In his last interview as part of the Barron's Roundtable, from which he is retiring at the end of the year after three decades of participation, Felix Zulauf, owner of Zug-based Zulauf Asset Management had some parting words of caution.
First, in his discussion of stocks, Zulauf said "markets exhibit the signs we usually see going into a peak. My trend and momentum indicators are still bullish, but excesses are building up as stocks and sectors move too far above their moving averages. Investor-sentiment readings are getting excessive. July or August could bring an important peak in stocks."
Comparing to previous episodes of market exuberance, Zulauf said that "today seems like late 1999. We haven’t seen the peak yet. Much depends, as noted, on whether China continues its current policies. Either way, there is a window of vulnerability in the markets. I’m not talking about a 5% setback. It could be 20% from August to November."
As a reminder, this is what late 1999 looked like, and how it is oddly similar to the S&P tech sector currently.
What could catalyze such a drop: "The popularity of passive investing could enhance the selloff. Once the quant models and algorithms change, models that have said buy, buy, buy for years suddenly say sell, sell, sell. This has nothing to do with the economy or fundamentals."
Discussing how policy could affect markets, Zulauf believes that it will be up Trump to pass his much delayed fiscal program to push markets higher from here: "If the Trump administration doesn’t launch a stimulus program by early 2018, the Republicans could have big problems in the midterm elections. That’s why I think they’ll come up with a program. If so, it would probably drive the 10-year Treasury’s yield up to 3%, and the market would shift toward more cyclical and value stocks."
Finally, here is his outlook on the near term:
I don’t. Investors should tighten risk-management strategies to their portfolios. I expect the FANG stocks and the Nasdaq to have a big selloff. They could easily fall 30% or 40%. But I don’t want to end my Roundtable career on a bearish note. Once the bear market is over and the recession or economic crisis passes, stocks will go up again.
Of course they will, but what size will the Fed's balance sheet be then?
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Full interview excerpt, via Barrons.
Barron’s: You were presciently bullish about this year’s first half, Felix. What will the second half bring?
Zulauf: Although I am often labeled a bear, I predicted that the market would climb 10% into mid-year, and that is looking about right. Markets were helped by the political backdrop. The French elections went well, in that Marine Le Pen, who advocated France’s exit from the euro, was defeated. The next test in Europe will be Italy, which could hold a general election as soon as September. Italy is unlike the other countries in the euro zone; polls indicate that about half of the voters want to keep the euro. Only one political party is in favor of keeping the common currency. The others are against the euro.
How does the rest of the world look to you?
The world economy is growing at a slow pace. There is hoopla about accelerating growth here and there, but I don’t believe it. Europe had a growth spurt in the second half of last year, and everyone thought it would lead to much higher growth. I don’t see it. When you examine the figures closely, you see that momentum has already peaked.
The European economy will grow by 1% to 2%, and 2% is probably the trend in the U.S.
China is delivering 6.5% economic growth like clockwork, although China is slowing, and that is the key to what will happen in the second half and beyond. A few months ago, China appointed a new head of the China Banking Regulatory Commission to reform the financial sector. Reform means that China will have to squeeze out excessive leverage and systemic risks, and it can’t do that without doing some damage.
What sort of damage do you fear?
Right now, China has a mini credit crunch. It is the only country in the world with an inverted yield curve, and not because the central bank has tightened rates. It is because the system has tightened due to reforms. The shadow banking system has been squeezed, and the banking system is short of deposits, so there is a funding problem. The question is whether current policies will continue or ease ahead of the November meeting of the 19th National Congress of the Communist Party.
If the policies continue, there will be a bigger credit squeeze and a continued slowdown in economic activity. If China’s economy slows, markets could have a big downside surprise in the second half. The vibrations would be felt worldwide, because China has been the growth engine of the world economy for the past eight years.
Technically, markets exhibit the signs we usually see going into a peak. My trend and momentum indicators are still bullish, but excesses are building up as stocks and sectors move too far above their moving averages. Investor-sentiment readings are getting excessive. July or August could bring an important peak in stocks.
Are you referring to U.S. stocks or stocks globally?
It could be worldwide, because all markets are extended. In the medium term, there could be a tremendous internal rotation, particularly in the U.S. The Trump reflation trade died earlier this year. Oversold sectors, such as financials, could bounce up. The FANG stocks and other e-commerce stocks that have led the bull market since 2009 are extended. They could have a correction. But after that correction, they could go even higher.
Markets are driven by global monetary excesses and algorithms. There has been a dramatic move into passive investing—buying indexes and sector ETFs and things like that. Passive investing is basically a bull-market strategy. The bigger the index weightings in those sorts of stocks, the more money flows into them. It is a self-fulfilling mechanism.
Today seems like late 1999. We haven’t seen the peak yet. Much depends, as noted, on whether China continues its current policies. Either way, there is a window of vulnerability in the markets. I’m not talking about a 5% setback. It could be 20% from August to November.
The popularity of passive investing could enhance the selloff. Once the quant models and algorithms change, models that have said buy, buy, buy for years suddenly say sell, sell, sell. This has nothing to do with the economy or fundamentals.
How should an investor behave in this environment?
If the Trump administration doesn’t launch a stimulus program by early 2018, the Republicans could have big problems in the midterm elections. That’s why I think they’ll come up with a program. If so, it would probably drive the 10-year Treasury’s yield up to 3%, and the market would shift toward more cyclical and value stocks.
Do you have any specific investment picks for the second half?
I don’t. Investors should tighten risk-management strategies to their portfolios. I expect the FANG stocks and the Nasdaq to have a big selloff. They could easily fall 30% or 40%. But I don’t want to end my Roundtable career on a bearish note. [Zulauf announced at the January Roundtable that he is “retiring” from the panel after this year.] Once the bear market is over and the recession or economic crisis passes, stocks will go up again.