funds, which, if you look at the ISI
Group’s numbers, are about as long as
they could get.
A Bigger, Stronger Bull
This market’s rise has lasted much longer and gone
much further than most since World War II,
suggesting that it might lose steam before long.
Bull Market Duration Bull Market Magnitude
(Months)
You mentioned all the similarities to ’87.
What’s different today?
The valuation level in the S&P 500 is not
as extended as it was back then. Then it
was selling at 20 times earnings, now it’s
selling at 15µ-16 times current earnings.
But if you normalize the earnings, we may
be looking at peak earnings for the S&P
or very close. Also, the S&P is much
cheaper than almost any other aspect of
the market.
By our estimation, were the S&P to go
back to median valuation levels, it would
decline about 13% from current levels.
But mid-caps and small-caps would
decline about 25% or 30% because the universe of 3,000 stocks we cover in those
categories are in the 97th percentile of
valuations historically and at about 21µ
times normalized earnings. In terms of
normalized earnings, the S&P 500 is in
95%
55
80%
36
Post WWII Median
From October 2002 Low
Source: The Leuthold Group
What about the public?
The public isn’t participating. Net inflow
into U.S.-focused equity funds this year is
about $16 billion. That sounds like a lot of
money, but a year ago, at this same time,
it was $38 billion-$39 billion. We are seeing the market making new highs and yet
there have been weeks of net redemptions.
Are they still going overseas?
They are. Net inflows into foreign funds,
as of a few weeks ago, was about $69 bil-
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lion, compared to the $16 billion into U.S.
funds. It is performance-chasing. One
thing you can bet on is that when we get
to extremes, the public is going to be
wrong. One of the few bullish sentiment
factors in this U.S. market is that the
public has not come in. The question is
whether they will.
We’re approaching the 10th anniversary of
the big Asian financial crisis. Any thoughts
about whether we are going to find ourselves in a similar situation?
It is possible. We still have 8% in foreign
markets, and it’s all in emerging markets.
That had been as high as 15% a couple of
years ago, then we moved it to about 6%
and since the first of the year we’ve been
slightly increasing it. Our biggest single
position is 2% in China. I ask myself
every day if this parabolic advance in the
Chinese market is the end of the road.
Right now, we don’t think so, but
maybe as we get closer to the 2008 summer Olympics, the market will begin to
discount a correction. We just did a study
on stock multiples of companies with more
than $1 billion in market value in China
and the average is 32 or 33 times earnings, whereas in Japan they were 42 to 43
times earnings at the 1989 peak. But I
don’t think there is any way that China is
going to quit investing in dollar-denominated securities, though they could allocate more to euro- or even yen-denominated securities or maybe other currencies in the Middle East. But unless the
U.S. is stupid enough to raise a major
threat of restricting or taxing imports,
which it looks like some politicians would
like to do, there will be peace until after
the Olympics, and we are not likely to see
some type of a trade war.
What’s the impact on U.S. companies?
A trade war could really hurt when you
consider that about 48% of the earnings in
the S&P 500 come from foreign operations. The long-term average of up-todown earnings, from 1984 to date, is 1.68.
Today, with 90% of our earnings, the current up-to-down ratio is 1.16. The only
times we’ve seen it lower than that was in
the past two recessions. That is kind of
scary. It shows the breadth of earnings
advances is being focused more and more
in the large-cap stocks. They are the 3Ms
(Ticker: MMM), the Intels (INTC) and
the Dells (DELL) that have big foreign
operations and are global.
There seems to be quite a few instances
of “only-in-a-recession” data coming out.
We are going to see two quarters of negative GDP by the time we get to mid2008, which would be the official definition of a recession. Earnings may not
reflect that because we have exported so
much of the labor function. But it looks
like maybe the consumer, for the first
time in my lifetime, might actually be
tapped out. I’m not expecting any huge
decline or a new secular bear market or
anything like that. But we certainly could
see a 25% to 30% kind of a correction,
which would be a normal cyclical bear
market. That’s my opinion, but as I have
often said, our numbers are more reliable
than our opinion and right now our numbers are neutral.
What influence are hedge funds and private equity exerting on the market?
Our preliminary numbers show the price
private-equity firms are paying to buy out
companies is 33% to 40% higher than a
year ago, based on cash flow. And everybody and his brother is running screens
as to who the next likely leveraged-buyout candidate will be. It turns out everything is an LBO candidate. There has
never been any kind of a technique,
including any kind of portfolio management, that can’t be defeated as an effective strategy by too much money and
that’s exactly what we are seeing happen.
But the fallout in the stock market probably is going to be quite a long way away.
I don’t think private equity is going to be
the thing that sinks the stock market.
The negative stuff is going to come when
two years or three years or four years
down the road, private capital attempts to
regurgitate these companies and sell
them back to the public after they have
stripped all the assets out of them or
taken their big dividends and so on and
so forth.
Let’s talk about interest rates. Recently,
rates started rising to levels that made a
lot of people sit up and take notice.
The 30-year went up to 5.01%. The 10year went to 4.90%, temporarily. They
are probably going to go higher. The reason they are going higher is that we have
to be competitive in the rates we are paying, because rates are going up in
Germany and the U.K. It is very weird
because at the same time you are looking
at T-bill rates going down and the spread
between T-bills and the Fed funds is very
wide now. But it has reversed the inversion of the yield curve, which a lot of people point to as being a positive thing,
because they are scared of that inversion.
The inversion itself isn’t negative but we
are seeing higher longer-term rates
building. I think we’ll get to 5.60% on the
long bond.
In how long?
Within six months. What that does is put
another strain on the whole housing
industry because it has a direct impact on
mortgage rates, especially since they
have curtailed the interest-only mortgages and the “liar’s loans.” People’s
mortgage payments are going to be higher, and that is going to hurt the sales of
new houses, probably.
Steve, where are you looking to make
profits from this market?
We should focus on foreign markets
because there is intrinsically stronger
growth there. The U.S. is a mature economy. The emerging countries are not. I
am not sure China is the place to go.
There are some other emerging markets
like Korea, which is a lot cheaper, that
may make a lot more sense.
Thanks, Steve. n
Leuthold Funds, Inc.
The opinions expressed within this article are those of Steve Leuthold and The Leuthold Group, L.L.C.,
and are subject to change without notice.
Investors should consider the investment objectives, risks, charges and expenses of the investment company
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Prospectus, call toll-free, 1-800-273-6886, or download from our web site: www.LeutholdFunds.com. Please
read the Prospectus carefully before you invest.
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Distributor: Rafferty Capital Markets, LLC Garden City, NY 11530
06-11-2007
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