Bob Rodriguez: We are in a Rolling Depression
Robert L. Rodriguez was the former portfolio manager of the small/mid-cap absolute-value strategy (including FPA Capital Fund, Inc.) and the absolute-fixed-income strategy (including FPA New Income, Inc.) and a former managing partner at FPA, a Los Angeles-based asset manager. He retired at the end of 2016, following more than 33 years of service.
He won many awards during his tenure. He was the only fund manager in the United States to win the Morningstar Manager of the Year award for both an equity and a fixed income fund and is tied with one other portfolio manager as having won the most awards. In 1994 Bob won for both FPA Capital and FPA New Income, and in 2001 and 2008 for FPA New Income.
The opinions expressed reflect Mr. Rodriguez’ personal views only and not those of FPA.
I interviewed Bob last week.
When we last spoke a year ago, it was before the pandemic surfaced, yet you had argued strongly against monetary easing by the Fed. You were very critical of rising federal deficits. Now in response to the pandemic, the Fed has eased monetary policy further and the deficit has grown sharply. Did policy makers have a choice?
Monetary policy was excessive throughout the decade and leading up to this period. It created a massive financial bubble. Last year, I conveyed to my colleagues and others that, in the next financial crisis, the balance sheet of the Fed would grow by approximately $4 to 6 trillion from approximately $4 trillion and we would likely be a facing recession in Q4 of 2019 or Q1 of 2020.
Just before we talked last September, the repo market had just experienced a disruption, where rates rose from 2% to 10% in one evening. I considered this a warning shot across the bow. But the Fed did not. When the crisis hit, we had the highest system-wide financial leverage in history. This situation forced the Fed's hand. It had to enact massive support measures for the economy. Those actions stemmed the immediate crisis in the bond market and also private businesses.
But you have to ask the question, “At what cost?” The Fed is now in a deeper hole than when it was with quantitative easing this past decade. As I wrote nearly a decade ago about quantitative easing: It was very much like the roach motel – you can check out, but you just can't leave.
How should the Fed have responded?
I don't think it could've done virtually anything different because it had become a prisoner of its own policies enacted over the prior decade. Those policies rewarded excess and encouraged speculation. It was too late to respond differently; the die was cast. This is why I thought in the next crisis, its balance sheet would grow sizably.
You may also remember that in 2009, I forecasted that if we did not get our economic house in order by the end of 2013, we would likely face a crisis of equal or greater magnitude than we experienced in 2008-2009. The 2017 tax cuts and the 2017 ominous budget postponed this likely occurrence until sometime in 2019. This was another reason why I was very anxious last year. The Fed responded and with fiscal stimulus, both totaling nearly $6 trillion, a record amount was thrown into the economy. If you consider annual GDP and break it down to a quarterly rate, it implied that we would lose something like $2.5 trillion in one quarter or possibly even more.
What the Fed threw at the system was emergency stabilization. In light of these actions, the economy remains in a quite tenuous position. In fact, I've used a phrase with my former colleagues and friends – we are in a form of “rolling depression.” We're not in a recession. Most people don't know the difference between recession and depression, other than saying, "a depression is worse than a recession." A depression occurs when there is a structural shift downwards in the economy, and it stays near this lower level of economic activity for a prolonged period of time.
With that in mind, the policies that are being enacted by the Fed and the federal government are going down the same road as in Japan and Europe. Thus, I fully expect a similar outcome of low rates, languid economic performance and high unemployment for a sustained period.
What does this mean going forward?
After the great recession of 2008-2009, I forecast that we would see real GDP growth of 2% for as far as the eye could see. Well, from June 30, 2009 through September 30, 2019, real GDP grew about 2.2%. I wasn't far off. We also had terrible capital spending and productivity cycles. Thus, coming out of this mess that we are in, I fully expect economic growth will be probably be no better than half of what we experienced after the great financial crisis, despite the president's saying we are in a V-shaped recovery. I'm looking for 1% or lower real GDP growth going forward, accompanied by poor rates of capital spending and productivity growth.
For the last five years, much of corporate cash flows were deployed into share buybacks, not capital spending or productivity improvements. We're probably in a more diminished state because of the financial engineering in the past decade than we were prior to the previous financial crisis. We're in a bad situation.
We're also facing two other challenges that create problems that few people realize. One is our debt multiplier has been declining for a couple of decades which leads to a low velocity of money. As I described to my friends, "It's very much like digging a hole and then filling it up again. You have a lot of activity but without much being accomplished."
The consumer has saved a lot of money because they've gotten all this stimulus cash. They've paid down debt. They haven't spent much more than maybe half of what they've received. This is viewed as a positive. But I say, "That's only one side of the equation." The offset is the government borrowed this money, so it results in a negative savings rate and the net effect is a system-wide savings rate that hasn't been improved. It's a very pernicious environment.
We've exchanged emails on the topic of responses to the pandemic. I would like your input on how state and city governments have responded. What do you see were the biggest mistakes and where were there any successes?
I would ask, “What has been the economic loss caused by government, be it federal, state or local?” Their actions killed the economy. There was a lot of talk about following the science. Remember when Dr. Fauci said, "We have to shut down because we have to bend the virus curve downward so we don't overwhelm the medical care system." Then it morphed from getting the curve down to having a vaccine. The goalposts keep getting moved. This has become very political. Once I saw the data that was coming out, both here and abroad, back in April, I viewed myself as not being much at risk. Even though I'm nearly 72, I'm very healthy. I don’t have any comorbidities or anything like that. I view the perceptions of risk from the virus as being vastly overestimated by a large proportion of the populace, especially among the primary working class people between the ages of 21 and 55.
The government, be it federal, state, and local, used a blanket approach rather than a targeted one. We effectively killed the economy to protect a small percentage of the population. I viewed it as very bad policy. I've been traveling around the country since April. I take appropriate precautions. I couldn't believe the airfares. As an example, I flew from Reno to Dallas to have lunch, do some business, and then flew on to LA, all first class, for $217 on American Airlines. Nobody was on the flight. I considered flying one of the safest places to be.
There have been a lot of mistakes made. But, you can't really second guess these people to a great extent. They were dealing with something they weren't prepared for. You have to give some a “get out of jail free” pass. But for others, I have my reservation. In Northern Nevada and Lake Tahoe, we've taken a far saner approach, and people are a lot happier here than they are in Manhattan Beach, CA, where I have a second home.
You talked about the effect of monetary policy on the economy. But the other thing that the Fed has done is that it's effectively destroyed price discovery in the markets. Investment banks have responded by underwriting a record amount of corporate debt, given low interest rates. Arguably, you could say that the central bank is inducing investors to fund operating losses and share repurchases. How do you see that process playing out?
I don't see it as very good. We're essentially watering our weeds and pruning our roses before they bloom. By that I mean we're not allowing creative destruction to occur. In effect, capital is being allocated to companies that should have been allowed to go under. They were going to go under anyway. We have zombie companies. Given a high percentage of zombie companies surviving, their continued existence distorts the supply of goods and services and negatively effects market pricing.
As an example, think about Warren Buffett and Berkshire Hathaway. Berkshire Hathaway closed down its manufacturing and textiles businesses back in the late 1960s. It was a very old line of business, and he basically used the philosophy that as long as it was generating positive cash flow and covering its costs, he’d keep them open. But when it started losing money, he shut it down. In today's environment, the primary focus is on all the jobs that are being lost and the problems this is going to create. But consideration is not given to the fact that there is a misallocation of capital that will likely hurt the economy longer term since it could be better deployed in other areas that would better enhance the system. The process of what we're in right now is diametrically opposed to what I just described with Buffett. It is the antithesis of creative destruction that keeps an economy vibrant.
The central question facing investors, which you've hinted at earlier, is how to reconcile the dissonance between the weakness in the economy, what you're calling a rolling depression, and the ebullience in the financial markets. You said last year that you liquidated your equity holdings in 2016 and 2017. What is your expectation for equity returns over the next decade?
We're in an even bigger bubble than what transpired before this year. Who could envision that Apple's market cap could be greater than the entire Russell 2000? I know I couldn't. The concentration of performance is in a very small segment of the top portion of the market. It's even more distorted than what occurred at the end of the 1999-2000 bubble. I don't consider that good.
I fully expect negative real returns for equities over the next decade. The other question is whether nominal returns will be positive? That's a function of inflation, which might happen.
The most important thing is what's transpired in the capital market with this massive liquidity infusion. The Fed’s policies have encouraged risk taking and speculation again. Keep in mind, the last decade was a function of financial engineering. When the update to total system wide profitability was released last September, as measured by the National Income and Profit Account, total corporate profits were unchanged from Q1 2012. Stock market performance, during the decade of 2011 to 2019, was primarily driven by PE multiple expansion. I don’t expect that to occur again in the next decade. It is an unlikely outcome.
Did you buy anything when the market dropped in March?
Yes, I did. I deployed capital into gold. When I saw what the Fed and federal government’s initiatives were going to be in March and April, I threw in the towel on the dollar and other fiat currencies. I began buying gold via Sprott's Gold Trust – PHYS is the symbol. I've been purchasing more on every pull back since then. This is my largest capital commitment in the shortest period of time in nearly 15 years.
I'm going to come back to your purchase of Sprott in a second. But let me shift to what you mentioned earlier about the structural changes in the economy. There have been many changes that are likely to be permanent and outlive the pandemic, such as working from home, moving to the suburbs, relying on e-commerce and virtual learning. Are any of those paradigm shifts underappreciated by investors and not reflected in market prices?
We're experiencing a structural change in system. We're not going back to where we were prior to COVID, which in my mind is probably pretty foolish to believe so. My former company, First Pacific Advisors, has learned how to operate effectively in a non-co-located format. A review of how capital is deployed in plant and equipment is now under reconsideration. In many cases, a smaller business footprint may now be required. What is being considered is how should a company be structured in this new environment? This question is now being addressed by corporations large and small across the land.
What is the best way to function? A company that's been a beneficiary of all of this turmoil is Zoom. It's created the opportunity for a large number of people to attend conferences or meetings in ways that were not thought possible before.
It announced some aggressive guidance earlier today.
I did my first Zoom communication two months ago. On Friday, I did my first Zoom presentation for a research symposium. There were over 30 presenters on this Zoom symposium that took place over a three day period. It came off great. I've seen other companies that have built up their technology platforms before this pandemic hit.
One has to reconsider whether it is wise to be invested in a lot of high-rise buildings. That question is being evaluated now. In New York, you can see this playing out rather dramatically as lease rents decline. This has happened before in the history of New York City. I doubt that all of this demand will go away and not come back. Some will come back, but there is some proportion that is learning how to operate more efficiently and differently from this experience.
In my own area of Lake Tahoe, we're seeing the evacuation from the major cities in California. This is getting reflected in real estate prices. They're selling like hot cakes where I'm living.
Banks have largely under performed the market since the March lows. Is there any message that you see in that price action?
I haven't been interested in banks for about 15 years because of the Fed's policy of lowering rates to effectively zero. Even though there's a steep yield curve currently, there are not enough basis points in the curve’s shape to be good for the banking business. They're going to probably try and recover some of the lost basis point spread revenue via fees. I don't know how successful they will be. The most recent disclosure by Warren Buffett that he is eliminating large chunks of his bank stock ownership should be a warning sign. He transferred some of proceeds into a gold-mining stock. He's looking at things a little bit differently than say a year or two ago.
In his latest quarterly letter, Grantham Mayo Van Otterloo’s Ben Inker makes the case that government bonds cannot provide two of the basic investment services they have traditionally provided in portfolios – meaningful income and a hedge against an economic disaster. Do you agree with that assertion and what alternative investments can you recommend for those purposes for the average investor?
I would agree with that for long-term Treasury bonds and also for longer term corporate bonds, since both have volatility characteristics very much like that of common stocks. The Fed has announced they're going to keep rates low. This means Treasury bonds are going to have negative real yields for a considerable period to come.
For me personally, back in 2014, after I saw that we were not going to get our economic house in order, I began repositioning my estate. My questions were, “Would we experience negative real yields?” “Might we also see negative absolute yields like those in Europe or Japan?” I wasn't sure. But I thought the odds were very high that yields would fall. So, I bought some intermediate term bonds for a period of time. But some of those are now maturing. I'm getting the opportunity to reinvest at virtually a zero yield. It's such a wonderful feeling knowing that a portion of my purchasing power is being confiscated by the government.
In any case, I chose to redeploy about half my net worth out of the capital market into alternative hard assets. This has taken place over the last six years. I envision this allocation could rise to possibly as much as 60% or 70%.
Among those alternative hard assets, what are the general categories you've found attractive?
I am deploying capital into gold. I also have some nice properties on Lake Tahoe. In Lake Tahoe, there are only 403 properties on the lake. In California, there are about 35,000 people who have an adjusted income of a million dollars or more. They're getting, shall we say, really irritated, given that California is likely to go to a marginal tax rate of 16.8% versus 13.3%. Californians will also be voting on a proposition this November, Proposition 15, to change the tax law on commercial properties. There's even one legislator who is proposing a wealth tax. There's probably a sizable population shift taking place from California into Nevada. With only 403 lake front properties, there is a good demand versus supply imbalance. I have a little bit over a 5% market share. It's fully paid for, so I don't have to worry about debt or anything else. I can just be like a cork on the water and just bounce along and get by.
The third asset that I put capital into, and I won't go into it specifically, is in the collectible rarities area that have some interesting dynamics.
While we're on the subject of real estate, the CARES Act permitted a substantial number of people and businesses to seek forbearance on their rent or mortgages. What are the investment implications of that going forward?
It’s not good to be a landlord. You have forbearance. Will you have forbearance for the landlords who have leveraged their properties? How will that play out? We're still working through that process and it's difficult. It has provided a temporary salvation for many companies and individuals. But, I fully expect a large portion of this debt will be written off by the government.
How many companies, both public and private, had built up rainy day funds ahead of this time? I doubt many did. This crisis has laid bare a policy that was started way back with Alan Greenspan in 1987. It is the socialization of risk. It's hard to argue this point when people are in such pain. But let’s step back and ask, “How is this going to change the dynamics of capital-risk investing?” If you're going to build out a project, now you don't know if you're going to be able to collect or evict. That poses a risk factor; in the development of a project, you have to factor it in. That would mean that your discount rate on cash flows will have to be considerably higher to reflect this new risk that you didn't think you had to face
It sounds like it could be a while before the commercial and residential real estate markets reach an equilibrium where prices and rents have reached a level that can support one another.
That depends on how the economy is going to unfold and the length of the rolling depression that we're in. We have a long way to go before we have an idea of what and how severe the permutations of what we're going through will be and who will be the beneficiaries.
The trade-weighted U.S. dollar spiked higher during the February and March market decline. It has subsequently declined significantly, and is at roughly its level from mid-2018 until February. What is the message from the currency market?
In the first stage, when the dollar rallied (using the DXY or dollar-exchange index), it got to nearly 103. Since then, it's fallen. It briefly broke 92 the other day. The aggressive policies of the Federal Reserve and the federal government were more sizable than our partners in Europe or in Japan. Those policies have worked to undermine the dollar and force it a little bit lower. One has to ask the question, "What do you think is going to unfold over the next few years and how might that affect the dollar and then eventually other fiat currencies?"
In the case of the United States, I'm working under the assumption that the economy will not get back to Q4, 2019 GDP levels of approximately $21.7 trillion until possibly 2024 or 2025. A stronger recovery is not in the cards, despite what the recent stock market rally conveys. As such, the pressures on government and the Fed to do something will intensify. Thus, if I'm correct about this, we have the prospect of going to a 200% debt-to-GDP ratio by the end of the decade. The value of the dollar and other Fiat currencies will experience downward pressure compared to gold.
There's one other aspect that concerns me. We have a presidential election coming up. People will be on one side or the other. Looking specifically at one item of Biden's economic plan, it would be to effectively add a third mission to the Federal Reserve’s mandate. The Fed would need to address Black/minority equity and unemployment. This would further politicize the Fed. If this were to occur, I believe it would raise anxiety among many of our holders of Treasury securities, which total more than $7 trillion. If they decided to reduce their holdings, like what has been occurring over the course of the past year, this could put additional pressure on the dollar. It would also likely mean the Federal Reserve would have to be the buyer of last resort. This could increase the size of the Fed’s balance sheet even more so beyond the deficits that will occur over the next five years.
The dollar is in a tenuous position. Fiat currencies are experiencing competitive pressures as people exit them and are looking for other safe havens, such as gold.
I want to come back to what you mentioned earlier about gold. You explained that you had purchased the Sprott Physical Gold Trust. You gave your rationale for buying it. Among the various ways you can invest in gold, why did you choose that particular vehicle?
First of all, I did not go into gold mining equities. My strategy is about creating a store of value. Gold equities can be a store of value or they can also be a destroyer of value. Gold mining companies have been incredibly poor allocators of capital in my 50-year career. There are times when it is good to be in them. Quite frankly, this has been a pretty good time. The cost and revenue dynamics are very positive. One can read about this with what Warren Buffett did with his investment in Barrick.
In the case of Sprott, you have the ability to exchange your shares for gold should you want to. However, you have to be either an institution or a wealthy individual, because to exchange requires sufficient shares to buy a 400-ounce bar of gold, which today would be about something close to $750,000. It's not for the typical small investor. But it affords the ability to exchange your shares for the actual physical gold, which keeps the share price of Sprott within a narrow zone of its net asset value. This information is available on Sprott’s website for the Sprott's Gold Trust.
Over the past decade, its share price has traded within plus or minus 1% of its NAV. In the week of March 20th, when people were experiencing margin calls and couldn't sell certain types of securities, they ended up selling PHYS. As a result, during that week, PHYS went to a low of a 4.3% discount to its NAV. It was wonderful to be able to acquire gold this way. You're buying gold at basically $60 to $70 an ounce less than the spot price. During that same period, there was a physical supply shortage in the retail market. If you wanted to buy an ounce of gold, let's say one of the U.S. or Canadian ounce rounds, you'd pay anywhere from a 7% to 10% premium over physical spot price. During this same period, there was an opportunity to acquire gold at a 11% to 13% discount to retail by buying PHYS. Today, it trades at about a 1% discount to NAV.
The last thing is that Sprott acquired a company (the Central Fund of Canada Limited) about three years ago. This fund didn't have the same gold exchange option and thus, it was selling at a 10% discount to NAV. Sprott came in, made a hostile offer, and announced that they were going to merge it into its company. It would then have the ability to exchange into the physical asset. Low and behold, before you could say Sprott, the discount went from 10% to approximately 3% and now it trades very much like Sprott's physical trust.
ETF outstanding shares are either increasing or decreasing every day. At the end of the day and over a period of days, GLD, the largest one, has to settle or true up the gold that it owns for its shares. There are people who are concerned about the actual physical gold. Gold has been leased several times. Are there more owners of gold than there is actual gold? I have no idea how to determine this. In the case of Sprott, it sold shares and then went into the market and bought gold. The gold is held in custody at the Royal Canadian Mint. You are buying a percentage of a fixed gold repository.
Commission-free trading and online brokerage platforms like Robinhood have attracted a substantial number of investors. Some people claim it now represents nearly a quarter of the trading volume on the equity markets. What advice do you have for those retail traders and investors?
I recommend they have a real job. The likelihood is their investment portfolio will be devastated with all the shenanigans they're playing. At Robinhood people were buying Hertz stock aggressively while its debt was entering bankruptcy. Hertz was going to do an initial bankruptcy offering. The SEC got involved and stopped this insanity. Talk about going into bizarre-o-land.
That is indicative of a highly speculative market. I read that people who were getting their $1,200 from the government were taking that money and putting it in the stock market via Robinhood. This is speculation.
You better have a job. You're living in the greatest Ponzi stock market in history.
You've talked about the fact that you've live in Lake Tahoe, Nevada. As a state that has no personal income taxes, a majority of the state's revenue is derived from tourism and special taxes on gambling. You've also talked about the positive outlook for real estate there. But, with those two sources of revenue severely curtailed by the pandemic, how do you see the future for Nevada?
Nevada is trying to manage its finances as if it was a household. When it has tax revenues, it has money to spend. When tax revenues decline, it cuts back on expenses. It was a miraculous action to see. For example, in the Reno area, gambling is now a very small percentage of tax revenues. You can go out and look at the Reno business park. It's growing like crazy. That's where the huge Tesla mega plant is. The Chamber of Commerce is experiencing record levels of inquiries from businesses considering a move here.
I visited Austin, Texas, back in the early to mid-1990s. If you looked at an aerial view of Austin and you put corporate logos that were there, you'd only see a couple of them. But then all of a sudden over a period of 20 years, it just filled in like crazy. I don't expect Reno to be that way. But it could be a mini-Austin, Texas with what is unfolding. You have a lot of land. You have transportation. You have distribution hubs. It is located next to the sixth or seventh largest GDP, California. That has attractive aspects.
Las Vegas is more heavily focused on tourism. But it also has the benefit of being a major distribution hub and having the U.S. federal government there with one of the largest military facilities. There are federal dollars that come into the state of Nevada through that vehicle. Nevada has a proclivity to manage its expenses, unlike California.
We do have politicians who are becoming somewhat California-like. Now that I've been in Nevada for 14 years, I think I can call myself a Nevadan. I don't like what I see going on with some of these politicians.
My last question is one for my own curiosity. What information sources do you find most valuable for insights into the economy or to the markets?
One of the sources of information that's rather intriguing, but you have to cut through some of it, is the website ZeroHedge. A lot of the news that will break on the major channels shows up there first. In fact, they were talking about a potential pandemic coming out of China back in early January. I find that one to be of interest.
I read veraciously, with a wide cross section. I try to be observant of what's going on around me. I've always thought about thinking outside the box. But right now, I have it easy because my strategy is different. It is very much about winning by not losing. This is an investment environment that is historic in terms of its excess. I'm focusing on return of capital rather than return on capital.
One of the least manipulated or distorted markets is the commodity market, versus the debt or equity markets, where prices are being influenced by governmental excess. But at least there is a clearing mechanism that functions more normally in commodities, as compared to what is taking place in the equity and fixed income markets.
I urge people to be cautious. I will be looking at policies that will unfold over the next year. My guess is we're going to see tax cuts announced sometime in the second or third quarter of next year because the economy will be struggling. I think you'll see that by the first quarter of this coming year and a V-shaped recovery will not be what people are talking about; I expect a recovery that is more like a square root. If you start to see that, how will this influence deployment of capital decisions?
This is truly an unprecedented period of time that we're living through both in terms of the pandemic and central bank policies. There's nothing like this in 5,000 years of recorded history. It's unbelievable.