TRAHAN: STILL BULLISH TRANSCRIPT

October 10, 2014

A rare interview with Cornerstone Macro’s Investment Strategist, François Trahan, who has once again been named the number one ranked strategist on Wall Street by Institutional Investor magazine, as he has been for eight of the last ten years. Trahan has been a stock market bull since the fall of 2011, when the recovery and the markets looked very dicey. Since then he has stuck to his guns and the market has proven him right. What’s his view now? Despite faltering growth in much of the world, rising geopolitical risks and the U.S. stock markets regularly flirting with record highs, he says the U.S. bull market still has several years to run. He’ll explain why.

CONSUELO MACK: This week on WealthTrack, a recent American citizen is also a patriot on the U.S. markets. Cornerstone Macro’s top ranked investment strategist explains why the U.S. bull market can go the distance. Next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. Last week on WEALTHTRACK we talked to a financial thought leader and leading economist Nancy Lazar about why she believes the United States is resuming its role as the primary driver of world economic growth. In case you missed it her thesis is that the U.S. has several big advantages – it’s recovered from the financial crisis ahead of just about everyone else in the world, it’s become very competitive globally because of cheap and abundant domestic energy and other business friendly attributes, and because of all of these developments it is undergoing a job creating manufacturing renaissance.

Since Lazar’s outlook for the U.S. was so positive, I decided to find out what the firm’s market outlook was, so we called Francois Trahan, one of Lazar’s partners and Co-Founders of Cornerstone Macro, the macro research firm they started last year.

Trahan, who has been on WealthTrack many times over the years, is the head of the firm’s investment strategy team. Trahan was ranked the #1 Portfolio Strategist by Institutional Investor in 2013 as he has been for 7 of the past 9 years.

Trahan has been bullish since the fall of 2011, when the recovery and the markets still looked very dicey. As you can see from this chart it was a very good long term call. Since then he has stuck to his guns and the market has proven him right. But what about now, with many of the world’s economies faltering, geopolitical risks rising and the U.S. stock markets regularly flirting with record highs? Well, he is still bullish! I asked him why.

FRANCOIS TRAHAN: Well, because the elements that have supported the rally are still in place. We’re one of the few countries in the world that have addressed our structural issues. If you think about the litany of things that people complained about five years ago, consumer leverage, we’ve come a long way. We had a big budget deficit problem. The sequester got rid of that. We’re now staring at a two percent deficit to GDP ratio. We have zero percent Fed funds rate, but I think the process of unwinding that is already in place, and we have an underinvestment cycle in the U.S. we’re starting to see a cap ex cycle which is very labor-intensive,and so the rest of the world is dealing with structural issues. Ours are largely behind us, but I would argue that the world’s problems are also America’s opportunity. Europe’s issues is having an impact on U.S. interest rates. It is artificially depressing U.S. interest rates, helping the consumer. China’s issues is having an impact on commodity prices. We have oil at $90 today, also helping the U.S. consumer.

CONSUELO MACK: Which is low. Right.

FRANCOIS TRAHAN: Which is low, which is down from 108 a little over six months ago, and so it’s an incredible backdrop, and you have a U.S. dollar that is now rallying. I keep encountering people that believe the U.S. dollar is about to melt. The reality is everybody else’s problems is lifting the U.S. dollar. If we did nothing in the U.S., the dollar would go up just because of Europe’s problems, of Japan’s problems, of China’s problems, of everybody else’s problems, and a rising dollar means rising P/Es, and so I would argue that the elements that have been in place now for a few years are still very much intact. The market is not as cheap as it was, and so I’m not delusional. The P/E of 16 is different than a P/E of 11, but a P/E of 16 is where we were in 1996 when Chairman Greenspan made his famous irrational exuberance speech, and if you got out of the market then, you missed the best four years for equities in the last century. To me, this might be the cheapest market we see for the next five years. The market will be expensive when the story starts to change, and right now I think it’s still just beginning.

CONSUELO MACK: Yet you are predicting basically we’re going to see a soft patch in the fourth quarter. What’s that about?

FRANCOIS TRAHAN: Sure, well, there’s been quite a few of them since 2011. Earlier this summer we had oil go up to $108 I mentioned earlier. We had interest rates rise for a little while, and so now we’re going to get the hiccough from that, if you will, in the economic data that always freaks out investors. So will the market soften a bit here? I think so, but I think it’s a phenomenal entry point longer term.

CONSUELO MACK: And phenomenal entry point because if it does soften, that’s the opportunity that everybody’s been looking for without a major correction in the S&P, for instance, for five years.

FRANCOIS TRAHAN: Sure. I don’t think we’re going to see a major correction but maybe four or five percent, something like that. So not the 15, 20 percent we got used to coming out of the ’08 lows. When we had corrections, we had major correction. Now that we have P/Es at our backs, the corrections would be shallower in my opinion.

CONSUELO MACK: What are the risks to your scenario, major risks?

FRANCOIS TRAHAN: All right, well, the risks are misperceived first off on the part of the Street. If you remember, a year and a half ago the sequester was going to be the end of the world. Everybody thought it was going to be the end of the world, and people didn’t appreciate that when you take the deficit from negative eight to negative two, the U.S. dollar goes up. Dollar goes up. P/Es expand. The sequester is one of the reasons why the market went up as much as it did last year. It was incredibly bullish. It wasn’t perceived that way. I would argue Fed tapering is the exact same thing, I don’t understand this fear of tapering. If you remember a year ago on the day the Fed was expected to taper last September, the S&P was sitting at an all-time high. If tapering was bad, I’d assure you the market would have been down. The reality is when the Fed moves towards less accommodative conditions and the rest of the world does the opposite, the dollar goes up. Dollar goes up, P/Es expand, and so the Fed is not your enemy here. The Fed is your friend. In a P/E driven world, more often than not, the market does great in a Fed-tightening cycle. The risk in my opinion is that Europe gets its act together and that rates start to go up, or that China finds some sort of stimulus, gets investments going again. It’s hard for me to see how this happens, but it’s always possible, and that all of a sudden commodity prices start to rise again. That to me is probably the biggest risk for the U.S. right now.

CONSUELO MACK: In previous interviews, you have told me that inflation is the new Fed funds rate.

FRANCOIS TRAHAN: That’s right.

CONSUELO MACK: Explain what you mean by that and, therefore, why rising inflation would be such a problem for the market.

FRANCOIS TRAHAN: Sure. Well, in a world of zero percent rates, at the margin things that make a difference become much more significant, and so the ebb and flow of inflation, the ebb and flow of oil and other commodities become very significant on the average consumer’s wallet basically. You get the dollar to go up. That means that your grocery bill’s going down. It means that you heating bill, filling up your car goes down, and so the dollar is a very, very important component here.

CONSUELO MACK: Because you’re buying the more valuable. The dollar is the more you can buy of imported goods as well as obviously oil is priced in dollars as well.

FRANCOIS TRAHAN: That is correct.

CONSUELO MACK: Looking at the Fed and the Fed funds rate and the fact is that QE is ending, we did have a taper tantrum as it was called when it looked like the Fed was going to raise interest rates a year and a half ago or whatever it was, and so the market seems to be very sensitive to what the Fed does with interest rates. What is the outlook at Cornerstone Macro, number one, for what the Fed is going to do that would affect interest rates, and how does that affect your outlook?

FRANCOIS TRAHAN: Well, the tantrum was a four percent correction in the market. In the grand scheme of things, that’s nothing.

CONSUELO MACK: It seemed scary at the time.

FRANCOIS TRAHAN: I know, but it seemed scary because we’ve had a very, very steady market. We’ve had a market that’s been going up on the back of both P/Es and earnings which is very rare historically. Usually you have one driver or the other, and so that gives you a market that is kind of a steady eddy if you will, and so now we see four percent as a tantrum which is kind of incredible in the context of 2007, 2008. I call it noise personally, and so I don’t think it’s a big deal. I think next year you’re going to see, if the U.S. economy is as strong as we believe it will be, you’re going to see the Fed probably raise rates. Will it spook some people? Of course it will because there’s this mantra on Wall Street that says you shouldn’t fight the Fed, but again in the ‘90s you had four Fed tightening cycles. In three of those, the market went up. One of them, the market was flat, and so the key here is the dollar. If the Fed tightening cycle leads to a stronger dollar, and in today’s world I would say that’s a high-probability event in light of Europe’s problems, Japan’s problems, China’s problems, et cetera, I think you’re going to see P/Es that keep ticking higher and higher and higher.

CONSUELO MACK: Explain that to our viewers in case that they’re not aware of why the dollar’s going to higher. It’s largely because interest rates around the world are so low that we look very attractive. So is it the money’s going to flow into the dollar because you can get a higher return? Is it as simple as that?

FRANCOIS TRAHAN: Yeah, I would say it is. When you look at the U.S. trade-weighted dollar and you look at all the components in it, the euro of course is an important component. The yen is an important component, but the largest one, ironically, is China, and China is just beginning to see the unwind of its investment cycle. For all I know, we’re staring at a 10-year period of underperformance from China and emerging markets. Obviously it was the growth engine of the EM trade for so long, and so that alone will lift the U.S. dollar. Remember that the dollar is always relative to all these other currencies, and so if we do nothing and we just let China deal with its structural issues, well, it means the dollar goes up, but we are doing something. We’re doing a couple of really, really bullish things. We’re producing more oil than we ever have. That means our trade deficit is shrinking because most of it was energy related, and we have a Fed that’s about to embark on a tightening cycle when the rest of the world is far from that. It means the dollar is going to go up. I think it’s an incredibly bullish environment for U.S. assets.

CONSUELO MACK: I don’t know what you’re forecasting S&P earnings are going to be at Cornerstone Macro. What will drive the P/E expansion if in fact earnings don’t grow or don’t expand that much?

FRANCOIS TRAHAN: Well, what grows earnings is economic growth. For small cap indices, economic growth in the U.S. is a great proxy for small cap earnings. Obviously for an index like the Dow or the S&P 500 where 40, 50 percent of your top line comes from abroad, U.S. earnings will carry you a certain way.

CONSUELO MACK: Only so far.

FRANCOIS TRAHAN: But only so far. You’re going to have a drag from what’s happening in the rest of the world. So for an index like the S&P 500, it’s hard to see how you’re going to see double- digit earnings growth no matter how strong the U.S. is because of these drags from overseas. For small caps, last year we got 14 percent earnings growth in small caps in the U.S., and so I think it is still an incredibly amazing opportunity.

CONSUELO MACK: That’s a contrarian call because everyone else is saying forget small caps. Obviously the Russell has peaked and has corrected. What is your view on the small cap outlook?

FRANCOIS TRAHAN: I think there was a big element throwing a wrench in the size trade this year. Interest rates came down. Normally in an economic recovery in the U.S., interest rates go up, but because of this bond yield conundrum, because I would argue of what’s happening in Europe dragging down rates around the world, well, lower rates tends to benefit the companies that have the most debt. They happen to be the large caps, and so if this had been a normal year, small caps would have outperformed no doubt. I would argue this bond yield conundrum has really helped the large caps significantly.

CONSUELO MACK: One of the contrarian calls as well that you’re making at Cornerstone Macro, and we talked to Nancy Lazar, your partner and the Head of the Economic team at Cornerstone Macro last week is the fact that you all think that multinationals are not going to do well and, therefore, you’re actually as a strategic recommendation are saying that we should sell multinationals. Why the top quality companies that pay dividends that everybody’s been flocking to, why are they vulnerable?

FRANCOIS TRAHAN: Well, quality is where earnings growth is going to be. Being diversified globally used to be a good thing, but when the world decouples, all of a sudden it goes from being a tailwind to a headwind, and so I would argue the best growth you’re going to find is in U.S.-centric investments, and there are some large cap companies that are U.S.-centric. Obviously the lower you go into the capitalization scale, the better you’re going to do. So again, this year the multinationals, the large caps, were helped by this bond yield conundrum. It obviously won’t last forever. At some point I think the small caps are going to rule. If you’re able to look out over the next several years, not just the next several months or quarters, I think you’re going to win out with U.S. small caps.

CONSUELO MACK: Let’s talk about what your strategy calls are right now. So what are your major strategy issues, and I know one of them is to get defensive. Is that just a fourth quarter call, or is that one …? It doesn’t sound like that’s a longer-term call.

FRANCOIS TRAHAN: No, it’s not. It’s a short-term call, and to be honest with you, normally we wouldn’t make a two or three-month call, but this is the fourth quarter. So for a PM who’s done great this year, if there’s a rotation that takes place in the fourth quarter and he’s not positioned for it…

CONSUELO MACK: It could really hurt a portfolio manager.

FRANCOIS TRAHAN: Right, and so because it’s the fourth quarter I think it’s important to make this distinction. There’s a soft patch in the data coming. We’ve already seen it in the ISM and the Philly Fed index. I think it’s going to broaden out before this thing’s over. It won’t last very long. It’s going to last two to three months, but it’s going to be two to three months where people are going to want defensive investments, the health care, the staples, the utilities. You’re probably going to see bond yields come down even more from here, dividend-paying stocks. I think that’s what’s going to do well between now and the end of the year. So that’s a very short-term call.

CONSUELO MACK: Let me stop you here. Bond yields are going to go down even more in the fourth quarter because …

FRANCOIS TRAHAN: Correct. As the data weakens, investors are going to flock to stability where they can find it, and the Treasury market is usually the favorite area.

CONSUELO MACK: So the Treasuries would be … Again, this is a very short-term call, but Treasuries are a defensive area.

FRANCOIS TRAHAN: Might have one handle on the 10-year before the year end.

CONSUELO MACK: One of the things on WEALTHTRACK, we talk to money managers all the time and obviously we talk to some financial planners as well, and so diversifying your portfolio is one of the key mantras. It has been for eons. U.S. over foreign, I mean, how much would you weight a portfolio U.S. over foreign?

FRANCOIS TRAHAN: As much as you can because the world has decoupled. That’s the reality, and the U.S. economy is unlike any other economy in the world. We’re very insular. We derive 72 percent of our GDP from the U.S. consumer, only 14 percent from exports, and so the rest of the world can slow as much as it wants. We feel very little impact from that on the U.S. economy, and so this decoupling in my opinion really changes the equation for asset allocation. I think you want to overweight the U.S. as much as possible.

CONSUELO MACK: This decoupling business. We have been talking about for decades the globalization effect and the fact that we are not a continent unto ourselves. You’re saying, in fact, that investment isolationism can actually be a virtue and for several years?

FRANCOIS TRAHAN: Well, I think as long as Europe is dealing with structural issues, Japan is dealing with structural issues, China is dealing with structural issues, yes. I would argue this is the best characteristic you can hope for.

CONSUELO MACK: And how long does this decoupling last, Francois? How long is the wind going to be behind our backs as U.S. investors?

FRANCOIS TRAHAN: Right, well, that’s the million dollar question. We’ll know it when we see it, but my sense is you’re talking about something that’s going to last for years and years and years.

CONSUELO MACK: This is called a long-term call.

FRANCOIS TRAHAN: That is called a long-term call.

CONSUELO MACK: So what are the beneficiaries of the stronger U.S. dollar, the kind of sectors that we should be looking at?

FRANCOIS TRAHAN: So when the dollar goes up, inflation goes down, and on top of that we have the developing world dealing with structural issues and so commodity prices that are under pressure from the demand aspect as well. We’re pumping more oil than we ever have, and so for some commodities we have more supply than we’ve ever seen. This is the perfect storm against commodities. So it means that we’re staring at a world of exceptionally low inflation in the coming years. So who benefits from that? Typically it’s what you call early cycle stocks. Those are the stocks that do well when inflation is falling. When inflation’s falling, what you’re doing is you’re giving a tax cut to U.S. consumers.

CONSUELO MACK: And you’re saying inflation is actually going to fall. It’s not that it’s going to stay at the Fed’s target rate of two percent. It’s actually going to fall more from here?

FRANCOIS TRAHAN: Well, remember the Fed looks at core inflation. If you look at what’s taken place just in oil prices in the last six months, you’re going to see nominal inflation absolutely melt here with $90 oil.

CONSUELO MACK: And core is ex food and energy.

FRANCOIS TRAHAN: That is correct.

CONSUELO MACK: Therefore, nominal includes energy, so that’s what you’re talking about.

FRANCOIS TRAHAN: That’s correct, and so the food and energy component is already negative, dragging down that core figure even lower, putting money in consumers’ pockets. Every time people go to fill their gas tank, they’re going to find themselves with more money left over in their pockets, and so things that are tied to the U.S. consumer tend to do very, very well in a world of lower inflation. The U.S. consumer is the trade that’s worked for many, many years. Inflation’s been falling for many, many years. My sense is there is still juice in this thing.

CONSUELO MACK: Therefore, retail stocks for instance?

FRANCOIS TRAHAN: Absolutely.

CONSUELO MACK: And what kind of retail stocks?

FRANCOIS TRAHAN: Almost all of them. When you look at the consumer discretionary sector, it’s a combination of a lot of different things. It’s retail. It’s consumer services. It’s consumer durables. Those are all segments that right now have a tailwind going for them, and they’ve done very well in the last couple months of course because of this decline in oil. I think we’re still just scratching the surface. The story’s just beginning.

CONSUELO MACK: And yet talking to Nancy Lazar at Cornerstone Macro last week, she was saying that retail is vulnerable, and that you have a thesis of the smarter consumer that’s not going to take on as much debt, that is going to be very smart about its purchases.

FRANCOIS TRAHAN: Well, Nancy was talking about the back-to-school period and things like that, not necessarily retail stocks per se. Remember the market’s a discounting mechanism. The market in September is trying to figure out what’s going to happen next spring essentially, and what it’s seeing with a stronger dollar, with lower oil, lower commodity prices is a consumer that will have more and more money, and so this is usually a world where the low-end consumer does very well. CONSUELO MACK: I remember talking to you several times about how much macro matters in the market and, according to your research, about 80 percent of the market’s moves are related to macro forces, not individual stock dynamics. Looking at the macro picture, all the things that you’ve described which are positive, there are a lot of negatives as well. There is, again, Europe is very weak, and it could have more problems because it could have political unrest. We certainly have Russia.

FRANCOIS TRAHAN: And that means even lower interest rates for U.S. consumers.

CONSUELO MACK: Mm-hm, and yet …

FRANCOIS TRAHAN: What a positive.

CONSUELO MACK: It’s a positive if you just look at it in terms of interest rates and inflation, but if you look at it in terms of what’s happening in the world … I’m looking at China and the unrest there. I’m looking at the Middle East and ISIS. I’m looking at the threat of ebola. I mean, how do these … ?

FRANCOIS TRAHAN: Consuelo, again, consumption is 72 percent of GDP; export is 14, and so Europe’s problems are American homebuilders’ opportunity. Interest rates are to homebuilders what oil is to retailers or oil is to airlines, and so I don’t view that as a problem. I view that as an opportunity.

CONSUELO MACK: Therefore, it sounds to me as if even given the fact that the market has appreciated as much as it has since you turned bullish and certainly since the market bottomed in 2009, that you’re basically saying it’s full speed ahead for U.S. stocks and for companies that sell into the U.S. market.

FRANCOIS TRAHAN: That is correct, U.S.-centric investments.

CONSUELO MACK: Francois, the one investment for a long-term diversified portfolio. What would you have us own?

FRANCOIS TRAHAN: I think the most compelling trade, in my opinion, is the U.S. dollar, and there’s a number of ETFs. You have to find one that covers the trade-weighted dollar. That’s what you want. It’s up a lot this year. I think it’s just beginning. We’re talking about a multiyear cycle. Or the opposite of that trade would be short gold. There’s a lot of inversely correlated ETFs as well for gold. To me, those are the investments that make the most amount of sense. If you believe that a stronger dollar and everything that’s happening around the world is going to lead to a period where deflation is going to be a bigger issue than inflation, then gold is basically toast even at these levels.

CONSUELO MACK: Is there a market that represents the quintessential American company market that you would invest into? It’s certainly easy to find index funds that represent different sectors of the U.S. market. FRANCOIS TRAHAN: Probably the S&P 400 mid cap index. That is probably the quintessential investment.

CONSUELO MACK: Is there anything that keeps you up at night as far as the macro picture and what’s going on with the market dynamics?

FRANCOIS TRAHAN: I think what can throw a wrench in the story is a recovery, a legitimate recovery in China, and the Chinese economy is an economy that is investment-centric. So we’re a consumer-centric economy. They’re an investment-centric economy. They’re very sensitive to changes in interest rates. If you get market rates to come down in China, you’re going to see investments catch a bid again. You’re going to see commodity prices start to reverse their decline. That to me is the single biggest threat. You’ve got to keep an eye on interest rates in China.

CONSUELO MACK: And how likely is that? What are the probabilities of that happening do you think?

FRANCOIS TRAHAN: Well, what’s happening in Europe depressing our interest rates is having a similar impact elsewhere around the world. So far they’re down about 40 basis points when you’re looking at the government bond yield in China. It’s not enough. You need another 150 basis points, but to me what could really throw a wrench in here, what can give us a 20 percent correction, not just a four or five percent correction starts with a recovery in China, a legitimate one.

CONSUELO MACK: Francois, what do you say to investors who say it’s too late for me to get invested in the stock market? I’ve missed the biggest gains. What’s your response to that?

FRANCOIS TRAHAN: Irrational exuberance, 1996. We’re basically at the same level of P/E, and we’re staring at the four best years for the equity market, a different world. I get it, but very, very similar set of circumstances, and so look for a catalyst. Don’t look at just the valuation level.

CONSUELO MACK: Francois Trahan, it is a treat to have you, especially with such an upbeat outlook on the world. We really appreciate it.

FRANCOIS TRAHAN: Thank you. Thanks for having me.

CONSUELO MACK: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point follows up on recommendations that Trahan and we have made in the past… it is: invest in dividend paying stocks. The contribution that dividends have made to stock market returns over the decades has varied, but it has always been significant. From a high of 77% of the S&P 500’s return in the 1970’s to a low of 27% in the 1990’s. Dividends cannot be ignored.

And as we have discussed in the past there are now many dividend paying vehicles to choose from. One of Morningstar’s favorites is the Vanguard Dividend Appreciation fund- symbol VIG. According

 


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