Gary Shilling's 2010 Recommendations: Is He Right?

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 |  Includes: ADRE, EPP, EWY, EWZ, EZA, FXI, PIN
by: Elliott R. Morss

Introduction

An exerpt of Gary Shilling’s “2010 Investment Strategies: Six Areas To Buy, 11 Areas To Sell” recently appeared on Mauldin’s website. It is interesting because I respect Shilling and yet many of his suggestions directly contradict my investment recommendations.

Who really knows what is going to happen? I certainly would not make such a claim. Nor do I believe would Mauldin or Shilling. I am always reminded of Ben Stein’s great line (NYT, December 26, 2008):

I found my own inventive ways to lose money on a colossal scale during these last 15 months.

Nevertheless, it will be interesting and possibly even useful to compare and contrast Shilling’s predictions with my own.

Shilling’s Recommendations Summarized

Shilling recommends buying Treasury Bonds, Income-Producing Securities, Consumer Staples and Foods, Small Luxuries, the US Dollar, and Eurodollar Futures.

He recommends selling US Stocks in General, Homebuilder and Selected Related Stocks, Selected Big-Ticket Consumer Discretionary Equities, Banks and Other Financial Institutions, Consumer Lenders’ Stocks, Low and Old Tech Capital Equipment Producers, Your House (yesterday), Junk Bonds, Commercial Real Estate, Most Commodities, and Developing Country Stocks and Bonds.

In what follows, I will comment on the Shilling recommendations highlighted above.

But I start with a comment on Shilling’s overall perspective:

We see the 2010 investment climate dominated by weak economic growth here and abroad, led by U.S. consumer retrenchment. More government fiscal stimulus and continuing Fed policy ease are likely in this setting. So is low inflation or deflation.

I agree with the first part of this statement – weak economic growth here. But weak economic growth abroad?

As I have said earlier, the global credit freeze was a Western phenomenon resulting from their banking systems collapsing. Its primary impact in the rest of the world happened via lower export demand from the West.

Consider the IMF’s growth projections for selected regions of the world appearing in Table 1 below.

Table 1. - IMF Real GDP Growth Projections

Country/Region

2008

2009

2010

2011

2012

World

3.00

-1.06

3.10

4.19

4.44

Advanced economies

0.56

-3.43

1.32

2.45

2.56

European Union

1.02

-4.19

0.45

1.77

2.25

Japan

-0.71

-5.37

1.68

2.38

2.32

United States

0.44

-2.73

1.52

2.77

2.62

Emerging and developing economies

5.99

1.70

5.08

6.06

6.38

Africa

5.18

1.69

4.03

5.24

5.31

Sub-Saharan Africa

5.48

1.31

4.13

5.48

5.45

Central and eastern Europe

3.04

-5.04

1.76

3.80

4.20

Developing Asia

7.59

6.21

7.35

8.12

8.41

China

9.01

8.50

9.03

9.73

9.84

India

7.35

5.36

6.42

7.28

7.63

Middle East

5.38

2.03

4.25

4.63

4.57

Western Hemisphere

4.17

-2.53

2.90

3.75

4.11

Brazil

5.08

-0.66

3.46

3.52

3.52

Mexico

1.35

-7.34

3.26

4.89

5.50

Click to enlarge

Source: International Monetary Fund, World Economic Outlook Database, October 2009

Start by looking at what happened to “Advanced” and “Emerging” Economies in 2009. As a result of the global credit freeze resulting from the collapse of the American banking system, GDP in Advanced Economies fell 3.4%. In Emerging Countries, the rate of growth fell, but they still managed to grow by 1.7%. Looking ahead, both the World Bank and the IMF see growth rates in Emerging Countries returning to where they were in 2008. At the same time, it is increasingly questionable what will happen in Advanced countries in the next few years.

Note what happened to China and India in 2009. Their growth rates slowed to 8.50% and 5.36% respectively. And their growth rates are expected to return to where they were before the recession in the next couple of years.

I sensed recovery in Emerging Economies while working at the University of Palermo’s Business School last November. While there, my students and I co-authored studies on how 7 Latin American countries were dealing with the global recession. Things have already picked up. Brazil is particularly noteworthy. You can read the Brazil study here.

Will the growth in Emerging Market Countries be adequate to lift the Advanced countries out of their recession? Probably not. The GDP of Emerging Countries is only 30% of global GDP.

Shilling’s Specific Recommendations

1. Buy Treasury Bonds.

They were yielding 4.7% at the end of 2009. So we've reactivated the strategy with our forecast of a return in yields to 3.0% or lower.

Hmm. I question this for two reasons. First, I believe the US dollar will weaken further (more on this later). Second, consider Table 2 which is the US Government deficit projection for the next few years. Might these deficits not increase the Governmment’s cost of borrowing? Instead of the Treasury Bond rate falling, might it have to go up to attract Bond buyers?

Table 2. – Federal Government Deficit Projections (US$ bil.)

2008

2009

2010

2011

2012

On-Budget Deficit

-642

-1,720

-1,485

-1,029

-721

Off-Budget Surplus

183

133

104

108

131

Total

-459

-1,587

-1,381

-921

-590

Total Deficit as a

Percentage of GDP

-3.2

-11.2

-9.6

-6.1

-3.7

Click to enlarge

Source: US Congressional Budget Office

Shilling says:

We do expect large federal deficits for many years, in part because of pressure on government to create jobs and restrain unemployment in a slow growth economy. But those deficits will increasingly be funded by U.S. consumers as their saving spree continues.

Oh, so the American consumer is going to buy most new Treasury bonds and in doing so, bring the Bond rate down to 3% for an extended period of time? I don’t see this as a good bet.

2. Buy the US Dollar

The financial meltdown in 2008 drove investors to the dollar as the global safe haven, but in early 2009 that status faded as fears of financial collapse melted…. the dollar remains the world's reserve currency and safe haven, regardless of suggestions by the Chinese and others that the dollar should eventually be replaced by a global currency.

In an earlier article, I presented a time-phased sequence of what is likely to happen to the Dollar. I said we would go from a stronger Dollar (safety) to a weaker dollar as panic levels fell and there was a growing realization worldwide on the size of the US government deficits that would have to be financed. Shortly thereafter, I tried to make the case for a stronger dollar. I found my arguments unconvincing. For a number of years, the Chinese and Japanese governments have kept the dollar artificially strong by purchasing a significant percentage of US government debt. With this projected massive expansion of US government debt, it is highly unlikely these countries will either want or be able to afford to continue their share of debt purchases.

Shilling is certainly right when he says the US current account deficit will fall because the trade deficit will decline.

The US Current Account is presented in Table 3 below. US import demand is falling more rapidly than is the demand for US exports. As a result, the Current Account deficit will probably end up just over $550 billion for 2009.

Table 3. – US International Current Account (in mil. US$)

(Credits +; debits -)

2005

2006

2007

2008

Current account transactions, net

-748,682

-803,547

-726,572

-706,068

Exports of goods and services and income receipts

1,816,723

2,133,905

2,462,099

2,591,233

Imports of goods and services and income payments

-2,459,633

-2,846,179

-3,072,675

-3,168,938

Trade Balance

-642,910

-712,274

-610,576

-577,705

Unilateral current transfers, net

-105,772

-91,273

-115,996

-128,363

Click to enlarge

Source: BEA: US International Economic Accounts

But Shilling makes no mention of the other major component of US transactions that have a direct bearing on the global supply of and demand for Dollars - the Capital Account. It is through this account that foreigners buy/sell US assets and Americans buy/sell foreign assets.These data are presented in Table 4 below.

Table 4. – US International Capital Account

2005

2006

2007

2008

U.S. Purchases of Private Foreign Assets

-566,266

-1,293,449

-1,449,731

534,357

Direct investment

-36,235

-244,922

-398,597

-332,012

Foreign Securities

-251,199

-365,129

-366,524

60,761

Foreign Govt. Purchases of US Govt. Securities

213,334

428,401

269,897

543,498

Private Foreign Purchases of US Assets

988,079

1,577,230

1,648,511

47,050

Direct investment

112,638

243,151

275,758

319,737

U.S. Treasury securities

132,300

-58,229

66,807

196,619

Other US Securities

450,386

683,245

605,652

-126,737

Click to enlarge

Source: BEA: US International Economic Accounts

Minus numbers in this table means the global supply of US Dollars is increasing. This will weaken the US Dollar. So when Americans invest aboroad, either directly or via financial markets, the global supply of Dollars is increased. This table is interesting for several reasons:

  • It shows that foreign governments purchased $543 billion US Government Securities in 2008 in an attempt to keep the Dollar from weakening when the Deficit was $459 billion. Did they buy more in 2009 when the Deficit ballooned to $1.6 trillion?
  • Until 2008, foreigners have been buying US financial assets (mostly equities). This net inflow of more than $600 billion in 2006 and 2007 almost by itself compensates for the US Current Accound Deficit. In the panic at the end of 2008, they were net liquidators (-$127 billion).
  • But Americans increasingly been buyying foreign securities (more than $300 billion in 2006 and 2007 before a panic liquidation in 2008.

When it comes to the future value of the dollar, here are the questions to consider:

  • Will the US Current Account Balance remain in the $500 billion+ range for the next few years?
  • Will foreign governments increase their purchases of Dollars to absorb the growing US Government Deficit?
  • Will foreigners resume their purchases of US equities?
  • Will Americans resume purchasing foreign stocks?

My summary answer to these questions is the global Dollar supply will increase and the dollar will weaken further.

3. Sell US Stocks in General

I could not agree more. The US recovery (?) is proceeding slowly. In December, the US lost another 85,000 jobs; in the last six months, the US has lost 805,000 jobs.

4. Sell Your House (yesterday)

Despite leaping mortgage delinquencies, federally-mandated but mostly unsuccessful mortgage modification programs are keeping many houses, especially middle- and higher-priced homes, from being foreclosed and sold--temporarily. Furthermore, the investment tax credit for new and some existing home buyers, which was extended beyond November 2009, is scheduled to expire in April. The overhang of aging new single-family homes available for sale is huge (Chart 5 ). Many owners have tried to wait out the bear market in housing, a technique that worked in earlier years when any price declines were small and short-lived. But huge excess inventories, a flood of distressed sales after mortgage modification attempts are over, depressed incomes and rising unemployment will probably keep sellers plentiful, buyers reluctant and prices falling throughout 2010 and perhaps beyond. In past regional house price collapses, it's taken homeowners a year-and-a-half to give up and throw their houses on the market for whatever they will bring.

Shilling is chilling and he is the expert here.

5. Commercial Real Estate

Retailers closed 8,300 stores last year, more than the previous peak of 6,900 in 2001. Businesses will continue to cut costs this year, not only by holding down employment and therefore the need for office space, but also by moving in the partitions to fit the remaining people in less space, as mentioned earlier.

Increasing use of telecommuting will also reduce need for office buildings. And more teleconferencing will cut hotel-utilizing business trips, especially after intensified airport security in reaction to the recent terrorist incident in Detroit on Christmas Day. At the same time, frugal consumers will restrain discretionary travel and the hotel and motel use involved. Weak consumer spending will keep mall and warehouse space under pressure.

I would add that recessions tend to accelerate economic changes already underway. Internet purchasing is growing in importance, furthering the reduction in demand for retail store space.

6. Most Commodities

…we believe that economic supply and demand will rule most industrial commodity prices this year and result in weakness due to sluggish global business conditions. Also, investors put a record $50 billion into commodities in 2008 but then retreated last year after prices nosedived. They learned the hard way that commodities aren't an asset class but speculations, and may be cautious this year. And the strengthening dollar should depress the prices of the many commodities traded worldwide in dollar terms.

As indicated in Table 1, sluggish business conditions will continue in the “Advanced” countries. But this is not the case in the “Emerging” countries, and there is growing demand in these countries for commodities. This is particularly true in resource poor China and India. As Shilling says, commodity prices in recent years have been influenced by speculators and changing dollar values. I sense that speculators are already returning to commodities. And as the dollar weakens, commodity prices will increase further.

7. Developing Country Stocks and Bonds

We doubt that the rebounds in emerging market stocks and bonds correctly forecast robust, decoupled economic growth that is sustainable…. Furthermore, as was made clear by the universal weakness in security markets in 2008, bond and stock markets around the world are highly correlated. With globalization, the days are gone when a globe-trotting sleuth can discover gems in the remote reaches of Asia or Latin America. The similarity of bond and stock performance is even greater when adjusted for risk.

Shilling is certainly right when he talks of how global stock markets move together. There is certainly considerable collinearity. But as Table 5 indicates, differences still remain. Many of the Latin American markets have fully recovered, while rapidly growing China has not. India is doing better, only 20% off its previous high.
Table 5. Global Stock Indices
Index
Index
Hi-Low
Index
Hi-Now
Index
High
Low
% Loss
Recent High
% Loss
DJ Eurstoxx 50 (DBX)
4,316
1,817
-58%
3,053
-29%
DAX
8,105
3695
-54%
6,153
-24%
FTSE 100
6,567
3530
-46%
5,560
-15%
Nikkei 225 (Japan)
18,239
7,086
-61%
11,080
-39%
S&P 500 (US)
1,565
683
-56%
1,176
-25%
S&P Asia 200
6,853
3,145
-54%
4,986
-27%
Shanghai SE Composite
6,036
1,706
-72%
3,440
-43%
Bombay 500
8,779
3,038
-65%
7,060
-20%
S&P Lat Am 40
60.426
21
-65%
47.79
-21%
TSX (Canada)
15,068
7,566
-50%
11,947
-21%
Argentina (Merval)
2,339
829
-65%
2,420
3%
Brazil (Bovespar)
73,516
29435
-60%
68,533
-7%
Chile (IPSA)
3,499
2,101
-40%
3,828
9%
Colombia (IGBC)
11,439
6461
-44%
11,730
3%
Mexico (Mexbol)
32,721
16,869
-48%
33,280
2%
Peru (IGBVL)
23,790
6,054
-75%
16,080
-32%
Click to enlarge
Source: Bloomberg
* January 26, 2010
Shilling likes to keep his investments at home. My view is that as we move ahead, we should look at country growth rates, how the stock markets have performed, and make our investments accordingly. I will shortly update my latest investment recommendations which can be found here.
But I want to close this piece with a few comments on China that in my view is misunderstood by most financial pundits. I worked in Southeast Asia with Chinese partners for more than a decade. My primary partner was Dr. Zhu Jia-Ming who now teaches courses on the Chinese economy at the University of Vienna. Yesterday I talked with him. His and my observations on China are summarized below.
  1. China’s economy is controlled by the government and the state enterprises.
  2. In the private sector, 5% of the population control 75% of the resources.
  3. The private sector and the government have a good working relationship.
  4. There is a real estate boom going on in China. It started in Shanghai more than a decade ago, spread to Beijing, and now has spread to other major cities in China. Major cities in China? There are 44 with populations with more than a million inhabitants. It is a big building boom.
  5. Real estate is bought and sold like stocks are in the US. And 33% of new units in Beijing and Shanghai are empty. No matter. They will soon have inhabitants and other units will be built. The banks will not foreclose.
  6. The recession did reduce exports, but the growth rate barely dipped because of the real estate boom and government investment in infrastructure. As a result of infrastructure improvements, China now has the best urban transport and interstate highway system in the world.
  7. China’s foreign exchange reserves – US$2.4 Trillion; US foreign exchange reserves - $131 billion

Disclosure: Author holds long position in PRLAX, EWZ, EZA, MINDX, EWY