The purpose of this interview
We sincerely believe that a proper understanding of how the economic machine works will lead to a more optimal allocation of capital. In investing, as in other fields, working hard, intelligently and in teams towards a common dream seems to have delivered better results to those who have done so. Applying the preceding process to understanding economics can be one of many other factors to differentiate the good from the great capital allocator in the future. Enabling investors to identify countries with the best growth potential in which to invest and, just as important, with asset bubbles, will enable them to profit from their consequences rather than paying for them. This interview was conducted with this idea in mind to enable you to understand the process Gary Shilling has used to identify unbalanced economic situations. Mr. Shilling also describes what he thinks will be the economic future of certain countries, and why.
About Gary Shilling
Gary Shilling's track record in accurately forecasting economic events is matched by very few. His framework to look for undiscounted situations based on past similar historical events seems to have delivered accurate forecasts over and over again, providing his clients with valuable asymmetrical bets.
Mr. Shilling received a Ph.D. in economics from Stanford University. It was during this era, while working for the Federal Reserve Bank of San Francisco, that he developed his framework by browsing in library books describing past economic events. One of those books was ‘’Hand-to-Mouth Buying and the Inventory Situation’’ by George A. Gade, which proved to be an invaluable source of inspiration to him. Shortly after founding the economics department at Merrill Lynch at the age of 29, he joined White, Weld & Co. Inc. as chief economist. At that time, he considered the current economic situation to be somewhat similar to the 1919 to 1921 period he had read about in Gade’s book. This lead him to accurately forecast the 1974 to 1975 recession. The following is a citation worth quoting from the Dec. 30, 1974 edition of the Wall Street Journal:
"Forecasting economic developments can be hazardous any time. A survey of 32 prominent economists taken a year ago turned up only one - A. Gary Shilling of White, Weld & Co.- who correctly predicted that economic activity would decline in 1974. Many had forecast substantial growth. It was not an enviable performance and today’s uncertainties, at the least, match those prevailing a year ago.’’
With confidence in his approach toward the economy, Mr. Shilling later decided to found his own firm in 1978, A. Gary Shilling & Co., Inc. Since its foundation, he has received many praises for his work in predicting the economic ups and downs. Among the various praises Shilling received, we will name Prem Watsa, who mentioned him in his 2012 letter to the Fairfax shareholders saying Mr. Shilling was one of the best economists he knew.
As some of you are aware, John Paulson's investors are probably among those who profited the most from the 2008 to 2009 U.S. financial housing crisis. What is interesting is the fact that Mr. Shilling was publicly recognized as part of the process leading Paulson's team to buy CDS, which materialised in a gain of many billions for their investors. The following is another good passage, drawn from the book "The Greatest Trade Ever" by Gregory Zuckerman.
“Paulson was a merger guy - he didn’t know Shilling was Wall Street’s version of the Boy Who Cried Wolf. When Shilling met with Paulson and predicted the collapse of home prices and a sharp rise in mortgage foreclosures, Paulson took notice ...
…‘’Boy, if you’re right, the financial system will fall apart,’’ Paulson said to Shilling, after one more dire forecast to a room of Paulson’s analysts.
‘’Yes, John, it will..."
‘’Do you really think it’s going to get that bad?’’ Paulson asked, after another dire forecast.
‘’As sure as you can be."
But that was not the only unconventional forecast Mr. Shilling made in his career, as you can read in the following interview. We also highly recommend his latest book because of its valuable insight "The Age of Deleveraging."
The interview
One of your first accurate forecasts, which was later followed by many others, was in 1969 when you accurately forecasted the upcoming recession. Can you tell us what are the main theories and fundamental things to look for to accurately forecasting recessions and the short term debt cycle?
It’s really imbalance, you look for things in the economy and in the financial market that look like they are extreme. Particularly when you see bubbles and things that look unsustainable.
In that case, it was a long time ago, they was heavy inventory building, and that’s one of the signs of trouble. When inventories start to mount, it usually means sales are weaker than business expects and what can’t be sold ends up in inventories. Sooner or later, production will have to be cut back to work down those inventories, and that often gives way to a recession.
But there are all kinds of bubbles, like the housing bubble we first spotted in 2002 and said it probably had a long way to go. We saw those ridiculous imbalances, when people were able get mortgages without making any down payments, and there were those liar loans, when people didn’t have to document their income or assets. Mortgage lenders were actually telling people that they would never have to put a nickel down because the house will appreciate so much that before making the first monthly payment, the appreciation will be great enough to refinance the house. When you start to see that kind of behaviour, you realize that it’s not sustainable.
The problem with bubbles is that there’s always an element of truth and reason for validity. In the case of the housing bubble, there was a tremendous factor in the government's support for housing. Succeeding presidents said that everybody deserved to own a house. But that’s not the case for everyone because if you can’t afford it, you just can’t afford it. In that case there was an element of truth, and a lot of government pressure that started to build, and you began to see people convinced that they couldn't lose. Initially some people made a lot of money, convinced others, and the entire situation began to compound.
In 2006, your high level of conviction regarding the upcoming housing crisis led John Paulson to listen to your thesis, and the situation eventually turned into the biggest trade in history, reaping billions for his firm. Can you tell us a little more about this episode?
I talk about it in detail in my book "The Age of Deleveraging." There's not much I can add today.
Do you have any techniques or theories to find those bubbles?
Not really, it’s an art more than a science, it’s just common sense. One of my fundamental principles is that I think that human nature changes very slowly over time, if at all. That means that people will react to similar circumstances in similar ways. Mark Twain said ‘’History never repeats itself, but it does rhyme." You look for situations and you ask yourself, does this resemble past experience, and if you think it has enough similarities then you can basically say well, let’s see what happened in this previous example and if the subsequent development could be repeated.
That’s sort of the approach, but to be any good at it, you have to be willing to buck the consensus. You have to be very comfortable sitting outside of the mainstream. It’s one of my other great principles, you don’t add any value by rehashing the consensus as it’s already discounted in the market. Also, you have to find something which is important and not just some trivial statistics. Secondly, it must have a good chance of happening, because you judge it based on your forecasting record. Third, it must not yet be in the purview of the consensus.
For example, it’s not a bubble, but it’s along those lines. Recently, most observers believed that the only route for successful investing is the index fund. This has become so widespread that it caught my attention. What I think happened is that the Federal Reserve had been pumping out a lot of money. Starting with the bailout of Wall Street and quantitative easing, a lot of that money went into stocks, and resulted in the expression that rising tides raises all boats. You really have little volatility in stocks, as within the market the stocks pretty much all perform the same. That’s a really tough environment in which to actively manage accounts, hedge funds or traditional funds, and they get discredited because they don’t do as well as the overall market. Two years ago, hedge funds were up 4%, while the market was up 20% and everyone said it wasn’t going to work. I said it was because of the Fed, all this lack of volatility and dispersion. This is a case of something that has been happening for so long and people believe it’s how God made the world, and that’s really when I start asking questions. When everybody says it’s completely obvious, I say it’s a signal to take a harder look.
This does not change the reality that over the long run, in any cycle with a lot of academic studies written about it, active management underperforms the aggregate of the market because of the fees they charge. Of course it’s what you would expect. If you take all the active managers together, they will underperform by the amount of fees they charge. It’s not surprising, it’s just common sense.
In 1981 you started advising your clients to buy long term zero coupon treasuries. You have continually recommended the same thesis over and over since 1981. If we had followed your advice, we would have had a return 6.4 times that of the S&P 500 index. Can you explain how it is technically possible to achieve such a high rate of return with bonds?
The longer the maturity, the better the appreciation for a decline in interest rate. You buy long term maturity bonds, in this case 25-year zero-coupon treasuries, and you roll them over every year or few years to maintain that long duration.
Can you tell us a little more about the thesis behind this strategy?
What happened is that in the late 1970’s, you had a double-digit inflation number. It was getting pretty scary. I looked at that and asked what is going on here. It seemed to me that the root cause of inflation was an excess demand. Again, that was my simple view, but I think it was true. So who created this excess demand? It was the government! The government is the only sector of the economy that can consistently create a very extensive and long term basis for demand. That typically happens in war times. If you look at all the years since 1749, and divide those periods between war and peace time, you will discover that in war years inflation increases on average by 4%, and in peace time it declines by 1.5% a year.
If you look at what was happening in the 1970’s, you realize that there was a tremendous delusion with the government. The reason is that the U.S. had gotten itself involved in two big disastrous government spending issues: One was Vietnam and the other was the Great Society program. As a result there was a lot of inflation, and the voters were getting very upset about this, and what we saw was in reaction to it. The first meaningful reaction was Proposition 13 in California in 1978. What that did was limit the tax increase for residential properties. And there were other issues also. Finally in 1980, when Reagan was elected, it seemed to me that the mood of the country had changed. People were opposed to Washington, they sensed that Washington had been responsible for this inflation. There was a lot of pressure exerted to unwind this excess spending. That was the basis of the forecast.
Is it true that when you look at bonds as an investment, you are not looking at them for their yield?
I couldn’t care less about the yield as long as it is going down. That’s a very interesting question today, as in Europe the Germans issued a 10-year bond with a negative yield. Why would anybody in his right mind buy that? There are three reasons: One is that banks have to own sovereign bonds; second is that if there is deflation, then even a negative yield can be a real positive return. If you have 2% deflation and 1% negative yield, you still have a 1% positive return. But the third reason is that it may have a negative yield but it can become even more negative. Again, you couldn't care less what the yield is as long as the yield declines.
Right now, it appears the whole world is concerned about deflation. With the ECB in an easing mode, what is the impact on the world economies? Will they be successful?
The ECB did that because when the euro is strong, that means the price of importing into the Eurozone is weak. It forces everybody who is competing with imports to reduce their prices or go out of business. This is what really got Mario Draghi to trash the euro; he said that they will reduce the euro, which in turn will effectively reduce deflation. The only problem was that everybody else was doing it.
The problem on the demand side, from our experience in the U.S. and in Japan, is that it largely results in pushing equity prices, and equities are mainly owned by high income people who don’t adjust their spending much in relation to their portfolio. But for the central banks, it’s about all they can do. They can only reduce or increase interest rates, buy and sell securities.
What do you think the future holds for international markets like India or China?
I think in the long term, India is a better bet than China. India seems to have lot of advantages that China doesn't. India has large publicly traded companies, while in China they are all state-owned enterprises which are very inefficient as they are politically controlled. From the British the Indians inherited the English language, which is handy in the current world, and they also inherited a legal system and a business orientation that is more western. But India has a lot of problems, such as income redistribution and land reforms, but the two major ones are corruption and subsidies for the poor. Let’s hope Modi succeeds, as Indians are very good in the technology area. Whether Modi succeeds to transfer what he has achieved on a state level to the national level will be a real challenge, and they still have a long way to go. As for China, I think their rapid growth is over.
What do you think we should keep our eyes on in the U.S. market over the next five years?
I think we still have some deleveraging to do and some slow growth for at least a couple of years. I think that once it is over, we will see rapid growth. Some people think productivity growth is over, but I don’t think so. There’s a lot of new technology that is more in its infancy than in its old age. If we look at what’s happening with the internet, I think it’s relatively new compared to what can be developed. There is robotic, biotech and so on, these are relatively new phenomena. When you have slow growth or any phenomenon that lasts long enough, the theory that prevails in the mainstream is that it will last forever, and this is easily received.
Disclosure: The introduction and transcript was written by Jean-Francois Nobert and Myra Eva Roussy. The interview was conducted by Jean Mai, Vivek Bhat and Jean-Francois Nobert, who share a common interest in value investing.
