Steve Leuthold, Chairman, The Leuthold Group
By Lawrence C. Strauss, Barron's | 7 November 2008
AN INTERVIEW WITH STEVE LEUTHOLD: A "perma-bear" joins the bull camp.
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Based on history and his reading of the economy, Leuthold says stocks should bottom sometime this month.Joe Treleven; Barron's Photo
Barron's: What is your assessment of the market's big selloff this fall?
Leuthold: There were two stages, the first being what we thought was a 'normal' cyclical bear market. We thought the economy had peaked in last year's fourth quarter. And then, about six weeks ago, after the market had come down about 25%, it looked to us as though the market had discounted a recession. By that time, the recession was eight or nine months old. So we thought that, as normally happens, the market tends to turn up in the middle of a recession.
Then came the liquidity freeze, which was the second stage, and that took us down over the past six weeks and really hurt us. We were doing pretty well up until that point because we were defensive, but we turned bullish too early.
In a recent research note, you wrote: "I remain bullish and wrong." Is that still your sentiment?
Yes, it is. I was just looking at an interview I did with Barron's in December 1980, and I was called a super bull. And then we got prematurely bearish in 1998, and people started calling me a perma-bear. Right now, though, I am not a super bull, but I am a very convinced and optimistic bull.
What underscores your case?
Certainly, the intrinsic value of stocks. In terms of our valuation model, it's the most positive we have seen since 1984. We look at 28 different factors, including price-to-earnings and price-to-sales, and they are quite decidedly positive. Because we look at normalized earnings, we smooth them out over a business cycle. We have always done it that way, and we are at about 12 times earnings now.
Is that on forward earnings?
No. What we do is we take the last 4½ years of historical earnings, and then we project forward only six months. Then we divide the whole thing by 20, or the number of quarters. We have found over the years that it is almost imperative that you do that— that is, smoothing out the business cycle to get the underlying level of earnings.
How does that 12 times P/E ratio compare to other periods?
Looking back 55 years, we are in the 15th percentile, well into the bottom quartile, and this is where markets very often have bottomed out. So on a valuation basis, this is a really cheap market. At these levels, we are really down in bull-market territory. From here, on a one-year basis— and this goes back to 1926— the market has been up about 18%, on average, in the next year.
The so-called green book that your firm puts out every month is famous for crunching and analyzing a lot of data. How do all of those numbers help you?
They give you the conviction that you haven't missed very much, if you missed anything. But that doesn't mean that things can't change. When you get a special factor like the freezing up of liquidity that we have seen over the last six or seven weeks, it can disrupt some of these quantitative indicators.
Have investors reached the point of capitulation?
We have been in a capitulation phase for two weeks.
And yet the market keeps going down, although there was a big rally last week.
Well, we get new people capitulating. You have the hedge funds and you have the mutual funds, although recently there were net inflows into U.S.-focused mutual funds for the first time in six weeks. It was a net inflow of $1 billion, compared to $14 billion that went out the week before. It's probably back to a net outflow for the most recent week, though. There are new people who are forced to sell securities. It is a series of capitulations, really.
You've worked in a lot of different markets. Does this one remind you of any you've seen previously?
The one market similar to this was the decline from 1972 through 1974, and we were also premature in turning bullish there. We turned bullish in the fall of 1973, when the market was down about 20% to 25% from its peak. The market turned around, but then it rolled over and went way down in 1974 to a brand-new low. That's very similar to what we are seeing now.
In that recent note, you looked at the various financial panics throughout U.S. history. How does this one stack up?
A lot of people haven't been in this business for 45 years, and they don't study market history, so I wanted to demonstrate that this— namely government intervention into the financial system— wasn't new. This is not something that has never happened before, because it has. But I don't think, except for the Depression, that we've seen a time where liquidity was as frozen as we have seen here. But there are some really good signs of that easing.
When did you turn bullish?
In August, and we went to an allocation of 65% equities, versus our maximum of 70%. Since that time, the market action has taken us back down to 60% in equities. I wouldn't be surprised to see that increase back up to 65%, momentarily.
Is the rest of your portfolio in bonds?
We can't find a lot to buy in the bond market, so we were holding quite a bit of cash. First, we put about 10% of our total assets in some foreign bonds where we saw really big yields, primarily in Australia and Brazil. Second, in the last week or so, we have added about another 10% in U.S. high-yield corporate bonds, whose spreads looked very attractive to us.
We also see a lot of value in municipal bonds. We normally will have a maximum of about 30% of our portfolios in fixed income. But we've had a terrible time here, because until recently we haven't seen much opportunity— because yields have been so low. So we are underweight fixed income, which would normally be about 30% of our portfolios. Right now, it's at about 20% for fixed income, 20% in cash and 60% in equities.
How does that compare to the beginning of the year?
We were only 30% in equities at that point, and that [has been] our typical bearish mode. We were sitting with a lot more cash because we still didn't see much attractive in fixed income. In mid-January, after the market took a big dive, we increased equities just slightly.
In light of what's happened this year in the banking world, do you see the pendulum swinging back to more regulation?
Absolutely. It may be free enterprise, but even free enterprise has to have some rules, or you get a free-for-all. It's like playing a football game with no rules.
Does this particular downturn remind you of any other economic slumps in particular?
This recession is probably similar to the one that occurred around 1981. The average recession since World War II has been about 11 months. The longest was 16 months, and we've had two of those. And I think this one is going to last at least 16 months and probably longer than that, maybe 20 months.
This recession started in the fourth quarter of last year, so you are looking at a recession through the fourth quarter of 2009. But you have got to remember that the stock market is a lead economic indicator, and historically it has turned up about 60% of the way through a recession. Applying that timetable suggests that this market should be bottoming sometime this month, and that is very, very possible.
Let's drill down a bit and talk about some sectors that you like.
Our U.S.-focused equity portfolio is about 50% of the total portfolio. About 32% of the U.S.-focused portion of the portfolio is in health care, normally a pretty defensive area. But we also know that when new bull markets start— and that is what we have to prepare for— it is very often the most aggressive stocks that perform the best. So we have about 15% in biotech stocks.
What's to like about biotech?
First, I don't think they are terribly closely aligned with the economy. Biotech firms operate in a world unto themselves. Second, they tend to operate without a great deal of government regulation in terms of products, because they are developing products. And third, many of them are acquisition candidates for the big established drug companies that really need to expand their product lines, especially if they don't have much in the [research-and-development] pipeline. Some of these are bigger biotech companies, and some are smaller. But when this market does turn, biotech could very well be one of the areas that really benefits.
What other sectors look interesting?
Another group whose shares have come down a lot is the oil drillers. Their prices have come down more than the price of oil has. But you are going to see more offshore drilling, regardless of what's happened to the price of oil short-term. These companies have built-in books of business for the next three years. Their problem is they don't have enough rigs to drill. They are trading at six or seven times earnings, which is really cheap when you consider that the earnings-growth outlook is outstanding over the next three years or so.
What else?
This is a little weird, but the home-improvement companies look attractive. And we have a fairly significant position in that sector. You can pretty much guess the names there.
Probably Home Depot [HD] and Lowe's [LOW].
There are couple of other smaller ones as well. We are not too excited about the consumer's prospects in the coming expansion, when that occurs. But you also have a heck of a lot of foreclosures and a lot of work that is going to be done to those properties to get them back into shape for sale. So these home-improvement stocks are relatively cheap, and they have good growth prospects. They have been beaten down, but it is one area where I feel confident about the consumer, primarily because of fixing up the foreclosed properties.
What about non-U.S. stocks?
We have 10% of our equity holdings in companies outside the U.S. We have a huge database covering 59 countries and every stock with a market cap of more than $200 million. One of the countries that looks really interesting is China. There are still 214 Chinese companies that have more than $1 billion in market value. The mean P/E on those stocks, as of last week, was 13, down from a peak in 2007 of about 56 times.
In China, you are going to see slower gross-domestic-product growth of maybe 5% or 6%, down from 9%, but there are some extremely attractive values there. And although people say you are trying to catch a falling knife, the Shanghai index is down 75% from the peak in October of last year. So China has become our largest holding in terms of emerging markets.
What's your view on small-cap stocks, which until recently had held up relatively well this year?
Small-caps generally are the best performers when the market turns. Looking at our entire equity profile, we are close to 60% in large-caps, with another 30% in mid-caps and 10% in small-caps. But I have been surprised that the run in superior large-cap performance has not lasted very long, maybe 18 months. This seems to be too early for the small-caps to be coming back, but they are doing it. So, that's one of the biggest questions we have: Is this a turn for real in small-caps— or not?
But couldn't you argue that, if you're bullish on the market right now, that this would be a good time to increase your small-cap allocation?
That's exactly right. That's why we have the small-caps in biotech, for example. And maybe we ought to have more in small-caps. Our technical analysis suggests they are re-emerging as market leaders, and then I think, 'God, it is too soon for that to be happening, considering the long period they had of leadership over large-caps.'
Thanks very much, Steve.
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