International Selection 12:18 - Febr 10th 2016

Fred Hickey: «We’re certainly well into a bear market»

Fred Hickey, editor of the widely read investment newsletter «The High-Tech Strategist», warns of more trouble to come for stocks and spots bright investment opportunities in the gold sector.

Around the globe financial markets are in turmoil. For Fred Hickey that doesn’t come as a surprise. The outspoken editor of the investment newsletter “The High-Tech Strategist” predicted towards the end of 2014 that the US stock market would fall when the Fed stops its stimulus program QE3. Since January, especially equities in the Nasdaq Composite index are getting clubbed. For the contrarian investor with a longtime experience in the IT industry this fits the classical behavior of a bear market. Mr. Hickey warns that stocks will fall further and recommends to buy gold and shares of gold miners.

About Fred HickeyFor many investors around the world, Fred Hickey’s monthly newsletter is a must read. It’s a unique treasure of deep knowledge that goes way beyond the tech sector. Having grown up in Lowell, Massachusetts, in the heartland of the computing cluster around Route 128, he’s been fascinated by technology since his youth. After graduating from the University of Notre Dame, he started working for the former telecom giant General Telephone & Electronics. In 1987, he began writing his newsletter for his friends and family. After just five years it went so well that he could make a living out of his investing tips. Today, the fiercely contrarian lives far away from Wall Street in Nashua, New Hampshire, and in sunny Costa Rica.Mr. Hickey, the bumpy ride on the stock markets continues. How dangerous is the situation?
We’re in a bear market. Technically, we’re not in a bear market yet, but bear markets are a process where it takes time to batter investor confidence and break it down. Bear markets start off as “healthy corrections” or just as sell-offs that turn into corrections. Only later do they reveal themselves. One could compare this process to a boxing prize fight. In the first round the eventual loser – which would be the US stock market investors – is dancing around the ring and is really excited after several rounds of gains. But as the US economy starts to break down and the stock market starts to fall off without QE and mutual fund outflows grow, the fighter starts taking a lot of body blows and weakens.  We saw that process occur all of last year. Stocks fell for the first time in six years and we’ve seen many market segments get hit hard, whether it’s energy, materials or transportation stocks. So last year was the breaking down process and now, since the beginning of 2016, it’s been a rough time.

How will this boxing fight go on?
As the bear market process continues fewer and fewer stocks remain aloft. One by one they fall and investors crowd into a smaller and smaller number of favorites which look like they’re invincible. This classic herding behavior has happened as long as I have been watching markets. At the beginning of the bear market in 1973, for example, investors crowded into tech stocks like Polaroid, Kodak and IBM. The same thing happened with Microsoft, Intel and Compaq in the early bear market of 1990. The next time we saw the market break in 2000 investors crowded into Cisco Systems, Sun Microsystems and EMC. Similarly, as the market started breaking down in October 2007 we had Apple, Research in Motion, Amazon and Google. They were even called the “four horsemen” and were still holding up months later after the market had already started to weaken. But finally, the knockout blow comes and even those stocks aren’t immune. In fact, they fall harder and faster than the rest of the market because they’ve held up before.

Last year, we’ve seen that very same pattern with the so called FANG stocks Facebock, Amazon, Netflix and Google. Some of those shares are now under heavy pressure. Does that mean we’re already near the knockout round?
Some of those stocks like Amazon and Netflix more than doubled last year in an overall market that was down. What’s interesting now is that some of these FANG stocks like Amazon and Netflix are even leading the market down. Also, biotech stocks are getting killed. These equities were all ridiculously overpriced and now the confidence is being lost. It’s hard to know when exactly the knockout blow comes. But we’re certainly well into the bear market when such stocks start to break down like this.

How can you be sure about that? Maybe this is just another temporary setback like the one at the end of August.
There are always rallies in bear markets. For instance, back in 2008 I counted six rallies over 1000 points in the Dow Jones Industrial. They are typically very sharp. Most of them are short but some can last for a while. We had several rebounds that lasted one month. But I also do know that in the later stages of a bear market these rallies begin to last only a day or two. It gets very violent before the bottom. This bear market will continue which means we’re headed lower with rallies in between until the Federal Reserve is forced to come in and start QE4.

At which point will the Fed step in?
The problem for investors is it won’t happen very soon. In December, the Fed sold everyone that the economy is improving so that they could raise interest rates. But the economy wasn’t strong. In fact, industrial production was in a recession and the ISM manufacturing index dropped to 48, indicating a contraction. Almost every time that happened in the past it lead to a recession in the US. Also, prices for oil, iron ore, copper and basically all commodities collapsed last year and continue to drop this year. And you see the high yield market getting crushed. That only happens in recessions typically. In the past, all of that would have indicated that the Fed would have been cutting rates, not raising them.

So how long can the Fed afford to stay on the sidelines?
The question is how much damage and how much blood is going to be on Wall Street. The problem for the Fed is that it’s going to be difficult to reverse course right away because it just raised rates in December. Not only did the policy makers raise rates, they indicated that they were going to hike rates all over this year and four times more in 2017. So they have to save their face and they’re probably digging in their heels there which means investors are at risk for more losses.

Will markets rally once again when the Fed reopens the spigot?
Ultimately that’s what’s going to happen. But in my opinion the Fed is completely dangerous. It’s the most dangerous entity out there. The policy makers are the ones who are causing much of the problems we have today. We have inflated asset prices and that’s favorable on the upside. But when they come down the pain is twice as hard. And ultimately it affects confidence. It’s not sustainable when you have valuations too high. It creates all sorts of malinvestments in the economy and ultimately all of those become unwound.

That painful process seems to happen in the energy sector. Why are investors so nervous about the drop in oil prices?
In its typical optimism, Wall Street wants to blame all the problems on oil. Wall Street wants you to believe that if oil prices stabilize the stock market will stabilize, too. But oil is not the problem. It’s just a symptom of a severe disease. The real problem is too much debt and too many bad government policies. The oil price has collapsed because the Fed and other central banks around the world pushed interest rates  down to zero. That encouraged new investments in energy production and in other commodity production whether it’s steel, copper or whatever. We’re overproducing everything now as a result of the zero percent interest rates.

How about malinvestments in your field of special expertise, the tech sector?
When you have easy money it encourages technology companies to invest in some of what they call the “growth areas”. Since there isn’t a lot of growth in PCs, smartphones, tablets and other areas they all crowded into the cloud business. I’ve been talking about that for some time. At one point around eighty companies were piling into the cloud space from every area of technology. We had all of the telecom companies like AT&T, Verizon and Centurylink piling in. We had IBM, Hewlett-Packard, Dell, Apple and all of those companies piling in. And then we had the social media companies and Google and Amazon. All those companies were building cloud capacity at the same time.

What are the consequences of that?
Everybody was building too much capacity. What we see now is that cloud demand isn’t growing fast enough and it hits the wall. It was the same thing with the fiber optic and hosting capacity build-up in 2000: You had people’s imagination running wild with easy money and it ended in an enormous amount of capacity. The same problem we have now with cloud capacity. So in the last few months of 2015 and since the start of this year we’ve seen a lot of companies drop out of the race. Hewlett-Packard dropped out and so did Dell. CenturyLink, Verizon and several others are trying to sell their cloud businesses. Also, Apple and Google slashed capex. And I believe Amazon has too much capacity, too. In fact, they had to do over fifty price cuts.

Is this going to be as bad as the burst of the dotcom bubble?
The early 2000s were pretty special. There was a total collapse. All the malinvestments, all the overvaluations were concentrated in the technology world. This time, the problems are much broader: We had too much fracking capacity build-up, too much steelmaking capacity, too much of everything around the world -  including in the technology world where we had this bubble of capacity build-up in cloud computing.

In the commodity sector, the build-up of overcapacities is also related to the fast growing demand out of China. How important is China for the tech sector?
China is very important because it is either the largest or the second largest end market for most technology products. For PCs and smartphones, China is the number one consumer and for autos as well. Now China has a lot of problems. It lifted growth around the world coming out of the last recession and to do so, it piled on debt from $8 trillion to $30 trillion. Now, the only way out seems to be devaluation of its currency which will cause problems for other countries that compete with China. Also, many of the emerging markets are selling to China and they have accumulated an enormous amount of debt, too. Debt was the problem in 2007 and, around the world, all we have done is increase the debt. In the US, the government increased its debt from $8 trillion in 2007 to almost $19 trillion. This is what zero percent interest rates, negative interest rates and money printing do: They encourage even more bad behavior by governments. Instead of getting the correction that needed to occur, we’ve only made it worse.

So what does China’s slowdown mean for the tech sector?
It’s going to have an effect on the technology markets. That’s a problem. And then there are bad news from other parts of the world as well, like Latin America. Brazil is in recession. Also, Japan, despite all of the money printing attempts, is back in recession. Japan is one of the top economies in the world and we’ve seen that PC sales have absolutely collapsed there. Europe is muddling through but that’s only because they have the benefit of a lower Euro right now. The US is a little better but clearly weakening. All that doesn’t make for a good outlook for the technology world and there doesn’t seem to be anything that could turn it around.

What’s the impact on earnings? As of now, most big tech companies have reported their results for the fourth quarter.
I’m not surprised that there have been a lot of warnings from the Apple world. You have to understand, Apple is a giant with $235 bn. in revenue last year and the tentacles are wide. It’s mostly a hardware company and two times the size of Hewlett-Packard, the largest computer company in the world. So when Apple is in trouble, it’s a huge drag on all of the suppliers. I call them the “Apple Dumplings” and there are many of them.

In fact, Apple’s numbers were one of the big disappointments in this earnings season.
The bad news has only just begun. People wanted iPhones with a bigger screen and Apple was very slow to bring those out. But when they did, there was a great hunger in their customer base for the iPhone 6 and the iPhone 6 Plus. At the same time Apple was rolling out those phones, it brought in the last major carrier that hadn’t been carrying iPhones. That was China Mobile with 800 to 900 million subscribers. So that led to the mother of all upgrade cycles and Apple’s numbers were enormously inflated. Now, here we are a year later and Apple is going to have extremely difficult comparisons. The fourth quarter numbers were disappointing, but the first quarter numbers are going to fall apart.

And what about the long term outlook?
Apple hasn’t brought out a really new product in years. They had some failures: Apple TV hasn’t gone anywhere and Apple Pay has been very slow. The Apple Watch has been a huge disappointment. There is tremendous amount of competition and they have overpriced the product. They want to bring out an Apple car in 2019 but there is no chance of that happening. Maybe they can bring it out many years later at best. The company has become primarily a smart phone company and that even more so over the past few years. That’s a problem because the smartphone market has matured. Even in China, the market has grown only 1% last year. And when a market in technology products gets saturated, prices start to drop and margins contract. That’s a permanent slowdown which the analysts haven’t really accounted for yet. The smartphone market becomes essentially another PC market – and that’s not a good thing as we have witnessed over the last ten years or more.

What does that mean for Apple shares. The stock has already lost more than 20% in the past twelve months.
I think Apple will fall, but it has the support of its dividend. So its decline will be limited. It’s the suppliers that are going to get killed. Stocks like Skyworks Solutions, Cirrus Logic, Qorvo, Avago and NXP Semiconductors that  doubled, tripled or quadrupled in the prior year leading up to the introduction of the iPhone 6. Those stocks have all broken down and they will continue to fall since I think that even when the iPhone 7 is introduced, it won’t be a leap in technology. There won’t be the kind of pent up demand like there was for the iPhone 6.

So where do you spot opportunities for investors?
We’re still in a money printing environment. I don’t believe the central banks are willing to let the free market forces correct. The correction will be so painful and it will prove that their Keynesian policies were wrong. As a result, we are going to get more money printing, debasing of currencies and even deeper negative interest rates – and that’s the best environment possible for gold. Also, because the gold price fell so hard in the last few years, we had no malinvestments in the gold mining sector in contrast to the energy space or in the cloud business. In fact, gold supply from mining is expected to fall this year. At the same time the demand in countries like China, Russia and India remains robust. That’s why I expect gold to rally this year and the secular bull market in gold to resume.

Even when stocks are in a bear market?
When the world’s stock markets come down, gold typically goes up. In the US for example, gold took off when the stock market broke in 2000. It went on a 13 year run whereas it was a lost decade for stocks. Same thing in the 1970s: There was a big bull market in gold and it was a very bad period for stocks. Just look at China today. The Shanghai Composite is down almost 50% since June of 2015 and the Chinese real estate market is collapsing. So what are investors going to do? Well, you go into gold in those circumstances. So if the central bankers keep debasing, we will see multi thousand dollar levels for the price of gold.

How are you positioned for this rally?
You have to be patient. But when gold lifts off the mining stocks will be even greater. Right now, gold mining stocks trade at multi decade lows relative to the price of gold. These are levels that even people who have been in the industry for a long time have never seen before. So the mining stocks would have to triple to just attain average levels relative to the price of gold. Therefore, what I have been doing this year and last year is to capture the downside of technology stocks through put options. I have been taking those gains and putting them into the mining stocks. I think that’s going to be the biggest payoff that I have ever seen.

Which are your top picks in the gold mining sector?
My favorite pick has remained the same for a while: Agnico Eagle Mines. They are managed so well and there are no concerns about them going under. Last year was a terrible year for the gold miners in general. Despite that, the stock of Agnico Eagle actually went up a little bit. Another nicely conditioned company is Detour Gold. And then there are the battered ones. Among them, I like New Gold, Goldcorp and Alamos Gold. But obviously, you can’t put all your money into mining stocks and into gold. Therefore, it makes sense to have a good amount of cash at this point to take advantage of the decline that occurs in the stock market. Because if the Federal Reserve launches QE4, that will likely lead to another upleg in stocks, and you want to be able to take advantage of that.

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