Merrill’s former market expert says this is different from 1999

(Bloomberg) — This year’s relentless stock market rally has won its share of celebrity bears, the most famous being JPMorgan Chase & Co. market strategist Marko Kolanovic.

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It’s a story as old as Wall Street. Just ask Charles Clough, chief global investment strategist at Merrill Lynch & Co. from 1987 to 1999, which remained bearish during the dot-com boom of the late 1990s, but was justified only after he left the firm.

Looking at the market today, Clough says it’s nothing like that era. Now 82 and still running his eponymous hedge fund Clough Capital Partners LP, he sees companies generating cash flow to justify their rising stock prices. The economy is doing well. Inflation and interest rates are about to fall. And in his eyes, the stock has plenty of room to grow.

When comparing today’s stock market to the dot-com bubble, “the differences are far more important than the similarities,” he said in an interview. “The cash generation and scale of these companies suggests that they will be around for a long time and will continue to be very profitable.”

Clough’s hedge fund celebrates its 25th anniversary this year. Before joining Merrill, where he became one of Wall Street’s most revered forecasters, he spent time at Cowen & Co., the Boston Company, Colonial Management Associates, Donaldson, Lufkin & Jenrette and Alliance Capital Management Co. . He is also ordained. permanent deacon in the Roman Catholic Archdiocese of Boston and serves in that capacity at his local parish in Massachusetts.

READ: Kolanovic’s departure triggers echoes on Wall Street of 1999

The conversation has been edited for length and clarity.

Despite some recent turmoil, the US stock market has had an incredible run since last year. Does it have staying power?

We have a very positive vision. The most important thing happening in the economy is that inflation is coming back. It started in 2020 and 2021, largely because there were a number of enormous mock packs. At the same time, there were supply restrictions due to Covid. We are indeed on the reverse side of this dynamic. One of the things that makes us pretty confident that demand will slow enough to help inflation go down is credit card defaults. Credit card usage has really increased in this expansion as fees have gone from 12% to over 20% so this cannot be sustainable. We even see defaults on auto loans. Meanwhile, the Fed is watching as immigration adds to the labor supply and more companies use short-term labor. So if you put supply and demand together, inflation continues to fall. If so, interest rates will also fall, especially on the short side. All of this is bullish for stocks. Our thinking is that if you look beyond the volatility that is happening now, the right strategy is to stay invested, especially in stocks. And with the amount of money sitting at the short end of the yield curve today, there’s plenty of fuel for stocks to look forward to.

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With Big Tech stocks dominating market returns, there have been many comparisons to the dot-com bubble. Do you see similarities to that period?

It hasn’t gotten to the point where it looks remotely like it was in the middle of the dot-com boom. The problem during that time is that it was really a result of aggressive Fed liquidity coming into the market. It started in 1998 with the Asian crisis, and the Fed’s response was panic. A huge amount of money came in just as the Internet was taking off. This money fueled what we think of today as the dot-com boom. But these companies were unprofitable. There were silly companies like Pets.com with the sock puppet, but none of them had business plans that made any sense. There was no path to profitability. Companies were huge users of cash and were unable to generate cash flow. Today’s Big Tech companies generate massive amounts of cash flow. Also, there have been hundreds of stupid IPOs. That really didn’t happen in this expansion.

Earnings growth is finally extending beyond the Magnificent Seven and the Fed has begun its tapering cycle. Will the stock market and other groups take over?

Large-cap tech companies are in a world of their own. But that doesn’t mean that as interest rates fall, there can’t be other areas of opportunity. You can see what’s happening in the aerospace and defense sector. It has been a very quiet sector for the past 30 years since the collapse of the Soviet Union, and now there is plenty of technology and demand to catch up. We are looking at the housing shortage. Builders have held up very well and we think housing durables will continue to do well.

How have things been since you left your role at Merrill and opened your own shop?

We are 25 years old, which for a small boutique is a long time. In our portfolio mix, we have both partnerships and closed-end mutual funds. I guess the popular term is hedge fund. We have two: one in the medical area, and the other, a long- and short-term hedge fund. We think thematically about where the profit cycles will happen and then invest heavily in those industries. Closed-end mutual funds have been around for almost 20 years and have proven to be a pretty good balance of business. The hedge fund sector has been in somewhat of a decline over the last few years, although it is a very effective way to protect money, so I think it will come back. Meanwhile, it was good to have both businesses. A year ago I took over two exchange traded funds, they did very well. At this point, it appears that the firm is sustainable.

At the end of your tenure at Merrill, you were bearish at a time when Wall Street was extremely bullish. What’s it like to go against the grain?

That’s just part of the job. There was no reason to be upset because the market can do whatever it wants. We knew we were right and were able to continue to analyze the situation. People were interested in what I had to say. And I think it turned out really well. I remember watching Cisco Systems quite closely because at the time it was probably the biggest investment firm for the dot-com boom with all the telecommunications infrastructure that needed to be built. When I started going negative, the stock was up six times before falling 95% from a high of $82 in March 2000 to less than $10 in late 2003.

What are your customers worried about right now?

What will the Fed do? What will the elections do? How will China work? There’s always something on the horizon. The most important thing is to have a basis for making investment judgments. What we’ve tried to perfect over the years is understanding the credit cycle. How money and credit work through the economy is ultimately the deciding factor. What the Fed does and what liquidity looks like are far more important than elections, international affairs, and most of the things people worry about.

What is the best investment of your career?

The best call I ever made was that interest rates were going to fall, and that call still stands. We have not seen the decline in interest rates – the decline that began in the early 1980s. The secular decline in interest rates has not ended. It lasted through the 90’s and into the early 2000’s. It was interrupted by the government’s reactive response to the expansion of excess money due to Covid, which took place in 2021. But that is relaxing now. You have to wonder: Interest rates were falling for 40 years before Covid stopped everything. What were the reasons and have those reasons changed? The interest rate cycle that began in 1981 is related to global demographics. It has to do with the fact that there is so much debt on the balance sheet in the private sectors throughout the developed world. And, of course, technology is a major factor in lowering inflation. That’s why our analysis of credit cycles is so important to building conviction in our views. I’d say it’s the most useful call because it’s still there and people are underestimating how much interest rates can eventually fall.

Do you think Wall Street’s practice of setting year-end S&P 500 targets is helpful for clients?

No, I think it’s a stupid practice. If people could do that, they would call their broker from their yacht. Understanding the dynamics behind the economy and the impact on capital markets is much more important than choosing a target.

What do you have in your portfolio?

We own Microsoft Corp., Alphabet Inc. and Amazon Inc. We are invested in some of the major US defense companies, notably Raytheon Co. and General Dynamics Corp. because there is a clear profit cycle. We are invested in homebuilders, DR Horton Inc. and Lennar Corp. There are some ideas where we think there are cycles that are somewhat independent of the economy. There is an LNG cycle, and we’re looking for companies to exploit that.

Are there risks that investors are underestimating right now that are keeping you up at night?

Whatever is there, you’ll be fine. We believe in our strategies. Find out what you don’t know and work hard to understand what it is, but don’t stay up at night worrying about things. As long as you’ve done the work and understand the market dynamics, the only thing you can get wrong is the timing, and that’s not a problem. The biggest issue for capital markets would be whether the Fed would continue to raise short-term interest rates and shrink the size of its balance sheet. I think erratic central bank policy would be the only thing that would keep you up at night.

There is a debate right now about how much the Fed will cut interest rates in the coming months. How important is the scale of the discounts?

Direction is more important than magnitude. If you look at the interest rate that any major money center bank is offering on regular demand deposits right now, it’s about 10 basis points. Some are smaller. If you are a very good customer, they will grow. But the only reason I can go up and get a spread is because I can repo a deposit at the Fed and get Fed funds. That goes away next year. So the bank tells you what the actual price of the money is, what they are willing to go out and bid for a deposit. In a year to 18 months, I think people will be surprised, maybe even stunned, at how quickly short-term interest rates have fallen. Because there is no demand for deposits. The market feels that the demand for money is low. Interest rates are coming down and I think people will be surprised at the speed at which this is happening.

You have had a long and prolific career in the financial industry. What keeps you motivated?

It’s fun. It is important to stay alive. It is important to keep goals in your life. And I can’t imagine doing anything else. I just don’t know what I would do with myself if I didn’t have financial problems to talk about.

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