Shilling is known for his foresight; he was one of the first to forecast the recession of 1969. He has been named as Wall Street’s top economist twice by Institutional Investor. Futures magazine has also ranked him the country’s best commodity trading advisor. He recently authored the bookThe Age of Deleveraging, which predicts a decade of slow growth and deflation. He is a frequent contributor to Forbes magazine as well as other news outlets.
Shilling received a bachelor’s degree in physics from Amherst College. He went on to receive a master’s degree and doctorate in economics from Stanford University.
He was an informal economic advisor to former President George Bush and an executive in-residence at the Amos Tuck School of Business Administration at Dartmouth College.
Why Still A Pessimist?
Steve Forbes: Well, Gary, good to have you with us again. And congratulations on your new book called The Age of Deleveraging. Everything you need to know, including a great endorsement from somebody I know. And if you don’t want to imbibe all of these observations and wisdoms, you can go to chapter 11 and chapter 12. Twelve investments to sell or avoid and ten investments to buy. This is a cliff notes version of the book.
But it’s doing very well. But I just have to begin by asking you, you can tell from the title that this isn’t a book of buoyancy and growth and bubbleness and happiness. Why do you remain such a pessimist when, you know, the market went up last year, the economy’s expanding? Why are you so cautious?
Gary Shilling
: Let’s say realist, Steve.
Forbes: You’re wrecking our party.
Shilling: Well, the basic thesis is that we are deleveraging after a huge amount of excess borrowing, and I pick out two sectors, in particular, that were involved in that. The financial sector, globally and U.S. consumers, domestically. And I think we’re going through the working down of that excess leverage.
I mean, when you look at Wall Street firms, when Bear Stearns and Lehman went from 20 times leverage – in other words, debt versus equity — to 40 times before they were carried out. And when consumers went from 20% routine down payment on a house to 5%, zero, or even negative, when they got a piggyback loan on top of a mortgage, I mean, that was the upside.
And I’m saying I think we’re working that off. And I think it’s very healthy. It will result, I think, in slower growth than we would have had otherwise. And that’s been a course of this recovery so far. But ultimately it’s very, very healthy to get rid of that excess leverage and get people’s balance sheets rebuilt.
Forbes: Well, in terms of deleveraging, hasn’t most of it happened? I mean, you look at companies, certainly big one, drowning in cash. Credit cards. People are paying them down. Savings rate, up. What’s not to like?
Shilling: Well, it’s just a question of how much. I mean, if you look, for example, at consumer borrowing in relation to their after-tax income, which is kind of a good denominator to use, that ratio used to run about 65%. It got up to 131%. It’s now down to 119%. Now if you believe in a reversion to the norm, which I do, yes, we have come down from 131 to 119. But I think we got a long way to go to get back to what I would consider a normal situation. The job is underway. But I don’t think it’s completed.
Spending Is Up
Forbes: How is it, then, that over the Christmas season consumers did do some spending — not at all stores – but consumer spending overall is up. Incomes of those who are still blessed with work are moving up. And, companies are starting to invest again. Doesn’t that mean that we’re getting back on track? Even last year with the miserable job creation, a least we created a million jobs. This year, it looks like we’ll create two, two and a half million. Not as much as we should but the trend seems positive.
Shilling: Yeah, I’m not saying this is non-stop recession. It’s just slower growth. I mean, if you look at the speed of the economy in the first five quarters that have been reported so far, real GDP grew 3.7%. Well, that ranks with the lowest post-recession expansions we’ve had and after a recession which was the most severe since the 1930s, you would expect normally a much bigger balance.
In other words, it has improved. And by the way, 60% of that improvement was because of the inventory cycle. Only about 40% was from everything else but inventory. So, it doesn’t say that things aren’t picking up. It just says that we’re at half-speed or maybe even less compared to what you normally would expect. And I think that’s this deleveraging effect.
I think the biggest thing is that anybody, at least in my view, anybody who thinks that 2008 was a bad dream and it’s gone and we’re back to the salad days of the ’80s and ’90s when consumer saving rates were going straight down and leverage was going straight up in the financial sector, I just don’t think we’re going back there anytime soon.
Inflation Vs. Deflation
Forbes: Now, we’re hearing theories about inflation — the Fed seems to love to print money. But you talk about deflation still.
Shilling: Yeah, well, first of all the Fed does not print money. I mean, yeah, $20 bills, the Bureau of Engraving and Printing does print those and they are issued under the Fed’s name. But that’s 10% of the money supply. But the Fed creates reserves. And that’s a bookkeeping entry. It’s up to the banks, as lenders, and the creditworthy borrowers to turn those reserves into money. And they have not done that.
We’re sitting with a trillion dollars excess reserves, over and above the requirements that the banks have to have. And now, if that process starts to work, and there has been some pickup in commercial and industrial loans, so maybe it is starting to work, but that’s the thing to watch. It’s not the reserves. And if they had another $600 billion with QE2 on top of the trillion they already have, that doesn’t do anything. But it’s the banks being willing to lend and the creditworthy borrowers being willing to borrow.
But as you point out, you know, if you look at the non-financial sector of the economy, they’ve got more liquidity than they know what to do with. And you look at the household sector, consumers, you point out they’re paying down their debts. In other words, there isn’t a booming demand for credit right now, regardless of what the Fed has been doing.
Bear Market Rally
Forbes: So, on the stock market, even a little over a year ago, you said this is a bear market rally. You still believe that?
Shilling: It remains to be seen. We haven’t gotten back to the peaks of 2007. So, I would say the jury’s still out on that one. And if you look at the stock market more broadly, you had a very long rally, of course, in the ’80s and ’90s. It peaked out in 2000, with the end of the dotcom boom and then fell off. It came back to essentially the same peak with the housing bubble and so on and the sell-off. And we’re not back there yet.
But whether it is a bear market rally or not, I think the main message to me is that the economy is probably going to grow more slowly for a while until the deleveraging is completed. And if history’s any guide, profits grow in step with GDP, long run. And so, unless you’re looking for a big P/E expansion, you wouldn’t expect stocks to have a very dynamic growth in relation to what’s happening in the economy.
Forbes: Are you surprised at how well profits have done since the crash?
Shilling: Yeah, I think profits have done very well. And, of course, in the financial area, they were coming off of actually negative profits, first time ever. But American business has done an absolutely bang-up job in cutting costs. A lot of that has been labor costs. But it’s been better organization of the business, it’s been offshore activities, globalization and so on. But there’s no question that we’ve very strong profits performance.
I think the question is, is that sustainable? Because if you go back into earlier years, American business was — American business has been cutting costs, really, for at least a decade. But earlier, people weren’t getting big incomes to buy all the goods and services that they were producing and imports, but they were willing to borrow, take money out of their house, borrow on their credit cards to bridge the gap between their incomes and their spending.
Now, if I’m right, they’re trying to save. So, it puts a different cast on that in terms of what happens to cost cutting and whether that ends up with enough income that people are going to be able to sustain the revenues that are needed to keep profits moving up.
What To Do With Treasuries
Forbes: Now until very, very recently, your advice, one of things you hit hard was buying treasuries. And certainly that astounded others by giving great returns. But since Ben Bernanke announced QE2, we’ve seen the 30-year go, despite his efforts, to four and a half. The ten-year went way high, three, three and a quarter, three and a half. People have had a loss. Did you warn people to get out and then get back in? What are you telling people now?
Shilling: It’s always difficult to play stocks in and out, and it’s difficult to play treasuries in and out. As you know, I’ve been a bull on 30-year treasuries since 1981 when the yield was 15.25%. It’s now four and a half. It’s been lower. The yield did bounce up. The prices went down, obviously.
And whether this was a matter with Bernanke of buy the rumor, sell the news — I mean, they rallied initially when the hint of QE2 came with a Jackson Hole last August. And in November when they announced it they promptly sold off. But I still think that 30-year treasuries are headed for 3% yields. And ten years for 2%.
But that is predicated on the idea that we’ve got slow growth, that we’re going to continue to have a lot of problems in Europe, maybe hard landing in China which will, as usual, create a zeal for the dollar and for treasuries as safe havens and that we may even have deflation.
Production Demand
Forbes: Concerning deflation, not deflation from productivity — I mean, high tech’s been in deflation for decades — but you make the point that demand isn’t going to keep up with production. But isn’t in a free economy, if people don’t see production they’re not going to produce.
Shilling: Well, we do have a global economy. And a lot of this production increase is happening in other locales. Now what happened for decades was the U.S. consumer was striving, not only the U.S. economy in my judgment but the world. And our ever-increasing trade deficit meant we were importing more than we were exporting and the rest of the world was exporting more than it imported.
And that, to me, was what drove China and most of the other Asian-developing countries, and even Japan. Japan’s been export-led, traditionally. Well, if I’m right that the U.S. consumer is retrenching, trying to rebuild net worth, work down debt and so on, will continue to increase its saving rate, then that means that this source of growth in the rest of the world is not going to be there. So, what are they going to do?
They still are export-driven. I mean, China is trying to move toward a domestically-oriented economy. But, hey, consumer spending in China is 34% of GDP. It’s 70% in this country. In Europe, it tends to be 58, 59%. The same even in Japan. China is so far behind on this. And I think they’re moving that way but that’s a long-term project. In the meanwhile, they still depend on exports plus their domestic stimulus which they enacted in 2009. And now they’re trying to go the other way.
But I’m just saying I think these countries are going to continue to be export-led. And they’re going to push even harder on exports because the U.S. consumer isn’t going to be as cooperative. So that, to me, is going to be a big source of excess supply in the world is this continual attempt of these developing countries to export their way out.
And by the way, if you look at what’s happening today on this export issue, without the U.S. consumer, how are these countries reacting? Unfortunately, they’re reacting with protectionism. They’re reacting with competitive devaluations. And I think if you cut through all that, although none of them say that, and I’m not even sure they think that, but I think that is a reaction to the removal of the U.S. consumer as this big buyer, first and last resort, for the world’s excess goods and services.
Bearish On China
Forbes: Grim picture. In terms of China, you’re a bear not a bull. Why? Essentially because they’re too export-oriented?
Shilling: Yeah, China is very export-oriented.
Forbes: So, you’re not buying a Chinese ETF, right?
Shilling: China is very export-oriented. I think 2008 was a wakeup call for the Chinese leaders because they had a marvelous machine going. It was driven by exports. And then they produced all the capital equipment and plant necessary to produce those exports. They had an inexhaustible supply of cheap labor. And they had good growth to accommodate all the people moving from the hinterland to the cities.
Those people saved like crazy. The saving rate in China is almost 30%, if you can believe that. They put that money into the banks at very low interest rates. And then they turned around and lent that to the state-owned enterprises. And they were, in effect, arbitraging on these very low-cost funds and kept a lot of inefficient enterprises in business. But it was a functioning deal.
Well, in think 2008, with the recession, and U.S. consumers retrenching was a huge shock for the Chinese leadership. And they realized that they have to get going and work on a domestically-driven economy, which I think they are. And they will. They’re very smart. They’re very determined people. But they’ve got a long way to go.
In the meanwhile, they’ve got a problem in that they stimulated the economy tremendously in 2009. Their stimulus program was 12% of GDP. Ours in 2009 was half of that, 6% of GDP. They got instant results. But they also got a property bubble and they got inflation. And they’re now trying to cool that off. I think they might have a hard landing coming out of that.
Forbes: So, in terms of where will you put your money, even though treasuries have been battered recently, you’d still buy treasuries. And you would advocate buying zeros, which has, in effect, even a higher yield than more volatility, yeah.
Shilling: Yeah, it’s more bang for buck. But unfortunately it works both ways. If rates go up, you lose a lot more on zeros than coupon bonds.
Forbes: So, you’d buy treasuries. Other things you’d recommend? The dollar? You still like the dollar?
Shilling: I do, I do.
Forbes: Gold says dollar sucks. These days it’s the default currency.
Shilling: Well, I think, to be candid, that the dollar is the best of the bad lot. And that’s the argument. It isn’t that we’re really doing things in the way that you would advocate and I would advocate. And I think the euro zone does have a lot of problems there. They’ll probably keep it together, but when they try to jam the Teutonic North with the Club Med South, it was an noble experiment. But we’re seeing that it’s under real strain.
Small Luxuries
Forbes: So the message, when you look at the world — instead of going 80, we’re going to go 40 for awhile. And so, one of the things you talk about, you talk about buy into small luxuries. Define that, please.
Shilling: Well, this is an idea I came up with years ago when I learned that in South Africa, when it was still under Apartheid, the blacks there, who may not have been able to afford a car or even a taxi were looking for a status symbol, something they could afford. And they were carrying these very thin silk umbrellas, like you see the investment bankers in London, the City of London, the financial district, carry.
And I thought, “Well, you know, there’s something to that.” And today, I think we see that because a lot of consumers are pressed in this country so they want a status symbol. Now, I think the ultimate status symbol today is an iPad because it clearly shows that, you know, you’ve got the latest thing
Forbes: Are you buying Apple?
Shilling: Good company. And the iPad is so big, you can’t put it in your pocket. So, you come and you slap it down on your table and you wait for the other guy and see if he’s got one that he can slap down. You know, this is a kind of one-upmanship deal. But it’s that kind of thing. It can be a watch. Watches, a lot of the big luxury watchmakers have come up with lower priced models of their watches. These are status symbols. It’s still got a fancy label on it, but it’s a cheaper version.
Or maybe it’s imported beer. Or maybe it’s things that come in a nice blue box — Tiffany’s. They make some relatively inexpensive, high-quality items that are in that traditional blue box. It isn’t a $50,000 necklace. It’s $50 or $100 cufflinks or whatever. So, these are the kinds of things that I think are important.
Forbes: What are the other areas you like?
Shilling: I like income-producing securities — stocks that pay meaningful, secure and increasing dividends. Because investors, in my judgment, want more money here and now. They want to see that. I think a lot of pension funds that were burned in ‘08 are deciding that they want to see more coming here and now.
Forbes: Amazingly, their dividend yields are higher than their bond yields.
Shilling: Yeah,, they are. Now, they should be because there’s higher risk when you’re comparing with treasuries. They should be. When they were lower, that was in the go-go years when everybody said, “Hey, don’t pay me dividends, I’ve gotta pay double tax on them. You keep the money. You invest it. I’ll take the appreciation.” But I think today, a lot of investors are not that convinced that appreciation is nonstop like it was in the ’80s and ’90s, so they want more dividends.
And this also applies to master limited partnerships which, you know, pay out money. REITs in the same boat. High-quality bonds — Munis are certainly in the dog house now, but corporates. But I am concerned when you get to the point of the big rush you’ve had, and the zeal for yield regardless of risk. And that’s driven a lot of junk bonds to very low yields, in my opinion. That’s one that I would avoid. But the high-quality dividend payers, I think, are interesting.
Commodity Bubble
Forbes: And commodities. You’re not a big fan.
Shilling: No, I’m not a fan of commodities. And if I’m right that there is a hard landing in China. that would probably prick the commodity bubble. For my money, we are definitely in a commodity bubble. When you see the amount of money that’s flowing into commodities by not just traditional commodity players — speculators and hedgers — but by institutions, by individuals going in through exchange-traded funds and physical holding of commodities and so on, I think this is clearly a bubble.
China is a big buyer of commodities. The industrial commodities and about everything else. And sure, some of the commodity increase has been because of bad weather, in the case of the agricultural commodities. In any speculation, there’s always a kernel of truth there. There’s always something. It just gets way overblown.
I think if China does have a hard landing, we’ll see the commodity bubble prick. And it will probably spread from the industrial commodities even to the agricultural commodities because speculators there will want to get out of the way. They may have positions in the industrials. They get burned there, and they want to pull out of everything else to preserve capital.
Forbes: And what else do you like?
Shilling: What else do I like?
Forbes: Yeah, we’re trying to end on positive notes here.
Shilling: Other than Forbes Magazine? Well, as I say, I mentioned the income-producing securities. I like the dollar. As I say, I think that’s the best of the bad lot.
Forbes: Ringing endorsement.
Shilling: Ringing endorsement, yeah. I like productivity-enhancing capital equipment. This is you know, when you’re in an area where business is having trouble, in many cases, raising selling prices and also getting volume expansion, the route to better profits is cutting costs. And they’ve cut a lot of labor cost. But also introducing productivity-enhancing equipment or really anything. Outsourcing is a way of doing that. And there are a lot of companies involved in that area. And this can be high-tech, low-tech, no tech as long as it helps companies improve their productivity.
Forbes: Now, you have one counter-intuitive area you like. Healthcare companies.
Shilling: Yeah, I do. I like healthcare. It’s a very tricky area, in my view, because of very heavy government involvement. The government giveth, the government can taketh away. And that is of concern. There are two areas within healthcare that I would point out. One is companies that produce products, procedures, services, whatever, that provide healthcare but at lower costs.
So much of healthcare is now oriented toward preserving life for another six months but it’s costing you $50,000 or $100,000 per patient. I think with the kind of constraints that we have on federal budgets and so on — and business not excited about cost increases — I rather suspect that those things are going to be under fire.
But by the same token, somebody who comes up with procedures that do essentially what’s being done now, but at lower costs — and this can be equipment, these can be home healthcare services, they can be better management of medical delivery systems.
Forbes: Energy you like, too. North American energy.
Shilling: Yeah. And by the way, let me say, the other thing in the healthcare area I like are medical office buildings. Because what’s happening is that hospitals are really ending up running the delivery system. Now over half of the physicians in the country work for hospitals, as opposed to independent practices, because all the medical record-keeping and referrals and so on, it’s just not economic to run an individual practice. Those hospitals are more and more operating out-patient facilities and so on. So I think that the medical office buildings that they will be building are going to be attractive investments.
Yeah, and North American energy. North American energy is attractive, I think, simply because we, as a nation, have decided that we do not want as much dependence on imported energy from unreliable places like Venezuela and Africa and the Middle East and Russia and so on.
Now the thing is that the cheap North American energy — except for natural gas, I’ll come back to that — has long been exploited. Why? Because it was in a safe area and it was close to the markets. So, a lot of it’s more expensive. You have to go offshore for oil drilling and go at least a mile below the surface of the Gulf of Mexico, for example. That’s not cheap.
Natural gas, with the shale gas and the new fracturing techniques, that’s a marvelous development, and I think that’s a very attractive area. But also, nuclear. I think that’s going to get much more interest. And the oil sands in Canada. I don’t like, however, the renewable energies. And it isn’t a matter that I’m anti-green. It’s just that they depend so heavily on government subsidies. I think that’s unreliable. I mean, you look at solar.
Forbes: It really burns you up.
Shilling: It takes about three times as much subsidy as a wind farm, and that still takes a subsidy. Again, you’re relying on government. Hey, I’ve got enough problems trying to predict the economy — I’ll leave it to you to predict the political developments.
Forbes: Well, thank you for being with us, Gary. And in chapter 11 and 12 of this book, you get 12 investments to sell or avoid, ten investments to buy, which we’ve touched on. Thank you for joining us. And thank you for sharing this wisdom.
Shilling: And on the back of it, you get a very noted endorsement.
Forbes: Oh, my goodness, I recognize this man. Steve Forbes.
Shilling: You got it.
Forbes: Full disclosure. Thank you Gary.
Shilling: Thank you.
5:10 AM
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