Streetwise Reports: For more than a decade, you led Morgan Stanley Investment Management's global investment strategy. Now you own your own research firm, drawing on your observations of the industry for more than 50 years. How do you explain the volatility in the markets right now, and how should investors position themselves to prepare for what is coming?
Joe McAlinden: It has been a wonderful bull market, a wild ride going all the way back to 2007 when the market made its top. That was followed by a horrendous plunge. We've not only made that back, but the market has reached highs that were 36% above the 2007 highs. I have been concerned recently, however, that price-earnings ratios have become elevated and we are seeing other spooky similarities to the conditions that prevailed prior to the 1987 crash, including the absence of a more than 10% correction for three years and a breakdown of small-cap stocks. The market could be vulnerable to some kind of major shock. I believe that the big shock is only beginning to unfold, and that as it does, this correction will get considerably worse, perhaps double what we've had so far and maybe even worse than that.
TGR: What do you think the market expects the Federal Reserve Board to do?
JM: The market is hoping the Fed will bail it out by postponing the tightening, but I don't think that's going to happen. It is appropriate for the Fed to begin the tightening process now. It's not the Fed's job to regulate what's going on in the stock market. Its job is to maintain the purchasing power of our currency. The Fed is tasked with keeping inflation and inflation expectations stable and fostering full employment.
"It is appropriate for the Fed to begin the tightening process now."
The U.S. government should not be in the business of trying to manipulate the stock market the way the central planners in Beijing do. We're supposed to be a free market economy. The Fed should not allow monetary policy actions to be determined by what the Dow does on a given day. I think that, as some Fed officials have indicated, it should and will go ahead with the quarter-point move in September.
I am worried about the tremendous gap between the Federal Open Market Committee (FOMC) members' expectations and the market's perception about the path ahead for the federal funds rate. When you look out to 2017, the gap is about 130 basis points. That is a big deal because we all learned in securities analysis 101 that stocks are worth the present value of the future stream of earnings. In the case of high-growth equities, future earnings are a big part of the current value, especially when the discount rate is influenced by the current policy of zero interest rates in the U.S. So my concern is that a) the market is overvalued, b) there are these similarities to 1987, and c) the gap between market expectations and what the Fed plans to do needs to be closed. My guess is that as it closes, there will be downward adjustment in equity prices and bond prices.
TGR: What were the causes of the "flash crash" that happened at the end of August? Are there black swans that could bring back painful 2008 scenarios?
JM: The consensus interpretation of the flash crash is that the volatility was due to the China slowdown. I don't argue that is not a factor, but the bigger problem was China's peg of the currency to the dollar, which just kept getting stronger. They couldn't hold the peg any longer and did that devaluation. I think it will probably not be the last.
Derivatives, which have proliferated throughout the markets, are vulnerable to jolts. It is unknown to what degree big players afraid of being exposed to liquidity problems played a role in the crash. The ability of banks to step in with capital has been greatly diminished and that could have played a role, along with Dodd-Frank and other reporting requirements. Many hedge funds today are driven by algorithms, so there is no human compassion in place to make rational decisions when anomalies occur. More corrections are likely.
The big question is: Where can investors hide if we are heading into major correction territory? I think we're going to see the relative strength of precious metals turn up sharply—it already appears to have perked up—simply because when you get into a scary environment, there tends to be that flight into hard money. But I think there's more involved here.
Conventional wisdom is that a hike in interest rates is going to hurt gold, but that is not borne out by history. When rates have gone up in the past, gold has risen, as have other precious metals. That is what will happen again. That makes me positive on gold, which, to be honest, I haven't been in a long time.
"When rates have gone up in the past, gold has risen, as have other precious metals."
Oil follows the same trends. Interest rates rose in the mid-1970s by a ginormous amount, but so did oil and gold. I was there and I can tell you I witnessed a broad move in precious metals and hard assets. Energy also enjoyed a tremendous move. Last month, I wrote a piece for our subscribers called "Time for Value" that predicted the value side of the market will outperform on a relative strength basis. In other words, if you were short growth and long value, I think you'd make money irrespective of how deep this correction goes.
TGR: Streetwise Reports looks for investing ideas across all sectors, including life sciences. Where else would you find value?
JM: I've been very positive on the U.S. residential housing market, largely because of demographics. Home ownership, for American families, is the hard asset of choice. Home prices will continue to rise to above where they were at the so-called bubble peak in 2006–2007.
"I've been very positive on the U.S. residential housing market, largely because of demographics."
If I'm right, we're going to see bond prices continue to erode from the cyclical highs they hit at the end of January when yields got down to a one handle on the 10-year government bond. Over the next several years, I think we are heading toward a three handle and maybe between a four and a five for the 10-year treasury.
TGR: You are a wise man who has seen a lot from your perch at Morgan Stanley and now in the companies you founded, McAlinden Research Partners and Catalpa Capital Advisors. How are you positioning yourself based on what you see coming?
JM: I work with hedge funds and portfolio managers and, now, increasingly other investors, doing market strategy research. I focus on change and only write about a sector when I see a shift. We are at a major turning point in the macro picture right now. There is potential for big moves up and down in sectors and specific securities.
For my own portfolio, right now, I'm very heavily in cash. I'm getting ready to deploy some money in the right opportunities.
TGR: Thank you for your insights.
Joe McAlinden has more than 50 years of investment experience. He is the founder of McAlinden Research Partners and its parent company, Catalpa Capital Advisors. Previously, McAlinden spent more than 12 years with Morgan Stanley Investment Management, first as chief investment officer and then as chief global strategist, where he articulated the firm's investment policy and outlook. He received a bachelor's degree cum laude in economics from Rutgers University and holds the Chartered Financial Analyst designation. McAlinden has served on the board of the New York Society of Security Analysts.
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