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Merk's Moves: A Bearish Outlook
08/14/2015 10:00 am EST
Axel Merk of Merk Investments is now bearish on the stock market, the most negative he has been since 2007; here, he offers his market outlook, explaining the reasoning behind his decision to begin establishing short positions . The commodities specialist is also recommending gold.
Steven Halpern: My guest today is Axel Merk of Merk Investments, which specializes in gold and currency funds. How are you doing today, Axel?
Axel Merk: Great, thank you.
Steven Halpern: Well, thank you for joining us. You’ve been growing increasingly concerned about the stock market over the past year. Could you walk us through your market outlook?
Axel Merk: Well, sure. The underlying theme is that the one thing central banks have achieved over the years of quantitative easing—or whatever you want to call it—is that they have taken fear out of the market. Technically speaking, they have compressed risk premium, so you see that very obviously in the junk bond market.
For example, bonds not yielding much more than Treasuries, but you also see it in the equity markets with volatility being low. When volatility’s low—the VIX index being low—that means that people don’t think that the market is risky anymore, and especially when it moves up, people pile into it not cognizant of these risks.
And the reason I’m growing increasingly concerned—the fundamental reason—is that as the Federal Reserve is trying to extricate itself from the policies, a lot of these things are going to happen in reverse.
That means the risk premiums are going to rise and that means—all else equal—stocks should be lower. Now, that’s just the underlying framework and there are lots of other parameters that make me increasingly concerned and think that the market is turning around now.
Steven Halpern: Now, from an investor’s psychology standpoint, as we alluded to earlier, low volatility and rising asset prices can create a risky situation. Could you expand on this and how concerned should investors be?
Axel Merk: Well, in my investment career, every single asset bubble was exactly accompanied by these symptoms. The tech bubble, as the price is rising, what can possibly go wrong?
Similar with the housing market. Similarly now, this is the sort of set up that you have, that people are chasing performance not cognizant of the risk, and of course, these assets are still risky and then it can "blow up in your face."
As an investment professional, I speak to lots of other professionals and I hear quite a few of them say that they are more invested in the market than they would like to be, but if they don’t they were losing clients.
Because clients, they are forgiving if you lose more money than the averages in a down market, but if you don’t keep up with the averages in a bull market, they crucify you. So, my view is that “every single body out there is currently invested in the stock market.”
Which conversely, of course, means that they’re willing to jump ship quite quickly. If you add to that, that we have lower liquidity in the market based on the increased regulations we have for participants and so forth.
I think the run for the exit could turn into a stampede and then, on top of that, of course, if you going to go away from the broader framework of what the Fed is doing, we see that companies are struggling to increase their revenue.
They do meet their earnings, but they meet the earnings with share buybacks. Now, keep in mind, those share buybacks become less attractive as interest rates go up because companies are borrowing money to get those share buybacks.
Also, think about PE ratios for example. PE ratios, historically, tend to widen—to increase—as rates go down, and conversely, as rates go up, there will be multiple compression.
Now, on the argument against that is many of these things are known and conversely, of course, the Fed is not expected to raise rates rather dramatically, but I see a bunch of other signs that this market is very, very tired and about to turn around.
Steven Halpern: In your latest market commentary, you note that it’s particularly difficult to time a market top, but nevertheless, the last time you were so negative on the market was in 2007. Do you see parallels there and what was your overall thought process in coming to this conclusion?
Axel Merk: Well, if you think about it, the time to take chips off the table is before a correction happens, before a crisis happens. Some people told investors at the end of 2008, “Oh, you should double down on your investments and you’ll make boatloads of money.”
And with hindsight, they were even right because the markets eventually, of course, recovered, but the point is that everybody has to invest according to their risk profile.
If you lose half of your assets in the market, odds are that you can afford to lose less, so recommending to double down, in my view, is irresponsible and so the time to take chips off the table is during good times.
In a classic setting, this means simple rebalancing and what investors should be doing, in my view anyway, or at least should be looking at, is that as the equity portion of the portfolio has come up, you may want to take chips off the table.
Now, the question, of course, where on earth do you put this thing because do you like bonds, do you like cash, do you like—what is that you put it in—but what investors have been saying is that, "Well, I need to get yield. I don’t get yield here so I stay in the markets."
It is clearly very, very difficult to time these pops, but from my point of view, just as when one is trying to increase investments, cost averaging is a good idea.
Similarly, when you take money out of the market, it is also, in my view, a good idea to rather error on the side of being early, I have just come to a stage where I have not just started money out of the market, but I’m at a stage where I’ve started to actually short the market.
Steven Halpern: Now, in your short positions, are there any particular stocks or sectors that you could comment on?
Axel Merk: Well, two things. First, I generally don’t like to comment on specific stocks, but more importantly, at this stage, I’m doing it with a broad brush. I’m just shorting the market as a whole.
I’m very much exploring to go after individual stocks, and then ultimately, of course, if one were to have the time to do it, that would be the right thing to do and I actually know how I would approach it.
Having said that, as you may be aware, our specialty is currencies and precious metals. Now some people might wonder, what the heck is a currency and a gold guy talking about the stock market. Well, a fundamental piece of work as part of the research in the currencies markets is to look at shifting risk sentiment, at shifting correlations.
Looking at the underlying dynamics within the markets and the ultimate risk market—the stock market—is an extremely relevant component in that and so I’ve also come from that perspective, thinking that the stock market has to tumble.
Now, keep in mind, by the way, one thing that people might not be aware of, some people say, "Oh, when the stock market falls, there’s a flight to safety," and safety being “the US dollar,” aside from Treasuries.
Well, over the last year, the market has been...the dollar has been rallying on the risk-on environment. When the sentiment was positive, the dollar was rallying.
A conversely, now as I think the market is falling—and we’ve seen that numerous times when we’ve had a decline of the stock market—the dollar is not rallying when the market is tumbling and so it’s just a reminder that every market is a little bit different.
By the way, the reason that is the case is because people have been borrowing money in euros because the rates are lower and as people are retreating from the markets, while they have to buy back the euro in that scenario, the euro’s actually benefiting from those set of environments.
So we get all kinds of quirks here and so I play these things more specifically in the currency market but, as far as the equity market is concerned, I just initiated a short position in the market.
Obviously, I can’t say what I’m going to do tomorrow, but my plan is that should these markets rally further, to potentially further increase that short position.
Steven Halpern: Now you’re well known as a leading expert in the gold market, and in this environment, you are looking at some gold miners as long opportunities. Would you be kind enough to share some names?
Axel Merk: I’m not going to give you specific names but let me just give you a few kinds of general points on what’s happening here. First of all, gold, to consider something as a diversifier in a portfolio, you want to have kind of two key attributes.
One is you want a low correlation to what else you have in your portfolio, and the other one, you want to have a return positive return expectation over the medium-term of whatever your time horizon might be, and so gold, I think most people agree that, over the medium- to a long-term has a low correlation to other asset classes.
The one thing people have a problem is with the outlook of gold going forward. When you go back to history, historically gold has performed quite well, at least over longer periods, but people are always reluctant to say well, what is going to do tomorrow and especially, are we going to raise interest rates so why on earth should gold be doing well?
I’d like to remind people that the Fed is all but promising to be behind a curve. That’s my interpretation when the Fed says that even as employment and inflation goes back to what’s historically considered normal there will be rates that are less than what’s considered normal.
So that’s just as a background here, and long-term, by the way, I don’t think we can afford positive real interest rates—meaning interest rates after inflation—in a decade from now, either in the US, Europe, or Japan, and so that’s why I like gold in general and everybody hates gold—everybody—I say that because it’s quite out of favor and everybody loves stocks.
Again, it’s certainly not everybody but that’s kind of the sentiment and one other reason why I think investors may want to look at it and so why I have gold in general.
Now, the miners, when we have the boom in gold, the miners were lagging quite a bit and the reason was that every gold mining company tried to get the most amount of gold at just about any cost. Everybody wanted to have a piece of the pie, taxes were going higher, the employees wanted to have higher wages.
On top of that, it is very energy intensive to mine gold, for example, and what has changed now is that miners have gotten extremely cost conscious and, at the same time, they valued many of them at levels below they were valued in 2008.
Keep in mind that miners, many of them are very credit dependent—especially juniors—and so you want to be careful about that when credit environments tighten, so I happen to focus more on the bigger ones.
I can’t give specific stock recommendations and clearly the dynamics here in mining are far more volatile than anywhere else. I happen to like it because they’re extremely out of favor, and so while I’m short stocks in general, I recently bought some miner shares.
Steven Halpern: Again, our guest is Axel Merk of Merk Investments. Thank you for a fascinating discussion.
Axel Merk: My pleasure.
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