A Foolish Conversation With John Mauldin
This week I am in La Jolla for my annual Strategic Investment Conference. It is packed, and of course I am quite busy, so not much time to write my regular e-letter. But a few weeks ago, Rich Smith from The Motley Fool did a fairly wide-ranging interview with me that just came out this week, and I thought he did an excellent job in putting together a coherent piece from what was a long conversation covering a lot of topics. So, let's see what Rich found interesting in my musings.
By Rich Smith
Do you have a net worth of $1 million? Own a hedge fund? If the answer to one of those questions is "yes," then chances are that you know John Mauldin -- president of Millennium Wave Advisors, author of the weekly e-letter "Thoughts from the Frontline," and perhaps the leading proponent of the theory that America is in the midst of what he calls a secular bear market. When you need a big-picture view of what's going on in the economy, John Mauldin is the guy to ask. Fool contributor Rich Smith did just that.
Rich Smith: John, let's start with a get-to-know-you question -- it's actually a compound question. What is Millennium Wave, why did you set it up, and what do you all do there?
John Mauldin: Millennium Wave is a "manager of managers" for accredited investors, primarily individuals. We evaluate the performance of hedge fund managers and firms investing in alternative investments and help our clients find the good ones.
As for why I set it up, in 1998, I became convinced that we were entering a bear market cycle, and that investors needed to shift their focus to investing on an absolute-return basis -- where you try to beat zero, or not lose money to the bear. That's as opposed to investing on a relative-return basis, where you try to beat a certain benchmark like the S&P 500.
As you saw in 2000 and subsequent years, and I think as you're seeing in today's market as well, that can be easier said than done. Some people lost as much as 80% of their investments in the last bear market, and when that happens, even beating the index can cost you a lot of money.
Rich: I'm a big fan of your weekly emails, where you digest incredible volumes of data into five to six pages of easy-to-understand thoughts on the state of the economy.
How did you get started doing this?
John: It got started as a way to synthesize what I was reading on a day-to-day basis, just trying to make sense of the big picture. I'd write these letters and send them out to people I thought might find them helpful. We started out with about 2,000 readers in August 2000, and it just took off from there.
The response has been overwhelming. I've been very grateful for the feedback I get from the readers, and I meet a lot of contacts and develop business opportunities from our readership. These days, the letter is sent out to about 1.5 million readers in a typical week. Sometimes more, because our readers will often forward the letter out to their own clients, or other publishers will include it in their letters.
Rich: Your letters often refer to a "$1 million net worth" requirement for individual investors to attend such-and-such a conference or invest in a certain fund. Can you briefly tell us what this requirement is, who sets it, and why you don't seem to entirely approve of it?
John: It's a requirement that originates with Congress, and it basically relates to hedge funds. The rules limit the number of investors in private funds to 99 investors worth $1,000,000 or more or 500 investors worth $5,000,000 or more, with a number of variations for certain types of funds, which can be very confusing to the individual. Take away the net-worth requirement and the investor limits, and anyone could invest in a hedge fund, just like anyone can invest in stocks, options, real estate, commodities, and similar "risky" investments. I testified to Congress a few years ago that they should create a new class of regulated hedge fund so that smaller investors could invest on a level playing field with the richer investor.
Congress also restricts the right of "registered investment advisors" to charge an "incentive fee" -- that's the 20%-of-the-profits take that you hear about all the hedge funds charging their clients. Basically, the rule is that you have to restrict your clients to persons with a net worth of $1.5 million before you're entitled to charge the incentive fee. Now, since hedge funds have to register, the minimum net worth is essentially $1.5 million.
Personally, I think the rule is profoundly unfair. It means the rich get the best deals. I mean, are hedge funds really more risky than stocks, commodities, futures, real estate, or other kinds of investments? And who is Congress to tell people with less than $1.5 million or $5 million, "No, you can't invest your own money in funds the rich get to use?" If Congress said that women and minorities couldn't invest in it, there'd be rioting in the streets. But for some reason, it seems Congress is happy to discriminate against "poor" people and only let the "rich" invest in hedge funds. It's insanity.
Rich: What is the rationale behind the rule?
John: Lobbyists from the mutual fund industry tell congressmen that hedge funds are too volatile and risky for the average person, who has to be protected. Congress doesn't know any better and so, like useful idiots, they pass the laws they're told to.
So the intentions are good, but the result is most profoundly unfair. If individuals could invest in hedge funds -- which outperform mutual funds with comparable investment styles by as much as 300 to 400 basis points, by the way -- then mutual funds would get beaten hands down. Investors would flock to hedge funds in droves, because they're simply doing a better job of earning people money, especially in down markets. Mutual funds would lose market share, and that is why they oppose such changes in the rules.
Rich: Speaking of funds, let's talk about a trend that's been popping up in the news a lot lately: private equity buyouts and mergers and acquisitions. There seem to be a lot of companies buying other companies lately: Procter & Gamble (NYSE: PG) buying Gillette, Service Corp (NYSE: SCI) buying Alderwoods (Nasdaq: AWGI), and Mittal (NYSE: MT) buying everyone. Plus a whole host of companies going private. Any thoughts on why this is happening?
John: You're right, there have been a ton of private equity buyouts over the past year or so. My feeling is that there are several factors at work here. On the sellers' side, in the wake of Sarbanes-Oxley and related legislation, management looks at the costs of being a public company -- compliance costs and the like -- versus what they could do with their money if they weren't public. Often, they decide they'd rather be private.
On the other side of the equation, there are a lot of potential buyers these days. The world is awash in cash looking for a home. M&A guys have access to more capital than ever before. But that poses its own problems. Say a private equity fund has the chance to raise $10 billion. Once it's levered those funds, it'll have $30 billion to $40 billion in buying power. Now that it's got tons of money, it's going to be looking for bigger and bigger deals.
I see this as a long-term trend, too. There is a lot of capital out there. The Fed opened the spigots in 2001 and has only recently begun closing them off, so it's going to be a multi-year process, putting all this cash to work. Don't expect the wave of going-private deals to end anytime soon.
As for mergers and acquisitions, that's a different story. Often, those are just deals where two bloated companies are strategically positioning themselves to survive, like with Alcatel (NYSE: ALA) and Lucent (NYSE: LU). There might be some synergies there, but there's a real difference between these kinds of deals and the buyouts. Just because one company buys another doesn't mean it's getting a good deal; but when buyouts happen, it's usually because they see an undervalued asset and finally have the cash to capitalize on the opportunity.
Recession in 2007?
Rich: Let's discuss another of your favorite subjects: the yield curve. What is it, and why is it important?
John: Basically, it's the difference between short-term and long-term interest rates. Fair value for short-term debt is typically 1% to 3% above the rate of inflation. And long-term debt would ordinarily command an even greater return. When long-term rates become lower than short-term rates, however, that's when we say the yield curve has become "inverted."
As for why it's important, there comes a time when the Fed has raised short-term rates too high. If inflation is 3%, and the Fed raises rates much higher than 5%, for example, then things start looking dangerous. And if at the same time as this happens, long-term rates are below short-term rates, then things can get really interesting.
My view is that the Fed is going to continue to raise rates until it sees results that affect the housing market. Specifically, the Fed is targeting the price of your home -- they want it to stop going up. That's going to hurt homeowners, of course, but the Fed is mainly concerned with preventing inflation in the future. They're willing to inflict some pain today to save even more pain in the future.
Historically, the Fed has a tendency to raise rates more than most people think it will and to keep raising rates until they see the economy slow down. Personally, I won't be surprised to see the Fed go to 5.5%, despite the release of the Fed minutes that many interpret as "dovish" on interest rates. If we see two to three months of prices declining in the housing market, then that would tell me the Fed might stop at 5.5% or even lower. On the other hand, if the economy is still booming and the housing market is still rising, I think they will go past 5.5%. But the Fed has clearly told us they are looking at the data from meeting to meeting, so we are close to the end; but the next month's data will have to tell us if we have arrived.
Rich: When the yield curve first inverted a few months ago, the financial press did the literary equivalent of rending hair and donning sackcloth. Since then, the stock market hasn't fallen, the world hasn't ended, and barring the occasional article, we hear very little about the inversion phenomenon anymore. Thoughts?
John: Well, remember that the yield curve only stayed inverted for a few weeks or so and was only inverted by a few basis points. What we saw in January was a "baby" inversion, but the yield curve is only a good predictor of recession when the inversion is of a significant size -- say 10 to 20 basis points or more -- and if it remains inverted for 90 days or more.
So that's the good news. If we're going to see a recession, it shouldn't be until 2007, because the inversion didn't stick. The bad news is that, with long-term rates beginning to rise again, the Fed now has room to continue raising short-term rates if it wants to -- and that could still slow the economy, even if we don't fall into a full-blown recession. That said, nothing in the yield curve today tells me that it's now time to pull your cash out of the market, although there are other factors which suggest it may be time to be more cautious.
Rich: The Fool's own resident sage on things financial and arcane, Bill Mann, wrote a column on this back in January. Where did Bill go wrong? Where is he right?
John: He's mostly right. But foreign banks have purchased mostly shorter-term paper, so they are not that big a factor in 10-year rates, although foreign individuals are. Further, while an inverted yield curve is not causative, it is indicative of a situation where the normal expectations of return are out of sync. And this is what we should be paying attention to.
Rich: Your latest book, Just One Thing, is a great read. But one chapter in particular stood out: Bill Bonner's laissez-faire rant in Chapter 7. What was he trying to get at there?
John: Bill is a libertarian. He's also a very successful businessman. While most of the book is devoted to my friends and colleagues giving their best investment advice, this chapter was what Bill wanted to say, and we both agreed it had a place in the book. Speaking of which, I think that's a real strength of Just One Thing -- there's something in it for everyone. And although it may not have a real practical application to investing, many people have written me to say that Bill's was their favorite chapter in the book.
Others liked Andy Kessler's chapter, for instance. He offers some great insight into using the concept of scalability to find tech companies that can really profit as a market expands. If you remember, Andy was the hedge fund manager who turned $100 million into $1 billion during the bubble and then got out at the top. You don't accomplish something like that by luck. Speaking of Andy, I should probably mention that he's working on a new book of his own, due out in June, called The End of Medicine, where he looks at the concept of scalability among medical companies. It will be his fourth book, and I think it is his best. It will be worth a read.
Rich: In your weekly letters, you collate reams of raw data into one or several easy-to-understand conclusions. Let me give you a few pieces of data, and ask for a conclusion here today:
a. You predict we'll see a bear market followed by a slowdown toward the end of 2006 and maybe a recession sometime in 2007 if the Fed goes too far.
b. You also predict a total of about two bear markets over the next decade, followed by another secular bull market as the world and its economy changes in unimagined ways, for the betterment of us all.
c. Warren Buffett counsels investors to never buy a stock that they would not be comfortable owning if the stock market should close for business tomorrow and not open again for 10 years.
Now, a lot of Fool readers, and especially subscribers to our Rule Your Retirement newsletter, like to think long-term, but are also facing retirement within a relatively short period of time. Say you're counseling Joe Fool, age 57, due to retire in 2016. Joe is considering investing tomorrow in one of the following:
- A Vanguard S&P index fund
- A high-tech superstar, say Apple Computer (Nasdaq: AAPL)
- U.S. treasuries
- His local bank's money-market fund
Over the next 10 years, where's he going to make out the best, and why?
John: Hmm. Well, not the S&P, and not the high-tech superstar. Investing in just one company is too dangerous for a retirement portfolio. Out of those four, I'd honestly go with U.S. treasuries. At a 5% yield, I think they'll outperform the S&P over the next decade. But I would hope there are other and better choices.
Rich: That's surprising. I would think most investors expect the S&P to beat treasuries.
John: You've got to remember that the market goes in cycles, from high valuations, to low, and back to high valuations. Right now, we're at about a 20 P/E for the S&P based on trailing core earnings. The long-term average is a 14 or 15 P/E.
When you start with a market that's at a high valuation as this one is, you're not going to see that 10.5% appreciation rate that everyone talks about. What's more, there's a very real possibility that the S&P will decline in value over the next decade. Historically, there have been several instances in which the stock market returned 1% or 2% -- or even lost money -- over a 10- or 15-year stretch when your starting point is where the valuations are today.
For these reasons, I don't think anyone contemplating retirement within the next decade should put their faith in a broad market index fund.
Rich: The Motley Fool is investors writing for investors. Few people in this country have your wide range of experience in investing and your extensive contacts. Can you give us a handful of stock ideas that we might not have heard about, but should watch?
John: I specialize in researching managers and hedge funds. I really don't do stocks. But as general areas for your readers to research, I like Eastern Europe, Canadian tar sand plays, and resource plays in general. China is of great interest to me, and I am devoting some time to looking at a few opportunities over there.
Rich: Speaking of China, and tying in to the previous question on mergers and acquisitions and such, we've seen CNOOC (NYSE: CEO) try to buy Unocal (before Chevron (NYSE: CVX) picked it up); CNPC just bought PetroKazakhstan; and now it seems China Construction Bank wants to take a stake in Bear Stearns (NYSE: BSC). What's with all the Chinese acquisitions? Any theories?
John: Well, Bear Stearns is simply a case of a U.S. bank seeking better access to the Chinese market. I don't think China Construction Bank came up with this idea on its own.
But as for the asset buys you mention, this is no different from ExxonMobil (NYSE: XOM) buying up wildcatter oil producers. China's economy is growing at 7% annually, meaning that in 10 years' time, the size of the economy will double. Where are they going to get the resources they need to feed an economy twice the size of today's?
It's the same problem facing India, growing at 5% to 6%, or any number of other Asian countries. Their economies need raw materials, and they have to go out and buy access to these raw materials. I think this is another long-term trend, and we could be seeing China buying foreign companies for another 15 to 20 years before it eventually succumbs to the same business cycle that controls all developed countries and begins to see its growth slow.
Rich: You're on record saying that the U.S. dollar has to devalue eventually. Which parts of the world look best set to weather a U.S. dollar storm: Old Europe, Japan, South America, other?
John: I essentially like all of Eastern Europe. As for Old Europe, the legacy costs there are going to weigh on the economies. France in particular is a "short." Meaning, if it was possible to short a country, France would be my long-term choice. And that is sad, because France is one of my favorite countries in the world.
As for other regions, I like some of the Asian economies and China in particular. Oh, and Canada. The Canadian dollar is going to get stronger over time. A few years ago, I said that eventually the Canadian dollar would reach parity with the U.S. dollar. People said I was crazy at the time -- and they may still think I'm crazy. But today, the Canadian dollar has already moved halfway toward parity.
Rich: Final question, John. You've mentioned in your letters that you've taken the exams necessary to become a registered broker with the Financial Services Authority (FSA) in England. Do you have any thoughts on the Nasdaq's (Nasdaq: NDAQ) purchase of a stake in the London Stock Exchange or a possible bid by NYSE Group (NYSE: NYX)?
John: As for the regulatory environments themselves, I much prefer the FSA to the U.S. counterparts. The regulatory climate over there assumes that listing companies and financial services firms are "good guys" and they work with you in a non-adversarial manner. If you do something serious to step out of line, they'll go after you, of course; but they do not see themselves as an adversary. Our rules, in contrast, assume that a company is "evil" from the start, and pile on the regulations, fining people for small potatoes infractions and imposing huge regulatory costs. Don't get me wrong, if you break the rules and hurt clients, you should get hammered. Late trading and the recent accounting scandals have no place in a financial world. But now, it seems like too many people want to be Eliot Spitzer. That's a major reason why you see so many new foreign companies listing in London and not in New York. We are losing market share in what should be an area where we are the best and clearest choice. And then we pile on costs like Sarbanes-Oxley, and it is no wonder the LSE is beating us.
Now as for the businesses, an acquisition of the LSE by one of the U.S. companies wouldn't have any effect on listings or listing companies. It would simply determine who gets to profit from all the business that is now being sent London's way.
©2006 The Motley Fool, Inc. All rights reserved.
La Jolla, Friends and Sci-Fi
I always look forward to coming to La Jolla for my Strategic Investment Conference. I get to meet old friends, make new ones, and have some very interesting conversations. Wednesday night I had dinner with David Brin, the brilliant science fiction writer. Most of you might know of him as the author of The Postman, which was made into a movie by Kevin Costner (the book was way better). His latest work, The Kiln People, is an even more interesting way of looking at one possible future world. There is the real possibility it will also be made into a movie. We had a very eclectic group of people (professors, tech venture capitalists, hedge fund types) all discussing the way the world works and will turn out over time. I live for dinners like this.
My conference started last night, and it is packed with meetings, dinners, receptions, intense discussions, and a lot of fun. Louis Gave just spoke on "when will the bubble in all the world asset classes end?" and was quite provocative. Normally he is quite the bull; but he suggests the top might have been last Thursday, to be followed by a slowdown in the US and maybe the world. I am really looking forward to being on a panel with Richard Russell, Martin Barnes, and Louis later tomorrow, after we have all presented. I think I might just throw some raw meat between Richard, Martin, and Louis and stand back. It should be great fun.
Tonight we dine outside, looking at the California sunset over the ocean. Great food and wine, wonderful friends. It doesn't get any better. Well, not much, anyway. Have a great week and find some time to be with friends and family of your own.
Your having fun being a Fool for a Day analyst,