(Bloomberg) — The stock market’s relentless rally this year has claimed its share of celebrity bears, most notably JPMorgan Chase & Co. market strategist Marko Kolanovic.
Most Read from Bloomberg
This is a very similar story to Wall Street itself. Just ask Charles Clough, Merrill Lynch & Co’s chief global investment strategist from 1987 to 1999, who remained bearish through the dot-com boom of the late 1990s, only to be vindicated after leaving the firm.
Looking at today’s market, Clough says it’s not like it was back then. Now 82 and still running the eponymous hedge fund Clough Capital Partners LP, he sees the company generating cash flow to justify a swollen stock price. The economy is doing well. Inflation and interest rates are poised to fall. And in his eyes, the equity has plenty of room to move higher.
When comparing today’s stock market to the dot-com bubble, “the differences are more important than the similarities,” he said in an interview. “The company’s cash generation and scale show it will be long-term and continue to be profitable.”
Clough’s hedge fund is celebrating its 25th anniversary this year. Before joining Merrill, where he became one of Wall Street’s most respected forecasters, he spent time at Cowen & Co., Boston Company, Colonial Management Associates, Donaldson, Lufkin & Jenrette, and Alliance Capital Management Co. He was also ordained. permanent deacon in the Roman Catholic Archdiocese of Boston and serves in that capacity in local parishes in Massachusetts.
Read: Kolanovic’s Departure Triggers Echoes on Wall Street Since 1999
The conversation has been edited for length and clarity.
Despite some recent turmoil, the US stock market has opened remarkably since last year. Does it have staying power?
We have a very positive outlook. The most important thing that happens in the economy is that inflation will come down again. It started again in 2020 and 2021, mainly due to the large series of simulation packages. At the same time, there is a supply restriction due to Covid. We are really in the reverse of that dynamic. One of the things that makes us believe that demand will slow enough to help inflation go down is credit card defaults. The use of credit cards really flourished in this expansion because the fees went from 12% to more than 20%, so it was not sustainable. We even see defaults on car loans. Meanwhile, the Fed is watching immigration add to the labor supply and more companies are using short-term workers. So if you combine demand and supply, inflation continues to fall. If that is the case, interest rates, especially in the short term, will fall as well. This is all bullish for equities. We think that if you look beyond the volatility that is happening now, the right strategy is to stay invested, especially in equities. And with so much money at the end of the yield curve now, there’s plenty of fuel for equities to look forward to.
With Big Tech stocks dominating market returns, there have been many comparisons to the dot-com bubble. Did you see the same at that time?
It hasn’t gotten to the point where it looks like it was in the middle of the dot-com boom. That period of time is really a result of the Fed’s aggressive liquidity flowing into the market. It started in 1998 with the Asian crisis, and the Fed’s response was panic. A lot of money came when the Internet was taking off. That money fueled what we think of today as the dot-com boom. But these companies are not profitable. There are silly companies like Pets.com with sock puppets, but no one has a business plan that makes sense. There is no path to profit. The company is a big user of cash, and cannot generate cash flow. Today’s Big Tech companies are generating huge amounts of cash flow. Also, there are hundreds of stupid IPOs. That really hasn’t happened in this expansion.
Earnings growth has finally outpaced the Magnificent Seven and the Fed has begun its cycle of cuts. Will another group take over the leadership of the stock market?
Big tech companies are in a world of their own. But that doesn’t mean that if interest rates fall, there aren’t other opportunities. You can see what is happening in the aerospace and defense sector. It’s been a quiet sector for the past 30 years, since the fall of the Soviet Union, and now there’s a lot of technology and demand to keep up. We see a housing shortage. Builders have been doing very well, and we think the durable goods associated with the housing cycle will continue to do well.
How has it been since leaving your role at Merrill and starting your own shop?
We are in 25 years of life, which for a small boutique is a long time. In our portfolio mix, we have partnerships and closed-end mutual funds. I guess the popular term is hedge fund. We have two: one in the medical area, and the other, a broad long-short hedge fund. We think thematically where the profit cycle will happen and then invest heavily in those industries. Closed-end mutual funds have been around for almost 20 years and are a good balance of business. The hedge fund sector has been on the decline for the past few years, even though it’s a very efficient way to protect money, so I think it’s coming back. In the meantime, it’s good to have both businesses. A year ago, we took two exchange-traded funds, they did well. Now, it looks like the company is sustainable.
During the last season at Merrill, you were bearish when Wall Street was very optimistic. How do you go against the grain?
It’s just part of the job. There is no reason to be angry because the market can do whatever it wants. We know that we are right, and we can continue to analyze the situation. People are interested in what we have to say. And I think it works out very well. I remember I watched Cisco Systems pretty carefully, because at that time it was probably the biggest investment for the dot-com boom with all the telecommunications infrastructure that had to be built. When I started going negative, the stock was up six times before declining 95% from a high of $82 in March 2000 to less than $10 in late-2003.
What is your client’s current concern?
What will the Fed do? What is the election going to do? How will China work? There is always something on the horizon. The most important thing is to have a basis for making investment decisions. What we have tried to perfect over the years is understanding the credit cycle. How money and credit work economically is the determining factor. What the Fed is doing and how liquidity seems to matter more than elections, international affairs and most of the things people worry about.
What was the best investment call of your career?
The best call I made was that interest rates were going to drop, and that call still stands. We haven’t seen low interest rates yet – the decline that started in the early 1980s. The secular decline in interest rates is not over yet. It lasted all through the 90s and through the early 2000s. This is hampered by a reactive government response to the excessive expansion of money in the Covid that happened in 2021. But now it cannot be done. You have to ask yourself: Interest rates were falling for 40 years before Covid disrupted everything. Why and why have these reasons changed? The interest rate cycle that started in 1981 is related to global demographics. This is related to the fact that there is a lot of balance sheet debt in the private sector throughout the developed world. And of course, technology is a major factor in the decline in inflation. That is why credit cycle analysis is so important to create confidence in our view. I’d say it’s the most useful phone since it’s still around and people underestimate how low interest rates can go.
Do you think Wall Street’s practice of setting year-end S&P 500 targets is beneficial for clients?
No, I think this is a ridiculous practice. If people could do it, they would call the broker from the yacht. Understanding the dynamics of the economy and its impact on the capital market is more important than choosing a target.
What’s in your portfolio?
We have Microsoft Corp., Alphabet Inc. and Amazon Inc. We invest in several US defense companies, Raytheon Co. and General Dynamics Corp. in particular, because there is a clear cycle of benefits. We invested in home builders, DR Horton Inc. and Lennar Corp. There are some ideas where we think there is a cycle somewhat independent of the economy. There is a cycle of liquefied natural gas, and we are looking for companies that will exploit it.
Are there any risks that investors are underestimating today that keep you up at night?
Whatever is out there, you’ll be fine. We are confident in our strategy. Know what you don’t know and work hard to figure it out, but don’t sleep at night worrying. As long as you have done your work and understand the dynamics of the market, the only thing you may be wrong at the time, and that is not a problem. The biggest problem for capital markets is that the Fed continues to raise short-term interest rates and reduce the size of its balance sheet. I think the wrong central bank policy is going to be the one that keeps you awake at night.
There is a debate now about how much the Fed will cut interest rates in the coming months. How important is piece size?
Direction is more important than magnitude. If you look at the interest rate offered by the major monetary central banks on regular demand deposits today, it is about 10 basis points. Some are cheaper. If you’re a great client, they’ll get it. But the only reason they can go up and get spreads is because they can repo deposits with the Fed and get Fed funds. That’s missing next year. So the bank tells you what the real price of money is, what they are ready to go out and offer for deposits. In a year to 18 months, I think people will be surprised, maybe surprised, by the fact that short-term interest rates are coming down. Because there is no demand for a deposit. The market has a sense that the demand for money is low. Interest rates are going to come down, and I think people are going to be surprised at how quickly that’s happening.
You have had a long and productive career in the financial industry. What keeps you motivated?
It’s fun. The important thing is to stay alive. It is important to maintain purpose in your life. And I can’t imagine doing anything else. I just don’t know what I would do if I didn’t have financial problems to speak of.
Most Read from Bloomberg Businessweek
© 2024 Bloomberg LP
