The ex-fund manager tells ThinkAdvisor why a recession could occur in 2019 and why he left the market.
The plummeting stock market is merely a prelude to the calamitous upheaval to come, legendary investor Robert Rodriguez tells ThinkAdvisor in an interview.
The former CEO of First Pacific Advisors for 25 years has been warning of another terrible financial crisis for the past several years. Now, he says, the likelihood of that is “near certainty.”
Rodriguez, who retired from FPA in 2016, is well known for forecasting the dot-com bust and the financial crisis of 2008-2009.
The odds of a recession are rising, and it could occur next year, says Rodriguez, who argues that the biggest threat to the market is the excessive leverage that’s been employed to stimulate U.S. economic growth, now slowing.
Rodriquez, 70, who, over the last four years or so, moved most of his personal assets out of the market, now has a tiny exposure to stocks, all of it in mutual funds. In the interview, he discusses this and his fixed income investments as well.
He chalked up a striking record at Los Angeles-based First Pacific. The FPA Capital Fund, which he managed from 1984 to 2009, had an annualized return of 14.2% during those years, according to Morningstar. It outperformed the market indexes by 500 to 600 basis points compounded during his 25 years with the firm, the former manager says. The FPA New Income Fund’s annualized return came to a strong 8.8% under his management.
Today, Rodriguez opines, reality is beginning to seep into the still “delusional” equity market, as evidenced by the current correction. In a ThinkAdvisor interview this past January, he likened the market to “Alice in Wonderland” populated by host of irrational Mad Hatters.
Interviewed by phone on Dec. 18, with an email exchange the following day, just after the Federal Reserve again raised interest rates, Rodriguez examined what he terms the Fed’s long-time “insane monetary policy” and his expectation for rates next year. He labeled the ever-swelling federal deficit a “non-sustainable trend.”
On Dec. 19, after the Fed raised rates and cut its expectation to two rate hikes in 2019 from three. He said in an email message:
“The reductions are a function of slightly weaker economic growth. I expect weaker GDP growth [in 2019] than what the Fed anticipates to be 2.3%, which is lower than its 2.5% September forecast. I expect to see growth rates of less than 2% or even 1%. Should I be correct, the two rate hikes may not occur; and the Fed may be forced to begin thinking about a reduction.”
He continued, “The longer term projection for the funds rate was lowered from 3% to 2.8%, and the 10-year bond yield fell to 2.76% from 2.82%, while the two-year inched up from 2.65% to 2.66%. In other words, the yield curve flattened more, to just 10 basis points. The flatter yield curve continues to pose a challenge for the equity market.”
In sum, “The market is now caught in a transition of Fed policy that includes shrinking its balance sheet, quantitative tightening and weaker economic growth expectations. This realization is causing additional downside equity price action, which has been and continues to be my view.”
In the interview, the star investor, speaking from his Lake Tahoe, Nevada, home, also offered his appraisal of President Donald Trump’s tenure thus far and enthused about his fun, highly unusual investing project that he hopes will be a smart inflation hedge.
Here are highlights of our conversation:
THINKADVISOR: Do you see a financial crisis on the way?
ROBERT RODRIQUEZ: It’s virtually impossible to forecast the timing, but I think the probability is near certainty.
What are your thoughts about the current market correction?
This is only the preamble. People are thinking, “Oh, we’ve already had a major correction, and we’re getting to the lows.” After nine years of insane monetary policy that has created unintended consequences that we don’t know about yet but will find out, this is only the initial phase.
What could happen?
If the S&P and Dow Jones levels break from where they are, you’ll get another rapid decline in the market because of quantitative-driven management strategies causing [managers] to jump on the downside.
In my Jan. 30, 2018, interview with you, you called the stock market “Alice in Wonderland” populated by a host of irrational “Mad Hatters.” Are they still in the Rabbit Hole?
The equity market was delusional and still is. All the excitement from the Trump tax cut has been washed away. And where did the corporate tax cuts go? Stock buybacks and dividends. Capital spending hasn’t occurred, which means that productivity is unlikely to improve appreciably. We’re substituting labor for capital. That’s part of the [reason for] lower unemployment rates.
What other evidence is there that big trouble is ahead?
You already have the Russell 2000 in bear market territory, down 20%. The S&P retailers are down 20%. You could argue they’re losing business to the Net; but even so, it’s a measure that things are changing. I believe this is the worst December for equities since 1931.
What does all this mean?
I think reality is starting to come into play [evidenced by] the stock market correction.
Do you forecast a U.S. recession?
The odds of a recession are increasing. It could occur next year very easily. At the least, you’re going to see a growth slowdown. I’ve been watching this for a decade, and the numbers are starting to come together in terms of the excessive growth in leverage in the system [and other factors]. When we have a recession, it will likely be a worldwide one, and that will create other issues.
You didn’t say, “If we have a recession.” You said, “When.” So you’re sure?
There’s no question that we’re going to have another recession. The laws of economics haven’t been eradicated. We’re getting close to a flat inverted yield curve [a predictor of recession], and that’s helping to cause uncertainty and consternation in the equity market too. I had expected that the yield curve was going to flatten. Historically, when the yield curve is flattened, stock market volatility has risen. It’s nothing new.
If the market correction is just the “preamble,” what comes next?
Economic growth is decelerating. It was only temporarily boosted by the tax cuts, and it will be weakening in 2019 and 2020. The higher GDP growth we’ve seen this year was a function of President Trump’s trade discussions or, shall we say, trade war. Corporations have been accelerating their inventory acquisitions in anticipation of higher import costs. So two-thirds of the GDP growth last quarter came from inventory accumulation. I doubt that in 2019 and 2020 you’re going to see inventory build-up again. I fully expect GDP growth to decelerate.
What’s the biggest threat to the market?
The excessive leverage that’s been built up domestically and internationally to try to stimulate the growth that’s now decelerating. What do you do for an encore?
What’s your earnings forecast for next year?
The consensus is calling for 8% earnings growth in 2019 and in 2020, nearly 11% growth. I don’t know what they’re smoking! Given that [marijuana] has been legalized in several states, maybe they’re getting their hands on it a little too frequently. Corporate profits are barely up from 2012. Last year we were getting a major P/E expansion; now we’re getting a P/E contraction.
What role do interest rates play?
If the Fed goes on hold or starts to reduce rates late next year, it’s because the economy is becoming considerably weaker than what they were expecting. If that’s the case, what does it mean to earnings growth rates in the stock market? It probably means they’ve got to be lower.
So the bull market is over?
The stock market will rally up, rally down; but some of the key drivers are coming to an end. For the last eight years the bull market has been driven by unsound monetary and fiscal policy. P/E valuations have been driven higher by lower interest rates. Now we’re facing four years of record maturities on the corporate-debt side. So we have a large amount of financing coming due over the next several years and with erosion in the federal balance sheet. The Fed is on a quantitative tightening mode — for the time being.
When I interviewed you last January, you said you weren’t personally in the market. Rather, you wanted “to own rare, fully paid-for assets that aren’t subject to calls [by others] and the vagaries of the banking system and financial markets.” You said, “I’m not worrying about whether Mr. Dow or Mr. S&P are going to be up or down tomorrow.” Are you in the market now?
I’m at my lowest exposure since 1971. I have less than 20 basis points total exposure to stocks. They’re via mutual funds. I have no direct ownership. I liquidated all that. [I sold] my last stocks in late 2014, when I completed liquidation of all my energy holdings. My last stock was [at] around 55; the equivalent price today would be about 14. Between 2016 and 2017, I’d sold approximately 98%-99% of what I owned.
I absolutely hated the capital markets. I’ve always been early. Some people say, “You’re premature, and that means you’re wrong.” They can also say, given the stock market’s [rise] over the last eight years, “Rodriguez, you’ve been a village idiot.” I say, “Maybe you’re right.” On the other hand, the full cycle hasn’t played out, and we haven’t seen the long-term deleterious effect from the unsound monetary and fiscal policies that have been implemented. This is a long-term game.
Anything you feel completely sure about?
I feel confident about one thing: When this market breaks more severely than it has, active managers will be caught — and by the way, so will ETFs and index funds.
Tell me more about the personal investments you’ve made.
Throughout this year, I’ve been deploying capital in two- to three-year maturity Treasury bonds. I thought the Fed’s expectations of rate hikes into 2019 and 2020 were, shall we say, devoid of some reality.
How have your bonds been doing?
A bond fund I own has generated a return that’s a lot better than what’s been going on in the stock market of recent vintage. Now the question becomes, will the stock market find a base here, and we’re off to the races again; or are we transitioning to something more unacceptable? I would argue it’s the latter. Therefore, the risks being taken in the stock market aren’t likely to be rewarded.
But you’re in the market now.
I’m still not in the market. I own less than two-tenths of 1% of my entire net worth. In other words, it’s a rounding error [laughs].
Do you think the Federal Reserve will raise rates tomorrow [Dec. 19]?
I believe that’s likely to occur. [But] in 2019 or 2020, the Fed will be forced to reverse course — from where they expect the Fed funds rate is going to be at certain periods in the future — that is, reverse the rise in interest rates given that the economy is slowing. The level [they’ve indicated] will have to start coming down. They’re expecting the fed funds rate to rise.
Why didn’t they figure that out correctly to start with?
The Fed has been behind the curve this entire cycle. They should have never done QE3. The Fed has blown this entire cycle and created bubbles in the financial system with their insane monetary policy and their data-dependent [approach]. [Former Fed chair] Janet Yellen was debating the nuances of 2% vs. 2.1% inflation! Who in their right mind would believe that you could get anything that accurate but an academician! You can see that my contempt for the Federal Reserve is extraordinarily high.
On several occasions, [former Fed chair] Ben Bernanke said there was no real estate bubble. They were clueless.
Right now, the full penalty for higher interest rates hasn’t been felt. Interest rates are skyrocketing: The average cost of a Treasury debt from the latter part of 2016, when it troughed, is up all the way to 2.5%, 30 basis points.
How high is the federal deficit now?
Since 2009, the cumulative deficit has grown from $9.6 trillion to just under $22 trillion. There was a Trump tax cut — but nobody [in government] really focused on what it would do to the cumulative debt outstanding. There isn’t any fiscal rectitude of any degree in Washington today. This is a non-sustainable trend.
How much do you expect the deficit will be in the future?
There will be trillion-dollar deficits for the next decade — and that doesn’t include a recession and adding everything else that will happen, including entitlements that will be going into negative cash flow. Each 1% rise in rates will add another $2 trillion to $2.5 trillion to the cumulative debt.
How significant is the trade and tariff situation?
Everyone hangs on, “Are we going to have an agreement with China or not?” Leverage growth in the United States — corporate, consumer, federal government — is really the driver behind the erosion in the trade account. I’m not saying that China and Japan don’t take advantage — but if you really want to attack our imbalances, you have to look home [the U.S.] We could get an agreement with China tomorrow, and I don’t think you’d see any appreciable shifts in the trade account longer term so long as domestic leverage growth continues at this accelerated rate.
Many people will probably say that the correction and potential bear market, along with the slowing economy, is all Trump’s fault.
I would expand that to say, it’s all Trump’s, Obama’s, Bush’s Clinton’s [fault]. I see positive attempts by both the Obama and Trump administrations, but they failed in execution. The politicians in Washington have created and are [still] helping to create this mess of non-sustainable debt growth and irresponsible monetary policy. I’m totally disgusted with both parties. I’m a proud Independent!
You’ve painted a grim picture of the economy.
But guess who else is responsible? The American public for electing these idiots and leveraging up their [own] balance sheets. It’s a total system-wide period of irresponsibility.
What’s your overall assessment of Trump’s two years in office?
He’s trying to keep his commitments. He’s been constantly saying “What a wonderful stock market.” I think that’s a hook he might be hung from eventually. I didn’t agree with his tax-cut policy. I was encouraged by his attempt to rein in regulatory overkill when it was on super-thrust in the Obama administration.
What do you see happening politically a year from now?
We’ll be at the beginning of the presidential election silly season. It will likely be a very nasty period politically. If anybody has enjoyed these last two years, they really must like a Greek tragedy.
How goes your numismatic project, in which you’re allocating assets to areas that aren’t part of the financial market?
We’re conducting a leading-edge experiment [seeking] historical information that was thought to be permanently lost from the surfaces of a very historic coin. I’m having fun!
Do you expect to make money from this?
I hope so. I view these small circular objects that are of extreme rarity and historical importance as reasonably good inflation hedges over the course of the next 10 or 15 years, especially if we have the type of dislocation and governmental response that I expect. If so, you’ll face a period of some type of monetary inflation.