Fabian: Interview with the Prudent Bear
04/25/2003 12:00 am EST
Bullishness is widespread; in fact, Mark Hulbert (The Hulbert Financial Digest) reports "that he has never seen such a huge shift of sentiment as happened between March 10 and April 10...when his index of 50 leading market timers went from an average equity exposure of minus 19%--indicating extreme bearishness--to plus 46%, an indication of remarkable bullishness. One advisor that hasn't been shifting to the buy side is Doug Fabian, editor of Successful Investing. Doug has been successfully moving mutual fund investors in and out of stocks and bonds for some 26 years.
In his latest editor’s overview, Fabian says, "So many advisors and money managers are awaiting the return of the bull market. Each newsletter I read, every forecast I see, and every broadcast I hear from the Wall Street establishment describes a future turnaround for the market. All of them envision a healthy, growing economy just around the corner, just another rate cut away. Analysts are still predicting the future earnings of companies months and sometimes years in advance. This advice has been consistent for three years and has caused trillions of dollars in losses. Very little is being said about the potential for a prolonged, secular bear market.
"I truly believe that there is the potential for tough times ahead. I don't want this to happen, but as a realist I recognize the potential for things to go wrong from here. I believe we have entered a new economic environment that comes with risk and opportunity. We have responded by implementing new tools and strategies that allow us to profit during short-term rises and renewed declines. A new era in trending has begun, one that may be very different from the past. We will always be prepared for the return of a bull market. In fact, most of our history and track record was built on bulls, but we are aware that the world has changed. Terrorism, war, oil prices, deflation, or inflation are all factors that may influence historical cycles, and we must be prepared for new and different opportunities to profit. We have positive returns on all our recommended bear funds while the market has lost ground. We are not alone in our advice to stay away from stocks. Even Warren Buffett has told investors that no bargains exist in this market.
Fabian recently has the chance to interview David Tice, portfolio manager of the Prudent Bear Fund . Says Doug, "Tice’s macro-economic views may be surprising to some, but his track record in this bear market is outstanding. I recently spoke to the fund manager of the Prudent Bear Fund, about the state of the economy and stock market as well as his fund’s success as one of the top performers of 2002, (and my current recommendation for conservative bearish investors). His answers are sure to provoke thought, and hopefully, action for those of you not quite comfortable following a shorting strategy."
Doug:How do you view the current state of the economy? A lot of people feel that with the NASDAQ down 70% and the S&P 500 down 45%, we’ve got to be close to a market bottom.
David:I think there are more people looking at numerology than they are stock market history. They’re assuming that just because we’ve had three straight years of market decline that we can’t have four. People are underestimating the extent of this bubble and the degree to which our policy-makers perpetuated it. There’s a direct correlation between excesses that were created in the prior boom and the magnitude of subsequent declines. This goes for the economy as well as the stock market, and, of course, they are terribly interrelated.
Doug:Do you think we’re headed for a double dip recession?
David:Yes we are. I think it’s baked in the cake. We’ve had decent growth in the last year because we’ve had autos and housing drive this thing with incredible financing. We’ve created up to $940 billion annualized new mortgage credit in the third quarter of 2002 compared to $307 billion in 1997. We’ve taken $130 billion cash out mortgages in the last 18 months. There’s no wonder there have been stumbles in the economy. Look at real estate prices, they’re up 20% year-to-year in California and Long Island. We’re lending money on cars at an incredible pace and rate. The average new car loan recently was 58 months with a 2.75% interest rate and 96% loan-to-value. We’re using financial gimmickry to keep factories open and people employed, but it’s almost Enron-style accounting.
Doug:Would you comment on who you think is responsible for this mess and how we got into it in the first place?
David:The Federal Reserve is at fault first in my opinion. Alan Greenspan saw the light in 1996 when he talked about irrational exuberance. The whole economic profession shares a great deal of blame. They don’t understand asset inflation; if you create credit too fast either you create asset inflation or you create goods and services inflation. Sure, real estate prices go up, stocks go up, but it creates even greater excesses resulting in negative savings rates, record amounts of corporate and personal debt and you create an economy that is largely geared toward luxury consumption. All the great depressions and severe recessions have typically followed asset problems. It’s sad that conventional economists follow a ‘thou shalt print money to get out of any bind until the CPI crosses 3%,’ rule, and that’s the extent of our economic wisdom today.
Doug:The market hit its lows Oct. 9, 2002, then posted an impressive rally. We have since given back half of those gains. Where do you see the market right now?
David:It’s an unpredictable current environment because of the war issue. We don’t think technology is coming back; you’ve got Intel making the same money today as it did seven years ago; we’ve got excess telecomm capacity, people aren’t buying new cell phones like they used to. In the short-term, it’s possible the market could go up for a while, but we think this is a secular bear market. These rallies should be sold instead of bought. War lends a great deal to uncertainty. I think the price of oil could go to $60 or $70 (a barrel) quickly. Wars are complicated and Saddam is not stupid. It’s likely to be a lot uglier than we think; even if it goes well, we still have a horrible excess asset problem.
Doug:Do you still believe the market is overvalued?
David:This market is selling at about 28 times earnings on the S&P 500; that’s very expensive. Individual investors need to recognize how Wall Street is trying to keep Main Street in the game. I would not be making a market judgment based on P/Es, on Wall Street’s earning estimates. The consumer has been kept alive due to credit excess in autos and housing. People don’t realize that in 1929 the market peaked at 12 times its earnings. At the end of secular bear markets, earnings go down for a long time. People forget the relationship between capital expenditure booms and over-capacity.
Doug:What would be reasonable P/E ratios, those that might signify that we’re getting close to the end of the bear market?
David:The average P/E is 15 or so, with bear markets ending closer to ten or 12. Some people argue that this one is the biggest bears of all time and that we should have a lower than average bear market P/E, or that P/Es should be adjusted because of low interest rates. Low interest rates occur at the end of asset bubbles, like the 1920s bubble here and the Japanese bubble in the late 1980s when the Nikkei went from 40,000 to 8,000 in 1989.
Doug:What are going to be the street signs of a market bottom?
David:You can’t have a bear market end with $1.63 trillion of equity inflows from 1990 to 2001. Last year, 2002, was the first year of outflows, with just $10 billion leaving the market. People may not be opening statements, but no one has sold yet. Investors need to be panicking and not wanting to hear about stocks anymore. The economy will worsen, with higher unemployment and a prevailing ‘I give-up’ mentality.
Doug:How is the housing bubble going to impact where we go from here?
David:We’ve gone from one bubble to the next to create credit excess. In 1998-99, we created the telecom, Internet, and NASDAQ bubble, which, in turn, created a lot more spending. Now the mortgage business is unprecedented. It’s the biggest bubble yet. The way bubbles work is that credit excess runs rampant when they’re close to bursting. We’re loaning people $500,000 for $400,000 houses; we’re at a 30-year high in foreclosures, with an 11.5% rate in FHA delinquencies. If you have home prices rising, then lend money based on comp sales in the neighborhood, prices will go up for awhile. But, eventually you will have a sick economy where you have consumers and borrowers losing jobs, income growth stagnating, and more homes going up for sale. It’s just a matter of time, in our opinion, that this slowdown and decline in income growth will result in more sellers than buyers. Prices will start to come down, and there’ll be hell to pay.
Doug:What will ultimately make this housing bubble visible to the consumer?
David:When there are more sellers than buyers and the unemployment lines grow longer. The consumer has managed to hang around, taking a ‘we’ll be all right if we all hold hands and buy another SUV,’ approach; aka, the ‘don’t worry, be happy’ school. People will begin to realize this economy is setting up for a double dip recession, and look around, not knowing whom they can trust. After all, the economists were saying that everything was going to be OK. But as more people lose jobs, problems will first creep up in the world of consumer finance, followed by an increase in for sale signs and credit delinquencies.
Doug:How did the Prudent Bear Fund perform so well in 2002, with 62% gains compared to -23% in the S&P 500?
David:We were short stocks and long gold (with a number of gold mining companies that did very well) and played the technology stocks pretty well. We were also able to be a little more defensive in the rallies and didn’t give back as much as in past years, cutting back our exposure to high risk names and utilizing put options effectively.
Doug: How is the Prudent Bear Fund’s portfolio positioned today in 2003, compared to the final quarter of 2002?
David:We have fewer gold stocks than before, but we’re getting ready to get back in that race. We’re still a little defensive because we don’t need to take quite as much risk on the short side when we have gold long working for us. Tech looks like a good move from a tactical standpoint, but we don’t want to be too early or too macho there.
Doug:Do you believe we’re in the beginning of a bull market in gold?
David:Yes, we believe very strongly that we are. Gold does well in bad deflationary depressions as well as in inflationary circumstances. If you’re not sure you’re going to be paid back by Ford Credit or GMAC or Fannie Mae, where do you go? Gold is one asset that is not someone’s liability. Gold does well in bad economic times as well as when there’s debt deflation. The Prudent Bear Fund is currently long gold 14%, but has been as high as 20% in the past.
Doug:What percentage is the portfolio short and what specific industries are you shorting?
David:Right now, we’ve got a 65% gross short position We’re shorting some big technology companies, financials, consumer lenders, banks, Fannie Mae, Freddie Mac, fraudulent smaller companies, energy stocks that have been involved in aggressive projects, and companies dependent on consumer spending.
Doug:How do you convince those perennially long investors that they can confidently invest in your fund and that you will react to change?
David:We are going to be mostly short for some time because we feel this is secular bear market. We will try to be more tactical and avoid big losses during rallies, but we are still going to stay more short than long. Eventually we will go long, but it’s hard to say what decline will warrant doing so. When we do go long, we’ll change our name to the Prudent Bull Fund. I won’t be a short seller forever. But we understand the economy about as well as anyone, and my two strategists think a recovery could take quite a while. This bear will probably be longer than we think."