In this week’s interview with demographics and economics prognosticator Harry S. Dent, Jr., we discuss why the current rotation into stocks may prove to be a bearish signal for longer-term investors, as well as ways to survive and even prosper during the impending major correction that he expects to occur in the second half of 2013.
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 atwww.harrydent.com.
EQ: There has been a lot of talk about investors rotating back into equities, and one argument is that this is a positive sign for the stock market. You disagree, however. Why is this actually a bad sign for bulls?
Dent: First of all, there’s just so much agreement on this right now. It’s just unanimous. You can see it with everyone on TV, or even from all these investment managers that I’ve spoken to. Everybody sees interest rates edging up over the next year as stocks continue to go up, and the economy continues to be good. Basically, what that just says to us is it’s a continuation of the same trend that we’ve seen since March 2009, where the government pushes money into the economy, and that money gets reinvested into things like stocks. Unless there is bad news about Europe, the fiscal cliff, or some other very specific threatening news, the market will just drift up.
The economy right now isn’t doing good, but it’s been doing just enough to keep this going. Earnings are going up because of better international earnings, so as a result, stocks just continue to drift up. They’ve gone up regardless of good news or bad news, and don’t seem to care as long as it isn’t really bad news. But stocks are probably getting close to peaking in the near-term. As for bonds, we don’t see a major move out of them, at least not yet.
What could happen, however, is something similar to what we saw in the summer of 2011, which was the biggest correction we’ve seen in this rally that started in March of 2009. We had to deal with some major headwinds like Greece coming back asking for more help even after a bailout. There was also the first debate over the debt ceiling, which was very contentious between Republicans and Democrats, and the market went down about 20 percent because of it. Gold shot up like 500 points, and bond yields went down. I could see something like that happen in a few months.
Now, Congress has kicked the debt debate down the road to May, and nobody seems to be that worried about the sequester cuts, which is supposed to kick in in March. There could be big problems with that. There’s been no bad news from Europe for a while, but that doesn’t mean that things are going great over there. A report just came out that shows construction is down over 66 percent year-over-year in Greece, and unemployment is approaching 30 percent. It’s not really accelerating to the downside in Spain and Greece, but it’s not really getting any better either. I mean, there aren’t runs on deposits with the banks anymore, but they’re not building them back up either. So it’s still a question mark, and anything could go wrong in Europe near term. It’s still the biggest threat.
Europe moved into a recession in mid-2012, and what was most surprising about that was it came after massive quantitative easing through the Long-term Refinancing Operation (LTRO), which injected $1.3 trillion between late 2011 and early 2012. That was more aggressive than our QE2 in the U.S., and their economy still went into a downturn anyway. That shows that at some point, stimulus programs don’t work so well. It takes more and more to create a less of an effect. I think the same thing will happen later this year in the U.S., even though the markets are obviously still rallying from QE3 right now. The Fed has said it’s backing the economy by putting in $1 trillion every year until we hit 6.5 unemployment, which to us means it’s going to take many years, because I don’t think we’re going to see the employment levels get that low for a long time.
EQ: So what are your thoughts on where stocks can go right now?
Dent: Stocks will like this until something goes wrong. Everybody has been focusing on the 14,000 level on the Dow Jones Industrial Average, but the real level to watch on the stock charts is 1580 to 1600 on the S&P 500, which is the all-time intraday high on the S&P 500 from back in 2007. If you draw a trendline from the 2000-2007 tops, which were only slightly higher on the S&p 500, that leads to 1600 later this year. If the market can push above 1600 and stay above there, then we may have a different scenario where stocks go higher. However, it’s more likely that the rally stops there. We don’t see a top now in stocks, but from what we can see happened in the 2007 top, there was an 8 to 10-percent correction on the Dow and S&P 500. From there, the market went to a slight new high, but then that’s when you saw divergences with buying and selling pressure, and advanced decline lines of small caps versus large caps. We’re not seeing those divergences on this rally yet, so this does not look like a major top yet. So we could see an 8 to 10-percent correction in stocks over the next couple months, however, followed by one more rally to a slight new high before coming down.
With that said, this rally does look like it’s very extended, and it wouldn’t take much bad news to spark a reversal. It could be something as simple as more serious debate over the debt ceiling, which is certainly going to come. Both sides have dug in their heels very deep here. Republicans are saying no more revenue, while Democrats are saying absolutely more revenue. Republicans are want to make some cuts in entitlement and not just focus on minor defense and spending cuts. Democrats are saying no to that. So somebody’s going to have to cave in the end like last time, but we could see a correction in May over this. I wouldn’t be surprised to see a more down stock market in March and April, and then we see a final rally pushing to a slight new high. From there, we’ll be looking for divergences. If we see what we expect to see, then that would tell us that this stock bubble could be topping, just like it did in 2007 and the early 2000s.
It could be a more substantial correction of 20 to 30 percent, at a minimum, if governments keep stepping in. If the government loses control of the economy, or if Europe blows up, we could see a 50 to 60-percent crash like we saw in 2008 and 2009. We’ll have to wait and see on that, but we don’t like stocks here because people are just so unanimous that it’s going to go up. People think bonds are going to go down and yields are going to go up, and both of those could eventually happen, but you’re going to see a reversal first.
EQ: So if stocks are reaching their peak, and bonds are still way overbought, where should investors look to for shelter? Is gold a good place to look?
Dent: Only in the near term. Right now, gold is just unbelievably oversold. They’re just killing gold and silver back down to where they got some strong support. Our theory is that all these asset classes such as bonds, stocks, commodities, gold ,silver, etc. have all rallied together at slightly different times and cycles. That’s why they call it the risk-on rally. Risk-off is when people go to cash or the U.S. dollar. The U.S. dollar is really a better place to be to protect yourself on a potential crash later this year. Gold, I just think is trading opposite of stocks, unlike in the past. It’s going to continue to do that, and if there’s a disappointment in the economy—whatever the cause might end up being—gold goes up, and stocks go down. Bond yields will go down as well, but then you reverse. So I’m looking at gold taking maybe a good run, but for only two to four months. Therefore we want to get people out of gold. If gold makes a new high above $2,000, then we’re going to tell people to get out of gold long term because we think it’s a bubble that’s going to burst down the road.
EQ: Does the Federal Reserve have any more bullets to stave off a deep economic collapse?
Dent: So far, they do. A year or two ago, I would’ve said that there was a limit to how much the bond market or even citizens on the street are going to let governments just print more and more money. Every time the economy goes down a dollar, they print a dollar. Every time a bank loses a dollar, they print a dollar. They’re just absolutely covering over a debt crisis and demographic decline. Now the word is “unlimited.” ECB President Mario Draghi said last year he’d do anything, which means unlimited. Then Fed Chairman Ben Bernanke basically said QE3 will go on as long as it takes, even if it is years and years until we get to that 6.5 percent unemployment rate. Then Japan just came out and literally said it would buy unlimited amounts of bonds similar to Draghi’s approach. So interest rates are rising a bit, and this may be the first signs of cracks. Quantitative easing is supposed to push long-term interest rates down even farther because they’re buying long-term Treasury and mortgage bonds, but interest rates are creeping up here.
If interest rates start rising, it may be people finally saying enough is enough, and a sign that they realize governments just can’t endlessly print money. So we’ll see, but so far there has been no resistance in the market or even among major economists. There are a few people on the Fed Board now who are saying they can’t do it forever, but I’m absolutely convinced that if we see any weakness in the economy or further weakness in Europe, the Fed will step in. The question is whether it will work, or will they lose control of the economy like we saw with Europe when it went into recession in the middle 2012. They’re still in recession in most countries despite the $1.3 trillion and the proclamation that they were not going to let the economy go down. Well, it went down anyway. I’m sure the economy would’ve went down worse without that injection, but it just wasn’t enough to create growth.
So I do think the Fed has enough bullets because everyone’s given them permission to do what they have to do. The question is whether the stimulus still works at a certain point. Do you get to a point where everybody who could refinance and qualify for a refinance and get their mortgage cost down has done it already? Or where everybody who would’ve bought a house because mortgage rates are low have already bought it? I think it’s more speculators now doing the buying, and not really more people buying houses. You get to a point where all stimulus in an overstretched economy just doesn’t make any difference because consumers and businesses don’t expand or spend more regardless of the Fed putting money into the economy. So when that slows, then earnings begin to slow for stocks, which leads to stocks beginning to crash. If stocks start to crash later this year—which won’t happen until at least June or July—but once they’re down 20 percent or more, the Fed will start to step in.
If the markets don’t see the effect they want to see, then interest rates will start to rise and people will start to worry about deficits and over stimulus. That’s a hard one to call, and we’ll have to wait and see, but the key thing for stock investors to focus on now is whether we can get above 1600 on the S&P 500. I don’t think we do, or if we do it will only be briefly and we come back down. That’s a real barrier because the “smart money” will be selling into that next rally, just like when they sold into the previous rally in October 2007. What we’ll be trying to do is measure that buying and selling pressure. So that’s what we expect to happen: a correction, followed by one more new high, but then stocks are done and we see another major correction. When that happens, we’ll see how much the Fed has left. I think they have plenty of bullets, but if the bond market starts to think their stimulus is not working or it’s excessive, that’s when the trouble comes.
EQ: With this in mind, is adopting a short strategy a no-brainer at this point for any investor?
Dent: Yes, if nothing else it can be as a hedge. People should consider it to just some degree. The problem with bear markets is that they can have strong bear market rallies within them, so it’s best to do it unleveraged. If you do it unleveraged and just buy an inverse fund like ProShares Short S&P 500 (SH) for example. If we get to 1600 on the S&P 500 or close to that, then I would look closely at SH to some degree for your portfolio, and just sit on that through the correction for later this year. One of the things that I always tell people, and a lot of people will agree on this, the debt crisis you can’t just push this off forever, but a lot of people think you’re going to get inflation from this runaway stimulus. Stocks go down whether there’s inflation or deflation. I think there’s going to be more deflation down the road, but stocks go down either way. If we have a deflationary downturn like we had in late 2008, stocks, commodities, real estate, all these things go down. If you have an inflationary problem, stocks aren’t going to like that, but real estate, commodities and a lot of other types of investments are going to like that. So there’s two ways to hedge yourself: PowerShares DB US Dollar Index Bullish (UUP), which tends to go up when there’s a crisis or crash just like in 2008 when most things go down. The other thing is to short stocks, if something happens down the road whether it’s inflation, deflation, blowup in Europe, or an absolute headlock in the debt debate, well stocks are going to go down.
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