Steve Leuthold, the veteran chief investment officer of the Leuthold Group, is bullish. Why should you care? Leuthold, a curmudgeonly value manager who relies heavily on quantitative data (in addition to fundamentals), has posted a pretty solid track record. Manager of $4 billion for Leuthold Weeden Capital Management (in seven mutual funds and separately managed accounts), he built a reputation over the last 30-odd years in the business as a “perma-bear.” He made a good call in 1999, for example, when he was so bearish that he paired back his U.S. equity exposure to just 15 percent. He remained bearish until the spring of 2003. I remember reading his monthly “Green Book” (the formal title is Perception For The Professional, but it is called the Green Book for the color of its cover) and seeing his comments. I asked him to write a story defending his position; “Welcome To The Bull Market” ran in January 2003 of this magazine. Leuthold was proven right.
His Core Investment Fund (LCRIX) is now 65 percent in stocks (his maximum exposure is 70 percent). To discuss his reasoning, we phoned him in late September (before the historic 18 percent drop during the week of October 6) as he was closing up his vacation house in Maine. The market may be crashing, but Leuthold follows his quantitative model's lead. He issued a bullish note on September 17 titled “Fear Is Here,” (Dow at 10,609) and despite (or because of?) the continuing equity market carnage — he issued another bullish note on October 10 (8451.19 Dow). His conclusion: The market was witnessing “the kind of wholesale selling that can only be described as extreme panic selling.” How is he feeling now? “I think this is now a stupid and irrational time to be reducing equity exposure,” he says.
Registered Rep.: What do you make of the government's bailout/rescue plan?
Steve Leuthold: I'm a history fan, so we have looked at all the times the government has come in to bail out the banking system, and this is hardly unprecedented.
RR: Are you referring to the bailouts in the late 1980s and early 1990s?
SL: Right, and beyond. In that period we saw about half of the savings and loans, in effect, go bankrupt. With the Resolution Trust Corporation, the government bought their properties — mostly commercial — and it cost roughly $125 billion when it was all done, maybe more. Then back in 1932 or 1933, during the Great Depression, the government actually took over about 10 percent of residential mortgages, lowered the interest rates and set up new ones. They became the lender of last resort. The first government bailout was around 1796 when several states had gone bankrupt. The government again functioned as a lender of last resort. And there was a whole series of these things through the 1800s after the Panic of 1873, and many other instances.
RR: So we've never had the free-market, laissez-faire system that some of us Libertarians would like, have we?
SL: No, that certainly is true. And actually the Fed was created in 1913 to provide the liquidity for the system. Back then, because we used a gold-based currency, there was a limit to how much money was available. There were huge demands for cash that would take place in the crop season each fall, and you'd see short-term rates go up to 20 or 25 percent, because there just wasn't enough supply of money. That's the main reason behind the formation of the Fed. But the government has always stood, here and in other countries, as that lender of last resort. There were many instances in the 1600s and 1700s when the Bank of England acted as the provider of liquidity when the systems locked up. So this is nothing new.
RR: You picked the 2003 turning point, and you were right. A couple of months ago you started increasing your exposure to equities. Was that premature?
SL: It looks like it — somewhat anyway. And people may question my bullishness right now, too. This whole constipation of liquidity is greater than we ever anticipated, and I think that's where we were premature. We turned bearish ahead of the crowd in late summer of last year, and saw the market peak back then. We normally don't catch peaks and troughs, and in that case we did. But this is the most panicky that I have seen the investment business since 1987.
RR: What do you think is attractive now?
SL: We think that we're extremely close to a major upturn in the market. The positives outweigh the negatives in our “Major Trends” index, so that's why we have 60 percent in equities instead of 30 percent as we did at the beginning of the year. We go as high as 70, but we're not there yet. Within our equity portfolio we've got roughly 15 percent in what we call the “green wave,” which includes solar, wind and includes various energy affiliated stocks. We also have 10 percent to 15 percent in biotech. And we just took a new position in the home improvement retail group — the Home Depots of the world.
RR: Wow. You are brave.
SL: Well, you look at all the foreclosures and the efforts that are going to be made to clean them up. This could be a very big thing, I think, for some of the companies like Home Depot and Lowes. So I think it makes sense. They're also acting pretty well. In fact, if we look at the homebuilders themselves, they made their bottom back in July, and they've been in an uptrend ever since. We have a 6 percent position in homebuilders in a very aggressive hedge fund that I run called the Concentrated Core, which has about $50 million in assets, and in which I'm the biggest stakeholder.
RR: You also recently increased your health care position to 33 percent. What other positions do you have?
SL: Right. That includes biotech, which is certainly aggressive. We also have the pharmaceuticals in there, which include some of the big ones, the Mercks and such. And we also have things like nursing homes and retirement homes and so on in there.
RR: What about inflation?
SL: I think it has peaked. With the exception of one recession, inflation has always come down. And I don't think there's any doubt that we're going to see the same thing happen. Our models show somewhere around 3 percent inflation in the first half of next year, down from a high of 5.5 percent — as flawed as that CPI figure may be. So that's positive. We think this recession started in the fourth quarter of 2007. The two longest recessions since World War II have been about 14 months. This one might run a bit longer, but we think this recession will probably end in 2009 and likely in the first half. Historically, the time to buy in the stock market is about midway through a recession, because the stock market is the lead economic indicator. By that clock we may be making the very bottom right now.
RR: And you think the level of fear is about right.
SL: I remember in 1974, a cover of The Economist read “Stock Markets in the World Going Straight to Hell.” My old friend, Walter Deemer says, “When it's time to buy, you won't want to.” That's very true.
RR: So, how do you describe yourself as an investor?
SL: Value, but we like to see group momentum. The individual stock selection process probably accounts for about 5 percent of your total return. The group dynamics probably contribute 20 percent. And the overall market trend is the biggest factor. If we look at our group performance, versus the stock selection process within a group, we'll get maybe an extra 200 basis points, or 2 percent a year over and above what the return would be if we just bought the whole group. That's good, but you know, it just demonstrates that the group concentrations are far, far more important than the stock selection.
RR: Let's talk about your methodology: You guys use a “normalized earnings” model. Tell us how that works.
SL: In order to get a fix on the market valuation, if you look at the Dow Jones reported earnings, there are deficits for this year. You've got to smooth out these periods. For instance, there was a multiple at the bottom in 1982 of 90 times earnings on the Dow Jones industrials. So, if you're taking current earnings or even projected earnings into a recession, you're really missing a step. We have to get to the underlying earning power of these companies. In effect, we have a five-year moving average of earnings. The reason that we originally started using a five-year model is because that typically duplicated the length of an economic expansion and contraction. So you'd have, say, three-and-a-half years, four years of expansion and a year of recession. So that's why we use the five-year.
RR: Like a lot of value investors you want to see a high P/E then, assuming earnings have dropped off?
SL: Right, because they've had a bunch of fat years. Take metals, which have seen prices going up for some time. Companies like Freeport McMoran, Rio Tinto and BHP and so on. If you just look at them based on their last 12-month earnings, they look dirt-cheap. But if we look at them in terms of what the projected earnings are, they're not so cheap, because the analysts are saying the price of metals have come down 40 percent and 50 percent. Meanwhile, their costs have gone up 50 percent.
RR: We know you're a contrarian, but you've initiated a position in automotive retail. Is that right?
SL: I know, it seemed like about the worst thing you'd want to buy, but it kept coming up in our quantitative data. I talked to a couple of people at auto auctions and some of the big car dealer chains, and what's happened here is that people have been getting rid of their big cars and trucks. They're scooped up by the used car dealers, and since the end of July have appreciated from their lows by about 25 percent in the auto auctions. So like most things, the public reacted just like the stock market. That's the best thing about our quantitative stuff — typically it makes you look at what makes the least sense intuitively.
RR: Describe the quantitative part to us.
SL: We have 150 industry groups that we monitor. I originally helped design the Dow Jones groups, industry groups, etc. We look at these groups once a month and score them on 27 different factors like earnings momentum, the PEG ratio, a valuation factor. A PEG ratio much higher than 1.2 would not be good. We consider the top 20 percent attractive so that becomes our potential buy list in terms of groups.
RR: What do you make of the recent news: Merrill being forced into marriage with Bank of America, Wells Fargo buying Wachovia?
SL: I think we're just in the big process of ripping out the excesses of the last 10 years. Derivatives with cross guaranties, 30- and 40-to-1 leverage — Warren Buffett talked about it five or six years ago; we talked about it 10 years ago. We knew it was going to end and it would end ugly, and that's exactly what's happened.
|Source: Morningstar. Returns through 9/30/08