The Year of Living Cautiously
By LAWRENCE C. STRAUSS
Analytic Systems' president and founder, John Moffatt, explains why he's overweight health care, financials and utilities—and why commodities like gold aren't as safe as people think
It's time to get defensive, albeit not by hoarding a lot of gold. That's the view of John Moffatt, president and founder of Analytic Systems. The Hopkinton, N.H., firm does sector analysis, based on its quantitative model comprising 20 economic factors, including inflation, demand for credit, housing, real personal income, consumer spending and the cost of energy. Moffatt, a 70-year-old Texas native whose résumé includes a stint working as an analyst for George Soros in the late 1960s and early 1970s, founded his quantitative-investment research firm in 1982. Currently, his recommended model favors health care, utilities and financials. The lone sector he rates underweight is consumer discretionary, with the rest neutral. Barron's, which profiled Moffatt 10 years ago ("Blue Skies Ahead?," May 28, 2001), interviewed him recently by phone to hear his latest thoughts on the economy, sector weightings and other topics.
Barron's: Let's start with your big-picture view, John.
Moffatt: We've been talking about a soft patch for some time, despite the consensus earlier in the year that the economy was going to accelerate by more than 4% in terms of annual gross-domestic-product growth. We are in the muddle-through camp, based on the industry groups we cover, growing at around 3%. We listened with interest to [Federal Reserve Chairman] Ben Bernanke's characterization of a soft patch in the economy, and the inflation rate as being transitory. The weakness in the economy may be transitory, but I would doubt that the increase in inflation is so transitory, and, in fact, we may see some stickiness in inflation. So in this environment, we are semidefensive, and one should be somewhat cautious. Instead of chasing high-momentum groups and names, we are opting for more safety with health care and utilities, which are both working fairly well, and financials, which aren't working yet. And we are underweight consumer discretionary. We liked that sector in '09, and we moved out subsequently. That group should probably be affected by higher commodity costs and higher gasoline costs, which are leading to some demand destruction, damping consumption. Another thing to consider is the overleveraged consumer.
You maintain that the market doesn't always discount the economy. Explain?
That's an important distinction about our service, which we have been providing for more than 29 years. We've made a lot of calls based on the premise that there are signals—and that we are able to process those signals based on economic trends that give us a reading on the future relative strength of industry groups. Our premise is that the economy is leading industry groups. Another way to put it is that the economy is leading the market, in contrast to the view that the market is leading the economy. So I would just ask those people who are saying that the market is efficient and discounting the future, what happened in 2000? Did the market discount the downdraft that occurred then? And what happened in 2008, which became a very unsettling period—and yet the market was complacent prior to the financial meltdown?
What's an example of something that's not a good predictor for your analysis?
We study which economic factors are reliable as predictors of future industry-group behavior. We have analyzed consumer-confidence surveys, for example, and tried to use them as predictors. But if you were to develop a model using those surveys as predictors, they actually throw off contrary signals. On the other hand, one of the best predictors is initial-unemployment claims issued by the states.
Why aren't consumer surveys that helpful for your research?
We come at it from strictly a mathematical point of view. Our test shows that consumer-confidence surveys aren't good predictors pertaining to industry groups' relative strength. The key is what people do, not what they say they are going to do. So we look at consumption. And it is a case where consumers may be very cautious, yet they are spending. In other cases, they may be very confident, but they are slowing their spending. So getting these economic signals from all the factors that are out there is quite tricky, and one has to look at it on a rate-of-change basis, which is what our model is based on. You have to watch the rate of change of consumption, versus the norm, as the source of information.
What's an example of a good call that you've made?
One of the best calls that we made recently was in December '08, when we overweighted the information-technology and consumer-discretionary sectors, and we underweighted consumer staples and utilities, amidst the gloom and doom of that year's fourth quarter. As we explained in our report that month, it wasn't that things were improving. It was that the deceleration in the economy was so steep, [and] we had never seen such a steep decline in factors across the board, such as consumption and spending—and we thought that steep decline was unlikely to be sustained. So we have a mean-reversion approach, and our model anticipated that we were on the verge of improvement. The economy actually started turning in June of 2009, and we were bold enough to talk about it as a V-shaped recovery in December of '08.
And what about a call that didn't pan out?
We saw the weakness in the economy in July of '07, with the headline economic conditions deteriorating sharply. Although our model was showing deceleration in the economy, we didn't take it seriously enough. We did temporarily have an underweight in financials, but we didn't hold to that underweight. We went back to market weight before the downdraft hit in '08. Our model is based on a 10-year history of data, and there was hardly any way that our model could have anticipated the dimension of that decline in '08 and early '09, so we weren't positioned defensively enough.
Why do you recommend a short duration for fixed income? Higher rates?
Everything we do is driven by our industry-group rankings. So it is very unusual that we've had both offensive and defensive industry groups ranked highly at the same time. We've had utilities and telecoms highly ranked, along with rails, steel companies and energy, up until recently. So we were trying to read what that means, and, in a sense, the high ranking of energy is acting as a tax on our economy, as payments for importing energy subtract growth from our economy. But it is also an inflationary indicator. Generally, when one sees energy as one of the best places to be, it represents a presence of inflation. So we had energy overweighted from October of 2010, until a about month ago.
But the implication on interest rates going up is that we are talking about inflation not being transitory—and that it is sticking. We've talked about the acceleration in inflation from 1.1%, year over year five months ago, to 3.2%, year over year currently. That's real acceleration of inflation. I don't see anything, practically speaking, except for some moderation in energy prices, that is going to act as a damping effect. Indeed, one of the biggest components of inflation—housing-rental rates—may be starting to contribute to higher inflation. And other sources of inflation, such as education, health care and transportation, suggest that inflation is here to stay and ready to edge higher. When I talk about this, frequently some of our clients point to the lack of demand, with the consumer being overextended. However, we've had inflation in the past with lackluster demand, otherwise known as stagflation. So it is a case where the dollar is weakening, and it is undermining the value of goods that we can purchase with that dollar. So it is likely to lead to inflation. We aren't talking about 5% annualized inflation, but closer to 3½% to 4%.
Why do more defensive sectors make more sense in this environment?
When you have sluggish growth, the more defensive areas are less affected by the economy. For example, the consumption of electricity is fairly stable. So even though we may have diminished economic activity, electric utilities generally will fare OK. Despite the surge in the Fed's balance sheet and the increase in the monetary base, we aren't seeing it affecting the economy that much. It's showing up as excess reserves in banks, but banks aren't lending, and small businesses are having a hard time getting credit. So there's a lack of animal spirits, generally speaking, to borrow a phrase used by economist John Maynard Keynes. There aren't enough animal spirits in this economy to show the typical growth that we would be seeing in a normal recovery. And part of the problem with the animal spirits, or lack thereof, is in residential real estate. There are still a large number of foreclosures putting pressure on home prices. When prices are under pressure, it has an automatic effect on the buyer. If one can buy something cheaper by waiting, why not wait? So that's what people are doing: waiting. They are watching these prices come down, and the banks are having a hard time getting rid of their housing inventory.
You talk about the potential of inflation, but isn't the scenario you just described one of deflation? Is this a case of the inflationary scenario winning out over the deflationary one?
They changed the method of using housing in calculating inflation. It went from the home-price effect to the rental-equivalent effect. So when there is diminished demand for houses, would-be buyers are renting housing. So when the rental market gets tighter, and rental rates increase, that impacts inflation. If we were to have a steep decline in home prices, another implosion in credit and the banks still have a lot of mortgage inventory—and if we had a real problem in home prices like we did in '08—then that could be deflationary. Deflation can't be ruled out, because we have a soft patch in the economy, and we have an overextended consumer. We have excessive debt, and we have a soft residential real-estate market. So this is a race against time, where the Fed needs to get the animal spirits to turn the housing market around before there is another downdraft, which would be deflationary. But currently, it doesn't appear that there is enough weakness to lead to that downdraft—although it is a month-by-month proposition.
Moffatt's Sector Picks
| |
OVERWEIGHT | NEUTRAL |
Financials | Materials |
Utilities | Consumer Staples |
Health Care | Energy |
UNDERWEIGHT | Industrial |
Consumer Discrectionary | Technology |
Source: Analytic Systems |
Residential real estate is mired in problems, and it was revealed last week that home prices had dropped to 2002 levels. Loan growth has been spotty for the banks. So why are you overweighting the financials?
Well, it is one of the few groups that hasn't yet recovered. The sector is undervalued, if it were to have normalized earnings, but we don't know when that will occur. Still, the financials are highly ranked in our model. One of the factors in their favor is that they are getting money for basically nothing, with short rates as low as they are, and the yield curve is favorable. Also, commercial and industrial loans are improving, despite the fact that credit is tight and banks aren't lending. Commercial and industrial loans bottomed last fall, but they have been showing increases every month since then. So we are seeing improvement for those loans, but not much. The weakness, however, is in mortgages. We aren't seeing enough mortgage activity to get that part of the economy going. But it is a case where the interest-rate environment is favorable, loan demand is improving, and, as the economy improves, financials should improve as well, although some firms are better positioned than others, of course. So one has to be selective, but it is an unloved group. Many of the negative factors that you talked about appear to be fully discounted, unless we have another downdraft. But it doesn't appear we are going to have one at this point.
Why are you overweight utilities?
With the yields on bonds very low, there are people searching for yield, and they've bid up the high-yield market to where it is probably too high. So utilities have a decent yield. The Utilities SPDR [an exchange-traded fund; ticker: XLU] yields about 3.9%. And utilities have a stable business model. So in this kind of muddle-through environment, utilities are another alternative.
What's your advice to individual investors?
The most important questions that their advisor can answer is, what is inflation going to do for the next 10 years, and where can I find a safe place? The one area we find to be relatively safe is large multinational companies that have a good dividend that is being earned -- that is, a decent dividend that is being well covered. I don't think Treasury bonds are safe, and I don't think gold is safe.
That's contrary to many investors, who are piling into gold as a hedge against the devaluing dollar.
We haven't said sell gold. At a conference last October, I said, 'Sell down to your core position, maybe around 4% of your portfolio.' But gold is in a potential bubble, like a lot of other commodities. There has been a tremendous amount of money piling into commodities and precious metals on the prospect of a devaluing dollar.
The problem with the devaluing of the dollar is that there's no other currency to replace it. The Japanese are in worse shape than we are, and the Europeans are in worse shape than the Japanese are, and so there's nothing to replace it. So this is kind of like the Roman Empire. Or, we are in the eighth inning, and we have plenty of time to rectify our problems -- if we just get started. But if we keep wasting our time, then we are going to go by the wayside. There is no competitor to the dollar; that's the reason it isn't going to be debased. And if the dollar recovers, then gold won't do well.
Thanks, John.
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