Gary Shilling is president of A. Gary Shilling & Co., author of The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation and a Forbes columnist. I recently sat down with Shilling to discuss why he is long treasuries, wary of the stock market and how bee-keeping helps his investments. Video and a transcript of our conversation follows.
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Steve Forbes: Gary, good to have you back. Your record has been phenomenal. I think you're about the only person I know who has consistently, for years, said, "Be in treasuries and you'll do better than the market." And indeed that has been the case.
Gary Shilling: Thirty-two years now, Steve. Since 1981.
Forbes: Well, we'll ask you in a minute about when you think that string may play out. But you make a couple of references. One is the age of a deleveraging and the other is the great disconnect you see right now. First, give us quickly the age of deleveraging and what that means for economies and for equity markets.
Shilling: We are in a age of deleveraging, in the fact that all the financial leverage that was built up in the financial sector and the global basis and U.S. consumers is now being reversed. And the leveraging up is when people went from 20% down on a mortgage to 5% to 0%.
The leveraging is up when the Bear Stearns and Lehmans of the world — before they carried them out — went from ten times leverage to 20 times leverage. Now is being reversed on a global basis. What it means is we're about five years into this process, and I think we private have about another five years to run. And that would make the usual decade of deleveraging after a major financial crisis.
During that time you can expect a continuation of slow growth here and abroad. We're looking for about 2% real GDP growth in this country and probably not much more in any other country in the world. As far as the grand disconnect, as I call it, this is the difference between the economies of the world, which are limping along at best, and Europe is in recession, U.K.'s in recession, Japan's in recession, China has had a big slowdown in growth. The U.S. economy I think is limping along.
The big difference between that and investor enthusiasm over central bank ease, investors are saying, "I couldn't care less about the economies on the ground, as long as the central banks are shoving money out the door. Don't fight the Fed,” is the sort of thing. So they are out there buying stocks and all kinds of low-grade securities as a result.
Forbes: Well, let's first talk about the age of deleveraging. What are the precedents? What periods have we gone through in the past of deleveraging? And what are the metrics you use to decide we're over-leveraged or that this debt is sustainable, so to speak?
Shilling: Well, of course we went through immense deleveraging in the 1930's after huge leveraging up in the 1920's. The 1920s were an era of big financial leverage. It was the first time that consumers were borrowing heavily. And that's because the new technologies in the '20s, electrification of homes and factories, brought with it all the appliances.
And, of course, mass-produced automobiles came in in the '20s. So that's when GM got into the consumer finance business, to finance cars, and GE to finance appliances. You had this huge leveraging up in the consumer area and the financial area, stock market booming. Then the 1930's was a fairly dramatic period of deleveraging.
How do you measure when you get back to normal? Well, we look at the cumulative outside net financing of the major sectors of the U.S. economy: the non-financial corporate sector, the financial sector, the state and local governments, the federal government sector and consumer sectors. When you look at those cumulative net outside financing, in relation to GDP, you see that they're fairly flat over time.
But then, starting in the '70s, in the case of financial sector, and in the early '80s, for consumers, they had this huge leveraging up. And so you say, "Well, they're coming down. How long will it take them to get back to norm?" Now if you actually just trace out the lines, it'll take more than five years. But I'm saying another five years because that, in combination with the five we already have, is about the normal decade after a major financial crisis, to get the leverage wrung out of the system.
Forbes: Talking about the consumer, from your studies of history, what's a proper level of indebtedness overall?
Shilling: Well, consumer debt is a very interesting pattern. It started very low after World War II. Everybody was still in a recession mode. There wasn't much you could buy that you could finance then. You couldn't buy cars and washing machines in the '30s. People couldn't afford them in the war years.
But basically consumer borrowing, and that's all borrowing, mortgage borrowing, credit cards, auto loans and now student loans have become big. If you look at that, in relation to after-tax income, the norm was about 65%. It ran up to 131%. We're now back to still over about 109%. We're still on the high side.
I'm a great believer in reversion to norm. I think that we're going to go back to those debt levels. At the same time, the flip side of that is saving. How much do people save out of their ongoing incomes? And that, back in the early '80s, was 12%. It got down to less than 1%. I think it's probably going to go back to double digits because, among things, the post-war babies have not saved. They've been lousy savers. And they need to save. They're facing retirement in the teeth. They don't have the tuition payments for their kids, by and large. And a lot of them are in their peak career earnings years, in their 50's and so on, where they can save.
So there are a number of factors. People no longer have the home equity to pull out of their houses. They don't trust their stock portfolios. I think there are a lot of reasons that people are going to not only work down debt but increase their saving.
Forbes: Can you both deliver and grow at the same time?
Shilling: Good point. You can grow, but more slowly. The saving rate declined 12 percentage points over a decade, about half a percent a year. And that meant, if you flip it over, that consumer spending was growing about half a percentage point per year faster than after tax income.
If you reverse that, I think the saving rate could grow about 1% a year or spending would grow 1 percentage point less than incomes. That would really take about a percentage and a half out of growth, going from a half a percent down to 1% up on the saving rate. Now what that means is that growth would probably still be there, but more about 2% while this process is continuing, versus the 3.7% annual rate of GDP growth back in what I call the salad days, from 1982 to 2000.
Forbes: You look at the long-term growth in this country. It has averaged about 3.5%.
Shilling: Correct.
Forbes: Before the Federal Reserve, some point out, 4%. Even as people repair their balance sheets, as companies have shown, you can do very well, even as you're repairing the balance sheet.
Shilling: Oh, you can. You can. One of the interesting things right now, Steve, is what I call ‘theory following fact.’ When you have facts last long enough, the theories are always concocted as to why they're going to last forever. The most recent one is this idea of why we're going to have slow growth forever. Professor Robert Gordon at Northwestern, I know you're familiar with his latest idea that we've invented everything that's inventible and technology is never going to push the economy again.
Forbes: First came along 200 years ago.
Shilling: Right and good old Reverend Thomas Robert Malthus is still alive and kicking. I just don't go along with that. But I think that's exactly what you expect, because we have had five years of slow growth so the theory is following the fact and will last forever. I don't think that's true. I think we get through the deleveraging, we'll go back to rapid growth. And we have a lot of, I think, technologies today, which are going to drive growth. There are things like computerization, the internet, biotech, robotics, semi-conductors. I don't think these things are fully exploited by a long shot. And they still have immense impact on the economy.
So I think we're going to go back to norm and maybe even faster growth. But, again, that's after the deleveraging is out of the way.
Forbes: Before we get to what you should do in the meantime, you made reference to the great disconnect. Why is that and how long can it last?
Shilling: It will last until there's a big shock out there. You not only have this grand disconnect, with people that couldn't care less about the economies of the ground only what the central banks are doing. But a corollary to that is the zeal for yield.
With low interest rates, the feeling is, “I want the highest returns,” and it means the junkiest of the junk. If you look at what happened in 2012, emerging market bonds and junk bonds, total return of about 20%, investment grade 5%. The worse the credit, the more people rushed in because they just couldn't care anything about the quality. It was a zeal for yield. I think those two are intertwined.
How long will it last? Well, right now it's a risk-on trade. It's people saying, "I want to buy stocks. I want to buy junk bonds, emerging market bonds," all this very low quality paper of one sort or another.
Two things can happen. One is the economies of the world, with big delays on the monitoring fiscal signals, could basically rise to meet investor expectations. But with the age of deleveraging I don't that's likely. More likely, is that we will see some kind of shock. The scales will drop from the eyes, as they said in ancient Greece. And investors will realize that there's a lot of hot air between them and reality.
Forbes: So do we have a bond bubble outside of treasuries today or are treasuries part of the bond bubble?
Shilling: We definitely do. If you can believe this, 46% of junk bonds are selling at or above call. In other words, they are selling at or above a price at which the companies can call them back. And of course they call them back as soon as they can because they can reissue the debt even cheaper. Another thing is the difficulty with which a low-grade company has defaulting. It takes real skill to default today because there's so much money thrown at them. And this is, in my view, clearly a bubble.
Forbes: First, why don't you give us the four areas that you have investment advice for, like commodities and the dollar, and then we'll hit some of the specifics?
Shilling: Well, there is what I call a quartet. And it sort of alternates between risk-on, risk-off. When you're on risk-on, as you are today, people are interested in stocks. They're not that keen on treasuries, although treasuries have held up very well. They actually had a total return of a couple percent last year, the 30-year bond.
But they're not very keen on there. They want the junk. They tend toward junk securities and commodities. And they don't care much about the dollar. The yen is a special case now because of what Japan is doing. That's sort of the quartet, if you will, on the risk-on.
Now if you get to the risk-off, which I think would happen after a shock, and the grand disconnect gets reconnected, then it would be the opposite: long treasuries, short stocks, short commodities and long the dollars as a safe haven.
Forbes: Let's hit first long treasuries. The yield now on the 30-year bond is 3%?
Shilling: 3%.
Forbes: The ten-year, 1.6%, 1.8%? Pick a number. When we last talked it was 4.5% on the 30-year, which seemed low at the time and was almost 3% on the ten. How much more is there and how long can it last?
Shilling: I'm suggesting 2% on the long bond and 1% on the ten-year.
Forbes: Time frame?
Shilling: One of the great forecasters said, "You know, you either forecast what's going to happen or when it's going to happen, but not both." I would say over the next year or so, and that's assuming that this grand disconnect does get closed. If we go from 3% to 2% on the long bond that's a total return, assuming it takes place over a year so you get a year's worth of interest. That's a total return of about 16% and it's about 25% on a 30-year zero coupon bond. That's pretty attractive, relative to what I think would happen in stocks, which would be on the negative side.
Forbes: And the ten-year is going to go down to?
Shilling: The ten-year, but you don't get nearly as much bang per buck in the ten-year. The shorter duration, the shorter maturity makes a huge, huge difference. That's why I'm one of those guys who still likes a 30-year bond, even though the ten-year is sort of the standard by which the whole world judges government debt.
Forbes: Sounds like with a 30-year you don't have to really leverage to get a good kick.
Shilling: No, you really don't. You get even more bang per buck with the zero coupon. Unfortunately, it works both ways. If rates go up you lose more money in the zero than the coupon bond. But, you know, as you know, Steve, I've never, never, never bought treasuries — and I started buying them in 1981, when the yield was 15.21% — I've never bought them for yield. I couldn't care less what the yield is, as long as it's going down. That means the price is going up. It's the same reason most people buy stocks.
Forbes: Now, the dollar. We have the seeming paradox. The Fed keeps bloating its balance sheet. And yet we haven't had seemingly a traditional type of '70s-style inflation. Why is that? Just to be fair to you, again, you've made the point the dollar's the best horse in the glue factory.
Shilling: As one of our clients pointed out, he's a valedictorian in summer remedial school. But yeah, it is the best of a bad lot, the tallest midget, the slowest falling rock, if you will. And it is the international currency. It's the trading currency. It's the reserve currency.
So even last year, when everybody was going for the triple-C, the junkiest of the junk, the dollar still held up. And it's been particularly strong against the yen recently because the Japanese, the new government, Prime Minister Abe is determined that they are going to reduce the value of the yen against the dollar.
That's an interesting phenomenon right there, Steve, because what we're seeing is competitive devaluations. Countries have tried very hard with monitoring fiscal stimulus to rekindle rapid growth. It hasn't happened. So they're resorting to protectionism in the form of competitive devaluations.
Forbes: Which we haven't seen on that scale since the '30s.
Shilling: No we haven't. But unfortunately it's there. The Swiss, they've tied their currency to the Euro currency because they have a lot of trade with Euro zone. And we've seen competitive devaluations in Taiwan, Korea and elsewhere. It's interesting, competitive devaluations are never initiated. They're always getting even.
And if you listen to the Japanese prime minister and the finance minister, what do they say? They say, "The Fed's flooding the world with money. The European Central Bank is. Those are knocking down their currencies against the yen. We're just getting even."
It's like a mafia. You never get mad; you just get even. But that's the way competitive devaluations are. And they never work 'cause the other side does it against you. But the one thing is the dollar is the reserve currency. So I think what we're seeing is all these other currencies are basically devaluing against the dollar. It's one of the reasons that we're very bullish on the buck, long term.
Forbes: So long treasuries, long the dollar. Now on the stock side you say generically short stocks. But are there certain areas where you might make an exception, or not?
Shilling: Well, yes. I think right now, as long as you have the risk on and people are enamored with stocks and the grand disconnect is there, what we're suggesting is being long equities, but selectively and cautiously. In other words, I like things like consumer staples. I like companies that pay high rising and sustainable dividends. Those are some of the healthcare companies, some utilities.
Forbes: Healthcare companies?
Shilling: Yes. Well, some of them pay pretty good dividends. But it's a selective approach to stocks. It isn't a blanket endorsement and it certainly isn't an endorsement to go out and buy junk bonds, even though a lot of people are still. That is a bubble.
Forbes: Now in terms of stocks, you see the grand disconnect ending. What you still want to be in dividend-paying stocks?
Shilling: No. No, at that point I think you want to be out of stocks pretty much entirely.
Forbes: So you have a very delicate timing issue here.
Shilling: Well, it is delicate timing because, you say, "What sort of shock is going to end this?" Well, it could be, you know, the fiscal cliff has been postponed. It hasn't been solved. We come up to the debt limit issue or the sequestration, you know, that that is it. Or maybe there's a blowup in the Middle East with Israel and Iran, and the price of oil goes up. That's a big tax.I mean, some shock comes along and it is delicate.
But that's why I think that, even though the risk-on trade is still dominant, that I think you have to be prudent. You have to be cautious in approaching that. You have to be ready to really shift gears and get out of stocks and go heavier into treasuries and certainly avoid or go short things like junk bonds and emerging market bonds, more commodities, things that are right now in demand with the risk-on, with the grand disconnect in full flower.
Forbes: And your other area is, you say, short commodities? Even though everyone is printing money?
Shilling: Well, you know, that's a fascinating thing, that commodities actually have been declining since early 2011. And I think that that has been anticipation of both slower global economies, if not recession, and also a hard landing in China. The feeling earlier, if you go back to late 2001, China joined the World Trade Organization. No coincidence in my view that early in 2002 the commodity bubble started. And it has been a commodity bubble.
You see all the institutional money running into that pension funds. We work with a number of pension funds and they say that commodities are not an asset class. I say, "No, they're not an asset class. They're a speculation." And then you see people through exchange-traded funds. And mutual funds are moving into commodities. It's been a huge, huge bubble.
But it's interesting that that has backed off since early 2011, and despite all the flood of money going in there, and despite this grand disconnect and the risk and the zeal of this zero for yield. Commodities have actually been declining. They fell on balance last year. And that's even with the grains, with the draught problems that pushed up the grains. So I think it's telling you something, that the underlying pressure, that there's excess supply, that stockpiles are building.
They have so much copper in China that they can't put in warehouses. They're stacking it now on the ground outside and the ground is collapsing. There's too much weight. I mean, I think the world is awash of commodities. And you look long term. We've got a graph that looks at commodities, the Commodity Research Bureau Index, going back to 1750.
If you look from the mid-1800's on, that's when the Industrial Revolution was in full flower, and then later in the century when the Japanese came in, the inflation adjusted commodity prices have been on a steady decline. You occasionally get upward spurts, World War I...
Forbes: Like the '70s.
Shilling: ...World War II, the Civil War and then shortages with the oil embargo in 1973 and so on. But they're very short lived. What it says is human ingenuity beats shortages every time.
Forbes: Now on commodities, do you still like the energy area?
Shilling: I like North American energy, absolutely, because we as a nation, I think have decided that we are going to reduce our dependency on imported energy from unreliable areas like Venezuela, Africa and the Middle East.
Of course on top of that we've had this huge explosion of energy creation here, the fracking of both oil and natural gas, the horizontal drilling. It’s really created some interesting problems now. There are not enough pipelines to bring the energy from North Dakota down to the Gulf Coast refineries. So they're running it in rail tank cars, costs them about another $10 per barrel to do so.
Pipelines are one of the areas that we think is very attractive on that, both for oil and natural gas, because they produce the natural gas. You can't flare it. You can't burn it off in the lower 48 states. And they want to produce it, even if they don't make money on the gas at low prices, because they want the butane and propane, the natural gas liquids. So once they have the gas, you have to get it out of there. You've got to have a pipeline to get it out of there. I think that's an attractive area.
Forbes: Any other areas, aside from pipelines?
Shilling: Well, I think that the oil service area, onshore and offshore drilling, is attractive. Nuclear energy is kind of up for grabs right now. You know, the spillover from the Japan tsunami and earthquake.
Forbes: So even if oil goes from, pick a price, $90 a barrel, down to $50, $60, you still think it's an attractive area?
Shilling: It probably is. Now, you’ve got to worry about how low it is. And like the oil sands in Alberta [Canada] are attractive, but if oil goes low enough they're not attractive. And natural gas is a big substitute for that. Probably the biggest phenomenon in the whole energy area, that we've seen recently, is natural gas, the explosion of shale gas and what that is doing. And, it's backing out coal. Coal is now very distinctly on the decline because of the pollution and it's less polluting to burn natural gas. And natural gas is cheaper.
Forbes: Now the Federal Reserve. We made mention, huge excess reserves. And they're going to pile more excess reserves. Why has that been effectively sterilized? Why is it just sitting there?
Shilling: Well, because that's the whole point of this, that the deleveraging in the private sector is so immense that, despite all the monitoring and fiscal stimuli here (and it's a worldwide phenomenon), we still have slow growth. It tells you, it measures the tremendous power of this deleveraging.
In other words, if you had a normally-growing economy, the 3.5% real GDP we talked about earlier, and you put this much monetary and fiscal stimuli on top of that, the economy would be through the roof. We'd been back in a serious inflation. But here we are, limping along at 2% in this country, and less in a lot of other areas of the world. So it is telling you the immense power of this deleveraging. The Fed is saying, "Well, you know, we hope it'll work." But all they're really doing is building up excess reserves.
They are getting some effects, in terms of stocks in particular, where somebody sells a treasury or a mortgage-backed security to the Fed. What do they do with the money? They turn around and maybe they buy stocks. The Fed hopes that then that creates a real wealth effect: that the price goes up. They feel wealthier. They're going to invest. They're going to spend. And it'll create jobs. That’s what the Fed wants to do.
But I've just described five steps that it goes through. Meanwhile those reserves go into the bank reserves at the Fed and they just sit there. We've got a trillion and a half excess reserves now; they don't get lent and re-lent. Nobody wants to lend and nobody wants to borrow.
Forbes: How much of the non-lending is because regulators at banks put a real chill on making a loan to a small or medium size business?
Shilling: Probably a lot of that. It's hard to quantify it. But there's no question we went from basically the classic no documentation subprime mortgage loan to very tight regulation. I'm a top-down economist, Steve. I start with, the financial, economic, political sphere, work down to a forecast and down from there. I'm not a bottom-up detail stock picker.
But you really have to get into that when you see what's happened to the financial area, because now you've got these bank examiners that you're alluding to. These guys are crawling all over these banks and looking over their shoulders.
"How do you justify that loans?" "What about this one," and so on. And the official policy, and even the guys running the banks maybe, "We’ve got money to lend. We want to lend it." But they've got those bank examiners and a lot of people that work for those banks are saying, "You know, when in doubt, why take risk?" So it's undoubtedly a major factor. But, again, that's what you've got to expect after the tremendous loose lending and the problems that we have as a result.
Forbes: Final question. What's the outlook for honey? You're a beekeeper. May not give us milk, but at least you can give us honey.
Shilling: I'm always bullish on honey. Well, my bees are safely tucked in their hives for the winter. You know, bees don't hibernate. That's why they make honey. That's to get through the winter. I'll be looking at them about in March. And I hope that they came through the winter in good shape.
But there are a lot of diseases and pests that have beset honeybees in the last couple of decades. It takes somebody with a tremendous determination and unwillingness to quit, like me, to want to be a beekeeper. But I enjoy it. I enjoy it. It's good physical exercise. I like to be outside on a nice day.
And also it's amazingly intellectually challenging because, with all these problems with bees, I open a beehive, I'm looking, I'm listening, I'm smelling. I'm going through a whole deductive logic sequence. Is there a queen in there? Is she laying? If not, what do I do about it? I come home from a day out in the beehive and I'm wrung out, not only physically but mentally. You wouldn't think that but it's true.
Forbes: That's probably how you renew your brain for the financial work you do.
Shilling: Well, it is. It is. I did an article for Forbes years ago on this, describing a pair of bee gloves, the bee gloves with the long sleeves that are mounted in a glass case in my office. And they're full of all these stingers. I was out, a late fall day, and it was raining. And the bees are unhappy then. And it was getting dark. And they were unhappy then. And I was being stung. I probably have 100 stings on each one. And they could get through these because when it’s rainy and wet your clothing sticks.
They can get through the gloves into your flesh. And I keep that there. And I mentioned this in this Forbes article, that says when we're having a bad day with our forecast or our portfolios I look up there and I say, "Life can be worse. And it has been."
Forbes: Gary, thank you.
Shilling: You're welcome, Steve.
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Steve Forbes is the co-author of Freedom Manifesto: Why Free Markets Are Moral And Big Government Isn’t.
