Jeff Gundlach on the Next Economic Collapse

Jeff Gundlach, CEO of DoubleLine Capital predicted the election of Donald Trump and the 2007 housing crash. He is now providing insights into the next economic collapse.

Headshot of Jeff Gundlach

In 2011, he was featured as “The King of Bonds” in Barron’s, and named one of “5 Mutual Fund All-Stars” by Fortune Magazine. In 2012, he was named one of the “50 Most Influential” by Bloomberg Markets magazine. In 2013, he was named “Money Manager of the Year” by Institutional Investor.

When Jeff Gundlach speaks, people listen. Unlike most investment managers, he doesn’t hold back and is willing to tell it like he sees it. Listening to Gundlach is like getting a bucket of cold harsh reality poured on your head.

He was recently interviewed by a Swiss newspaper on what the next recession might look like. Gundlach warns investors to prepare because it will lead to big changes in the market. He argues investors need to reduce risk and own their house free and clear. (in fact, he says anyone with a mortgage should not own stocks.) While there might still be market gains over the near term, when the downturn does come people will be “overwhelmed by problems” with their investments. In particular, he sees big problems with the US corporate bond market.

“This time the liquidity is going to be very challenging in the corporate bond market. The corporate bond market in the United States is rated higher than it deserves to be. Kind of like securitized mortgages were rated way too high before the global financial crisis. Corporate credit is the thing that should be watched for big trouble in the next recession. Morgan Stanley Research put out an analysis about a year ago. By only looking at leverage ratios, over 30% of the investment grade corporate bond market should be rated below investment grade. So with the corporate bond market being vastly bigger than it’s ever been, we’ll see a lot of that overrating exposed, and prices will probably decline a lot once the economy rolls over. Furthermore, central bank policies have forced investors into asset classes that they usually would be a little bit more hesitant to allocate to.”

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Gundlach also sees major problems with the US stock market, arguing it will be the worst performing equity market in the world. Why? Partly because it is currently the strongest.

“The late 1980s saw Japan as invincible with the Nikkei tremendously outperforming every other market to the point where there was incredible overvaluation of Japanese real estate when the recession came in the early 1990s. The Japanese Market was the worst performer. It never made it back to that level. In the advent of the Euro, there was a lot of enthusiasm about the economic prospect of the Euro area, and the stock market in Europe was incredibly strong in 1999, outperforming every other market. When the recession began, it was the worst performing market and never made it back again, broadly speaking. This time US stocks are crushing every other area. It’s due to some fundamentals like the better economy, but also due to tax cuts and share buybacks. In the next recession, corporate bonds will collapse, and buybacks will stop. The dollar has already topped. It may begin falling in earnest during the next downturn and US equities will lose the most. They will probably not make it back to the peak for quite a while. When the US market drops, it will drop a lot.”

The next recession will see deficit spending balloon. The US is already running $trillion+ deficits and this is supposed to be the best economy ever. The next recession could put upward pressure on interest rates, as demand for funding rises. Of course, the Fed will do everything in its power to combat this, but possibly not until after a crisis emerges. The firefighters don’t show up until the house is ablaze.

“Powell said he’s going to use large scale asset purchases to fight the next recession. That’s what he said at his last press conference. He could introduce negative interest rates, but I think Powell understands that the US cannot introduce negative interest rates without the entire global financial system collapsing. Because where’s all that capital going to go? Which markets are big enough? Negative rates are the worst thing that could happen in the US. You can see what negative rates have done to the banking system of Japan and Europe. All you’ve got to do is look at the relative performance of bank stocks. The underperformance of European banks is correlated to the yield of the 10-year German Bund. I don’t know if the politicians understand that negative rates are fatal. It’s fatal to Deutsche Bank and insurance companies in Switzerland.”

So what happens post recession when US public debt levels skyrocket due to massive deficit spending? Suddenly, the problem everyone has ignored could smack the US right in the face, and the US government will look for solutions.

You could create inflation through universal basic income. That would debase everything. Or you could default on Social Security benefits and welfare benefits. These are the options. We’ll do some combination, maybe raise the eligibility age from 65 to 75. I don’t know what’s going to happen, but what we have now is unsustainable. The debt is unsustainable. Interest rates are unsustainable. The wealth inequality gets worse every minute. It’s already beyond the point of sustainability, and when the next downturn comes, there will be a lot of anger and unrest. …the misery is going to be apparent for a considerable fraction of the population. It’s going to be pretty intense, and the response will be money printing. When Ben Bernanke said, we’ll never have deflation because we have the printing press and when he used the word helicopter money, people thought it was some euphemism, some joke. People thought that that could never happen. Now we have candidates running on it. Kamala Harris has a version of it, Cory Booker has a version of it. And for Andrew Yang it’s the centerpiece of his campaign.”

Gundlach is not talking about a garden variety recession. This situation – massive debts, slowing growth, rising wealth inequality – has been building for decades and the world is approaching a point at which seismic shifts will occur.

This situation has taken since 1945 to develop. And it really got going with US-President Ronald Reagan. So I started in this business when the scheme was starting. And we used to think that 8% interest rates were set to last forever, and it was unthinkable that the Fed would buy bonds, inconceivable! And now it’s normal. And free money used to be unthinkable. What people got themselves fooled by was feeling somehow that there’s real stability to societal institutions because they’ve experienced it most of their life. Some still think they’re experiencing it. But they’re not.”

So what does normal look like?

In 1970, there were no credit cards. In 1970, there were no car loans. People saved money and bought things. That was normal. The debt-to-GDP ratio was stable. Economic growth was real. It really happened. In 2018, the dollar growth of nominal GDP was less than the dollar growth of the national debt. That means that there is no growth. We’re having an illusion of growth. It means that we’re issuing IOUs and spending it, and it shows up in the calculations as growth. But spending is not growth.


How to Become a Better Investor

Image: George Catlin, Cabane’s Trading House, 930 Miles above St. Louis (1832)

The sooner you realize you suck at investing, the sooner you’ll become a successful investor. Unfortunately, many people believe they are the exception. The truth is, most people barely achieve ⅓ of broad market returns due to their emotional decisions. 

This isn’t simply about stock picking or choosing a fund manager who will outperform. It’s about swimming against powerful market tides.

You Suck in Bear Markets

Bear markets are a form of psychological torture.  Believe me when I tell you that even seasoned investors are tempted to sell everything when markets are pummeled. The relentless and pervasive barrage of negativity goes on for months leading even the most resolute to question their own beliefs.

Whether you invest in stocks, index funds or active funds, do you have the intestinal fortitude to buy when the entire market is dying and everyone is screaming ‘sell’? It is easy to say ‘yes’ from the comfort of your armchair when unemployment sits at record lows and markets are near all-time highs. But it isn’t as easy when your friends and family are losing their jobs and people are going bankrupt. At that point in time, self preservation becomes paramount and one can easily rationalize selling underwater investments to protect what’s left. 

You Suck in Bull Markets

It is just as difficult to do the opposite (sell) when everyone around you is getting rich off the last vapors of a bull rally. The conservative investor that misses the final months (or even years) of a bull market is made to feel stupid. Meanwhile, your friends and family with sub-par IQs are rolling in dough as they plow every penny into risky assets.

These are precisely the emotions you need to combat even if you simply want to passively buy and hold low cost index funds to match market performance. Investing is simple…until it’s not. It’s simple until you start paying attention to the noise around you. Unfortunately, the noise is hard to ignore.

These emotional decisions cause investors to lock in losses and miss out on gains. Consequently, the average investor vastly under-performed the broad stock market over a 20 year period.

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How Does the Typical Investor Actually Perform?

According to Richard Bernstein of Richard Bernstein Advisors:

“The performance of the typical investor over this time period is shockingly poor. The average investor has under-performed every category except Asian emerging market and Japanese equities. The average investor even under-performed cash (listed here as 3-month t-bills)! The average investor under-performed nearly every asset class. They could have improved performance by simply buying and holding any asset class other than Asian emerging market or Japanese equities. Thus, their under-performance suggests investors’ timing of asset allocation decisions must have been particularly poor, i.e., investors consistently bought assets that were overvalued and sold assets that were undervalued.” 

BlackRock made similar comments back in 2012:

“Volatility is often the catalyst for poor decisions at inopportune times. Amidst difficult financial times, emotional instincts often drive investors to take actions that make no rational sense but make perfect emotional sense. Psychological factors such as fear often translate into poor timing of buys and sells. Though portfolio managers expend enormous efforts making investment decisions, investors often give up these extra percentage points in poorly timed decisions. As a result, the average investor under-performed most asset classes over the past 20 years. Investors even under-performed inflation by 0.5%.”

How to Become a Better Investor

So what can you do? Perhaps the more appropriate question is ‘how can you do less?’. Because it is the ‘doing’ – the unplanned activity – that causes investors to fall behind. 

The best way to avoid unnecessary and detrimental activity is to build a plan for how you want to invest, in good times and bad. Perhaps the simplest plan is to invest a percentage of your paycheck every month into a pre-selected set of investments that align with your risk tolerance and objectives. Your plan can be more elaborate if you choose – e.g. creating trading rules such as stop losses – but for most the simple approach is best because it doesn’t require expert knowledge and is easy to execute.

Most importantly, make the decision today about how you plan to behave when markets are plummeting or irrationally exuberant. Because when you’re in the heat of a bear market or bubble economy, emotions will take over and you won’t be able to make rational decisions.


The S&P 500: Biased and Misleading

You’ve seen headlines like these:

“S&P 500 crashes today”

” The S&P 500 rose as earnings optimism rises”

“Record year for stocks, as S&P 500 up double-digits”

…and so on.

The problem with these statements is that they’re using the S&P 500 as a proxy for the overall market. I’ll be the first to admit that no index completely represents the market at all times. But in this article, I’ll point out some of the issues with the S&P 500.

The S&P 500 index is a market-capitalization weighted index made up of 500 of the largest publicly-traded companies in the United States. The stocks within the index represent a significant portion of value of all companies in America.

I am a big fan of low cost index investing. So why am I shit-talking the S&P 500?

Three reasons:

First, the index is arguably actively managed. All indices have a pre-programmed set of rules to determine its constituents, weightings and rebalancing frequency. An index and its characteristics need to be defined – like everything else in life – and that definition is the creation of a human being (or team of humans) making some sort of decisions. The activity undertaken to create these rules (and the activity in executing these rules) means that indices (like the S&P 500 index) may not be as passive as investors believe. While an investor can make a passive allocation to an index, that investor must first understand and believe in how that index is constructed.

Second, the index is highly concentrated. The chart at the beginning of this articles shows that the largest 5 stocks of the S&P 500 accounts for the same market cap as the last 279 companies of the index. These five companies are Microsoft, Amazon, Apple, Alphabet and Facebook. While these companies may seem like behemoths that could survive anything – thus deserving their big weights in the index – one only has to go back as far as 2010 to see a completely different composition. In 2010, the largest five stocks in the S&P 500 included Exxon, GE and Berkshire Hathaway. Where are they now? This degree of concentration presents a risk to investors, as the success of index constituents waxes and wanes. Essentially, the performance of the S&P 500 is dependent on the success or failure of just 5 companies.

Third, the index is effectively a buy-high sell-low strategy. Put simply, to get added to the index a company needs to be meaningfully large. Companies aren’t born large, so by the time they are big enough to be added to the S&P 500 they have often experienced years of growth. In other words, companies are added to the index AFTER they have performed well and potentially already trading at elevated levels. In contrast, a company is removed from the index if it falls from grace and has shrunk considerably (or even gone bankrupt) due to years of weak performance. Ideally, investments should be bought BEFORE they perform well and sold BEFORE they start to underperform. The S&P 500 (and many other indices) does the opposite, and is effectively a buy-high sell-low strategy.

Takeaway: If you are looking for simple, diversified access to passive exposure to equities I would first look for indices that are well constructed. These well constructed indices may not be what you see in the newspaper headlines, and some are proprietary to mutual fund or ETF manufacturers. Look for investment products that provide ‘total market’ exposure while capping the weight of each underlying holding. Take a look at the top 10 holdings of whatever index ETF or fund you are researching to ensure they represent no more than 25% of the overall assets. Finally, also consider an index ETF or fund that includes small, mid and large cap stocks to provide exposure to all phases of company growth (i.e. not simply to companies that have already gotten big).

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