Buying Into Gloom
A Wall Street veteran's thoughts on Silas Marner and why gold remains golden
By SANDRA WARD
AN INTERVIEW WITH DAVID RICHARDS -- The weather in Stonington, Maine, this summer seemed a mirror image of the stock market: damp, fogbound and windless. That ruled out sailing as an excuse Richards might use to duck a request for an interview. But, as he has done twice in the past, the Wall Street veteran and former money manager at two of the most respected investment firms around, Capital Research & Management and PrimeCap, graciously agreed to sit down and share his insights into economic conditions and what they might mean for the market. And for lessons on market psychology from the George Eliot novel Silas Marner, read on.
Barron's: It has been two years since we last spoke. Has your outlook changed? Are you still waiting for financial disaster?
Richards: The short answer is yes. There are practices going on that aren't sound, and if conditions change, which they may well do, the change could be sudden and not very good for the stock market.
Former money manager Richards uses a literary reference to help explain the logic of his current stake in gold stocks.
Q: Practices such as what?
A: One set of issues is the balance-of-payments deficit and central-bank intervention and the dollar and the huge buildup in foreign central-bank reserves. Another set concerns housing, consumer debt, mortgage debt, derivatives and the tremendous growth in asset-backed bonds. There is the issue of political stability in the U.S. We have a divided country. It's divided between Bush and Kerry, obviously, but there's a huge difference of opinion about the Iraq war.
Q: Is there, though? I'm not so sure.
A: There is a feeling among some people that we were misled and this is a war that shouldn't have taken place. Lastly, long-term trends in the world point to the power and leadership of the United States diminishing in a way we haven't seen in our lifetime. There's a quote I'd like to read. It's from Silas Marner, a novel by George Eliot, a good female writer, by the way.
Q: Even though she had to use a man's name.
A: Right. Times have changed. It goes as follows: "The sense of security more frequently springs from habit than from conviction, and for this reason it often subsists after such a change in the conditions as might have been expected to suggest alarm. The lapse of time during which a given event has not happened is, in this logic of habit, constantly alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent."
Q: Brilliant. How long did you search for that quote, or did it just come to you?
A: This is a quote I found many years ago during the Nifty-Fifty stock mania [of the early 1970s], when people were reluctant to sell high-priced stocks because they would then have to make a decision about something else to buy. Now, it brings to mind what's going on in the asset-backed bond market. The ultimate lender, who is the buyer of the bonds, has very little knowledge of the financial condition of the individuals who borrow the money. This is true of mortgages, of car loans, of credit-card loans and home equity loans. These loans are packaged by Wall Street and sold off to various institutions. There is a false sense of security on the part of the buyer, that because many of these loans are packaged by J.P. Morgan or Citibank or some other recognizable institution, that they are OK. The asset-backed bonds may have a default rider underwritten by MGIC Investment or some other company, and investors feel as if they are protected, but the system as a whole has become increasingly leveraged.
Q: This was a big concern of yours two years ago. Are you surprised we haven't seen really any major difficulties in the asset-backed market?
A: We haven't seen difficulties because Greenspan has kept rates low until recently. This has stimulated housing prices, and there hasn't been any decline in house prices that amounts to anything. There's been continued heavy buying of U.S. securities by foreign central banks, particularly China and Japan and Taiwan and Korea and most of the East Asian countries, but also India and Russia. They, in a sense, are the ultimate buyers. They're buying U.S. debt for political reasons and supplying this credit to borrowers who in other times would not be able to get a loan. The lending business is an incredibly competitive business and companies have come out of the woodwork and grown rapidly in it.
The risk comes to the fore when house prices level off. There are signs of that happening as inventories of unsold houses have gone up rather dramatically in the last two to three months in several parts of the country. People cannot sell houses as quickly and they are probably going to suffer some price degradation. Loans that were made recently may turn out to be under water very quickly since the down payments are very, very small in most cases. That can lead to a decline in prices. There's a sense house prices can't decline, but I live in Southern California, and in the early 1990s, prices went down 20% to 30%.
Q: So if foreigners stop buying the bonds...
A: The numbers are enormous. In the last 12 months, China's foreign reserves have gone up more than 30% and are now at $471 billion. The Japanese foreign reserves have gone up nearly 50%. They now have $800 billion in foreign reserves. Taiwan was up 25% to $230 billion. India has gone up 40% to $114 billion. East Asian reserves have gone up to $500 billion, or 35%, in the last 12 months. These countries are just collecting paper, and in exchange they're giving us Toyotas and TVs and socks and God knows what else. They're collecting all the bills, and at any time they could change their mind. Remember at the height of the bubble, when all the telecom companies were providing the financing to their customers to buy their products? Vendor financing. That's what these Asian countries are doing, providing vendor financing. And the customer is the American consumer.
Q: What's your sense of the health of the consumer?
A: Consumer spending, whether on houses or cars or retail sales, has grown from 10% to 12% more than personal incomes in the last dozen years. There are signs the consumer is tapped out. Interest rates have risen, and they're going to go up more. That's a potential problem. The problem could take the form of defaults. Also, because some in the financial markets are highly leveraged, playing the derivatives game, there could be an event along the lines of Long Term Capital Management that develops. These things come out of the blue. I have no idea who or when but the conditions are such that it makes me nervous.
Q: Is this soft patch the result of the slowdown in consumer spending?
A: If spending is growing faster than incomes, at some point the exceptional growth in consumer spending comes to an end. Now, who knows where that point is? This so-called recovery is very different from anything in the past. People are leveraged in a way they have never have been before. But when you have the inventory of unsold houses going up for the first time in many years, that's a change. When you see General Motors' car sales down despite big incentives and talk of production cutbacks, that shows the strain on their ability to continue to sell cars. Retail sales at department stores and Wal-Mart are soft. There are signs that the basic guy out there is under pressure.
Q: Is there any bright spot?
A: One huge change that's positive is the rapid growth of the Asian economies. People talk about China, but the whole of Asia, as well as Russia, which tends to get overlooked, and Eastern Europe have changed from socialist, totalitarian governments to market-driven and market-oriented -- albeit authoritarian -- governments. These economies are growing in the high single digits, with China growing a little faster than that. This isn't going to stop.
Q: How should investors factor this trend into their decision making?
A: These are material-intensive and energy-intensive developments. Many of these countries have to build roads, railways, sewer systems and real estate. In other words, there's strong demand for things we have already seen go up in price, whether it's steel, shipping, oil, gas, or copper or concrete. All these are in short supply because there is this tremendous new demand.
Consider oil. Oil is now priced well into the 40s. I don't know what the price of oil should be, but I know there is no excess capacity to produce energy. There must be a much greater effort to find and develop oil and gas than there has been. Spending must go up. I am very long energy -- oil and oil-service stocks -- because this is a very long-term play.
I also have some investments in Russia. Russia is blessed with excess energy. The costs of these materials and energy are likely to stay up. A lot of these costs haven't yet flowed through our inflation indices. There is a danger that inflation begins to show up as import prices go up, which, in turn, results in domestic prices being pushed up.
Q: What about a slowdown in China as the government tries to check inflation?
A: The Chinese inflation rate, its consumer-price index, is up about 5% year-over-year. That's despite lots of price controls. Recently, there have been reports of labor shortages in the Guangzhou area, and that's because agricultural prices have gone up in the hinterlands and the village people aren't as willing to leave to find work in the major cities. The assumption that China had an infinite supply of labor and could increase production without any increase in labor costs might not be true. There is talk they could slow down the economy by raising interest rates, which are now about 5.3%. But they can't do that, because capital from abroad keeps flooding in to take advantage of the low labor costs and high productivity.
The only way they really slow things down is to revalue the currency or suffer huge increases in inflation. Neither is very pretty to contemplate. If they revalue, the profit margins in a lot of factories that now export to, say, Wal-Mart are going to suffer. If they don't revalue, they are going to have a lot of inflation and that's potentially politically difficult.
Q: Revaluing is a choice they can control better than the other.
A: Revaluing is probably what they should do, but it is probably something they find scary. The point is, whether they revalue or not, we are going to see price increases on goods coming out of China. There are some signs that it's beginning to happen. When it happens, you are going to have higher inflation in goods and services in this country, pressure on the CPI and pressure on Greenspan to keep raising rates even though the economy may not be that great and housing could be punk. Rising interest rates are going to accelerate.
Q: Tie this into your concern about the balance-of-payments problem and foreign buying of dollars.
A: If the Chinese revalue, there would be a reduction in the amount of intervention, and that would probably have an upward impact on U.S. interest rates. The dollar could go down, and there could be a reduction in the holdings of dollars by central banks or, at least, a start of diversification out of dollars into other currencies or into gold. I've been buying gold stocks.
Q: Even since we last spoke?
A: I've built up the position in the last two years. It's quite sizable now, more than 20% of the portfolio.
Q: This hasn't been a great year to own gold stocks.
A: No, because nothing has happened yet. But remember Silas Marner.
Q: How about some picks?
A: Newmont Mining. AngloGold Ashanti. And Placer Dome.
Table: David Richard's Picks
Q: Is gold the biggest position you have in your portfolio?
A: No, energy is more than 40% of the portfolio. I have a total of 16 stocks: five oil-service companies and 11 oils.
Q: Do you own Yukos?
A: No, but I do own Lukoil and Tatneft.Transocean, Murphy Oil, Baker Hughes, ChevronTexaco and ConocoPhillips are also some of my holdings. I'm assuming the price is going to stay fairly high while the stocks and the industry are assuming the price will stay under $30.
Q: What do you make of oil companies refraining from investing in exploration?
A: They don't believe the oil price at $42 or $43 a barrel is going to hold. They're remembering 1998, when the price went to $10 from almost $25. An even more dramatic fall occurred in 1986, when oil prices fell to about $10 from well over $30, where they had traded through most of 1980 to '84 before starting to come down in 1985. Oil companies historically haven't been very good at forecasting the price of oil, and past experience makes them skittish about assuming that prices will stay well over $30. In the past, the price was driven higher because [the Organization of Petroleum Exporting Countries] was cutting production. They aren't cutting production now. They are running flat-out. Oil prices aren't high because there's been a cut in production.
This isn't a false-supply situation. It's because 3½ billion people between Germany and the Pacific Ocean are suddenly buying cars. Of course, not all at once, but if an economy is growing by 4%, 5%, 6% a year, and suddenly the world needs two million to three million barrels more a day of oil every year in an 80-million-barrel-a-day market, you have to wonder, where is it going to come from.
Q: How long do prices stay high?
A: Oil stays high for at least two-to-three years. Psychology has got to change. The oil industry must become convinced oil prices are going to stay high in order for them to go down. Only when they are convinced prices will stay up will they invest enough to provide the extra production.
Q: Let's segue into the issue you raised of political stability.
A: Bush is taking the country in a direction that is very different than it had been going in for the last 50 years. The notion of pre-emptive wars and the pre-emptive war that we have in Iraq is a failed strategy. If [Deputy Defense Secretary] Paul Wolfowitz were a money manager, and he made the forecast about weapons of mass destruction and the Iraqis greeting the American forces with flowers, and then declared "mission accomplished," when in fact we were totally unprepared for the uprising we face there, he would have been fired for incompetence. No one responsible for these decisions has been fired. If you had a big money-management company with bad research and bad portfolio managers making bad judgments, that would be the end of that company.
Q: Yes, and I believe there's been a few examples of that.
A: These people are delusional. They are deluded by the apparent military power of the United States. There are three levels of military power, and we have a great advantage in one: the middle level. The top level is the ability to produce atomic weapons and missiles. Now the Chinese can do it. The Russians can do it. The Israelis can do it. The Indians can do it. The Pakistanis can do it. The British can do it. Nobody has an advantage, and these weapons cannot be used without blowing the world to smithereens. In that sense, they are useless. The middle level is about projecting force, and that's what we're good at. We have airplanes. We have aircraft carriers. We have guided missiles. We have electronics. We have all that in profusion. There we have an advantage. However, at the third level, we have no advantage at all, and that's in guerrilla warfare and in controlling territory. That's the problem in Iraq. We needed a multiple of the number of troops that we have there to control that country. Unlike the Russians and the Chinese and many of the European countries, we don't have a conscript army.
Q: Are you suggesting we'll reinstate the draft?
A: If Bush gets elected for a second term, and he's faced with an army that is overextended, there's going to be a draft. That will divide this country further. That's where the political crisis comes in. Because of the military overextension, you have some terrible decisions that have to be made. The draft is one. The second involves the budget. The war costs are much greater than they should have been.
Q: Bring this back to your point that our power in the world is diminishing?
A: The power diminishes because of this huge growth over the next 10-to-20 years of Asia. Also, our unilateral policies are angering the world, and it isn't unreasonable to consider Western Europe joining with the Russians and creating a huge power bloc against us.
Q: Describe your overall portfolio. Are you more long than short?
A: I'm more long than short. I'm net long about 15% to 20%. The shorts are mostly Standard & Poor's 500 futures, probably two-thirds of them, and some QQQs [Nasdaq 100 Tracking Stock]. The S&P is very heavily oriented toward retailing, finance and drugs. The oil sector, which I am long, is only 7% or 8% of the S&P. I am basically shorting the U.S. consumer.
Q: Thanks, David.
