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Harry Dent: Danger Zones and Bubble Stocks

By  +Follow October 25, 2013 8:06AM
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In our latest discussion with demographics and economics prognosticator Harry S. Dent, Jr., we cover the ramifications of the government shutdown, gold being mortally wounded, and why investors shouldn't buy into the upcoming sucker's rally over the next few months. Dent is the author of The Great Crash Ahead: Strategies for a World Turned Upside Down, and editor of the free newsletter Survive and Prosper. You can read our previous interviews with Dent here, and learn more about his work at www.harrydent.com.  

EQ: The latest deadline for the U.S. debt ceiling was avoided, but not before a two-week government shutdown and more drama out of Washington. What did you take away from the whole series of events?

Dent: It was pretty much what was expected. It was the only leverage that the Republicans had, so they used it. They had to make the government system feel some pain, but then of course, their ratings drop. So they postponed it. Now we’re just going to hit the same debate in probably mid-January to mid-February and have another market correction then. So all they did was kick the can down the road, and that’s what the government has been doing with everything—debt in general, the whole banking crisis, etc. Everything’s about kicking the can down the road when they think it'll be easier to deal with. Well, it’s never easier. It only gets worse.

EQ: The market seemed largely unphased by what happened, and most other commentators in the media are saying that it suggests the economy avoided any long-term negative effects. Do you agree with that?

Dent: There’s some ramification. Fourth quarter GDP is going to be shaved a bit because some of the that people weren’t paid and things that didn’t happen. So there’s some costs there. But you also have things like the ratings agencies like Moody’s putting up their antenna again because the government can’t make better decisions than this. So do they have to downgrade the U.S. debt because of it? So there’s definitely some damage done here.

Everybody now expects these things to get difficult, then things to get solved at the last minute and it turns around. That’s why the market didn’t react to this as much this time as they did the first time. Washington now know that it’s too painful to go too far with this, so the market basically just went sideways and now they’re heading up again.

EQ: We’re in third quarter earnings season right now and based on where the S&P 500 is trading around, most market analysts say stocks are undervalued. In a recent article on your website, you strongly disagreed. What are some of the indicators that are telling you that the market is overvalued right now?

Dent: Most of these guys think that the price-to-earnings ratio of 16 to 17 is OK, because 22 or so is considered overvalued to them. But Robert Shiller came up with an alternative P/E ratio that looks at the price of stocks versus 10 years of average earnings, adjusted for inflation. So it’s something more real. We’ve had this strong stimulus and unprecedentedly low interest rates, and corporate buyback of stocks. These are all artificially making earnings and P/E ratios look better. So Shiller’s approach is a better measure because it takes out the cyclicality and takes out the strong surges when we’re in a bubble or near a top. Basically, the danger zones for P/E are around the 24 to 27 area. By his indicator, we’re sitting at 25 right now, so we’re in the danger zone. It’s very similar to the 2007 top, the 1965-to-1966 top, and a number of other tops in history.

The only ones that were more extreme were 1929 and 2000, and those were extreme bubbles. We are not going to see a stock bubble like the tech bubble. You only have one of those once. That was so extreme, we’re just not going to go there again. But right now we are at levels where most bull markets have peaked. So to me, stocks look like they’re going to go a little higher into early next year until we hit the next debt ceiling debate again, combined with some other problems around the world, so I do think we’re overvalued.

The other thing is that people tend to say, "Well, it’s not overvalued even at normal P/E of 16 or 17." But these aren’t normal times. TWe have Middle East crises in almost every Arab country off and on. You have the highest debt ratios, more than double on average the debt ratios we saw in the Roading '20s at the top of the bubble. You have Europe in a slump, countries in depression, and China overbuilding everything. These are not normal times. What makes it seem normal is the artificiality of the Fed and other central banks pushing short-term and long-term rates so low. Low rates tell investors and businesses that there’s low risk. Rates go up when there’s high risk. So we created this artificial sense of low risk, especially with investors acting like there’s low-risk, investing on high leverage and keep pushing up markets. That, to me, makes this incredibly risky. So even if you go by normal P/E ratios, these are not normal times. I think we should be at P/Es of 10 to 12 with where we are now, not at 15 to 16.

EQ: A lot of people were expecting the Fed to begin the taper before the year is over. Now with Janet Yellen named as the next Fed Chairman, there’s speculation that the stimulus program could be extended a bit further. Does that affect your targets for a market breakdown in early January?

Dent: It actually confirms it because I’m looking more at stock patterns and cycles to find divergences. We haven’t seen enough divergences in the last rally to suggest a top. We’ve had a correction here off and on since May of slight new highs and new lows, but I’m expecting another rally. The fact that they’ve put off the debt ceiling debate until mid-January, it shows a good place for the market to possibly top and get worried again. The fact that Yellen is going to come in in March for her first Fed meeting, that’s when the pressure sets in. I don’t think you’re going to see any tapering until then. They held off partly because they didn’t have confidence in the economy. They act like we’re in a sustained economy, but then they look at the figures and realize it doesn’t look that sustainable without stimulus. So they chickened out.

Then this debt ceiling debate comes around and you don’t want to taper during that, when the markets are already a bit worried. So I think they don’t see the first wave of pressure to taper until March. We’ve been seeing a top in stocks in the first quarter—most likely in mid-to-late January, and then again in March, followed by a big crash. That’s the scenario I’m looking for when I look at all the stock cycles and patterns I’m looking at. To me, these two events confirm that mid-January and mid-to-late March are two times to worry about the markets topping and going down.

EQ: Since late August, gold has just seemed to be on a continuous break down. It still has a ways to go before it hits your target of $750. Do you see a lot of volatility here over the next few months?

Dent: I see it going through more sideways trading unless we break below the low of $1179 from a few months ago. Gold has really been smacked, and I think it’s been mortally wounded. What happened was the markets finally got something that we’ve been saying for a long time. We’re in a deflationary environment because of debt deleveraging and the government is fighting that deflation with massive inflation, and they’re only getting a little inflation. So really, deflation is the trend and gold is an inflation hedge, and gold is a bet on inflation from all this money printing. Well, we’re just not getting much of it. I think what happened was the U.S. stepped up to QE3 and QE3-plus in late 2012, and in early 2013 the Japanese went off the reservation and did two-and-a-half times what we’re doing relative to their own economy, and then inflation rates dropped anyway. That’s when the markets just realized that we’re not going to get runaway inflation from all this money printing, and that’s when gold fell out of its trading range between $1525 to $1800.

It’s just mortally wounded now. When it rallies, funds that are holding it on leverage will bail out. They bailed out when it collapsed, and now you keep seeing successive moves out of it. So I think gold will be up and down, and will rally up to $1420, maybe a little higher, but my advice would be to sell gold on any significant rallies in the months ahead. I think by 2014 and 2015, it is heading toward $700 to $750, and even to $250 over the next decade.

Gold’s a bubble. It’s a commodity, and we’re heading toward deflation around the world, and gold is not going to like that.

EQ: Are there any specific areas of the market that interests you right now, either as a safe haven or overlooked opportunity?

Dent: To me, the big thing is we had these bubbles and when they burst, everything goes down. So there’s very little safe havens. There was very little in 2008, but what did do well in 2008 was staying in cash. If you were betting the U.S. dollar index and the PowerShares DB US Dollar Index Bullish ($UUP), or other bullish dollar funds, the dollar went up 27 percent. It did especially better when things got really difficult in late 2008 when gold and silver were collapsing, along with commodities, real estate, and stocks around the world.

The ultimate hedge is to short stocks. One of the hedges I point out is, as an example, take maybe 20 percent of a stock portfolio, especially if they want to hold dividends for income, and hedge that will Direxion Daily Small Cap Bear 3X Shares ($TZA), which is three times short small caps. Small caps tend to go down faster than large caps in a downturn, and that’s three times leveraged. So 20 percent would probably offset roughly a downturn in large cap dividend paying stocks. You can hedge or simply be short stocks.

I wouldn’t do it yet, because we don’t see signs of a market top yet, and I am looking for that starting in mid-January of 2014. We’re not likely to see a top before then.

EQ: So is now a good time to begin establishing a watchlist of stocks that could be topping?

Dent: Yes. Imagine Tesla (TSLA) . Apple (AAPL) was just before it, but everybody has piled into Tesla. It’s a good company and it’s a bold company, but they are way overrated. I look at cars like these and I’m a potential customer, but I’m not going to go sit and stop at charging stations every 250 miles going to Miami or New York driving. I would only buy it to drive around town. There’s also a lot of other problems. So I think that stock has blown up too much. You get any kind of market downturn, and even though the company has strong long-term potential, it’s going to get washed out pretty quickly.

EQ: What are some things that you’re focused on right now?

Dent: The big thing is we have a new book coming out on January 7 called The Demographic Cliff. People can pre-order that on Amazon.com and get the first copies. I just recently reviewed the manuscript before to goes to print, and it’s a really good book.

We also have our free daily newsletter called Survive & Prosper. It’s great content and all you have to do is signup for it at HarryDent.com

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.

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