«The only question is when the bomb is going off»

Fred Hickey, editor of the influential investment newsletter «The High-Tech Strategist», warns of trouble ahead for the stock market and spots bright opportunities in the gold sector.

Wall Street is in a champagne mood. Last week, thanks to a rally in Apple (AAPL 190.4 -0.55%), the Dow Jones (Dow Jones 25199.29 0.32%) surpassed 22,000 for the first time ever. Nevertheless, Fred Hickey doesn’t share the bubbly vein. The renowned contrarian cautions investors of an unpleasant surprise because central banks like the Federal Reserve are pulling back from their super easy monetary policy. “We could experience a severe market decline or even a crash”, says the outspoken editor of the widely read investment newsletter “The High-Tech Strategist”. A proven expert on the tech sector, Mr. Hickey makes out similarities to the excesses during the dotcom bubble and warns that dizzy valuations in large cap tech stocks and the boom in the ETF space are stirring up an  explosive cocktail. He finds shelter in gold and gold mining stocks, which he thinks will have a bright future.

Mr. Hickey, the Dow Jones is hitting one record after another. What’s going to happen next?
We are in a giant bubble. It’s already the third bubble in the last two decades. First we had the tech bubble in the late nineties, then we had the housing bubble that lead to the global financial crisis of 2007/08 and now we’re in bubble number three. All of them are of the same cause: central banks. Since the beginning of this bubble, we have seen a total of $12 trillion of money printing and in the first five months of this year central banks were printing at record rate of $3 trillion per year, up from around $2 trillion a year. So even though the Federal Reserve stopped printing, the other central banks continued. That’s the reason why we have all this insanity in the financial markets.

Now, the Fed aims to make another big step in normalizing monetary policy and start shrinking its bloated balance sheet. How is this going to work out?
The central bankers claim that they will be able to pull back and normalize interest rates without causing any difficulties. It will be like watching paint dry, Fed chief Janet Yellen says. However, the big problem is that it was their money printing that started this bull market off. It was the Fed’s money printing in 2008 that kicked off what resulted in almost a quadrupling of the US stock market. So how do you think you are going to get ever out of that? How can central banks pull back and it’s not going to have an impact when it’s their money printing that is responsible for this rally in the stock market? It’s a pipe dream. But they are going to try. They have to make an attempt to normalize monetary policy and that will likely lead to some sort of severe market dislocations. So as we head into the famous September and October period, we will likely get some kind of problem.

What kind of stocks are going to be most vulnerable? For instance, tech stocks have been on an astonishing run this year which brings back memories of the dotcom craze.
There are similarities and dissimilarities. The bubble at the end of the nineties primarily focused on tech, media and telecom stocks. Aside from that, all the value stocks were neglected. So there were still places where you could invest. You could also go into treasury bonds because they were paying a decent yield back then. Today’s madness is much broader. We have bubbles everywhere: in high yield bonds, in real estate all over the world, from China to Australia to Canada, as well as in stock market valuations that are insane. Almost all asset prices are up and it isn’t justified since we are witnessing the worst economic recovery since the Great Depression. Also (ALSN 113.2 1.25%), the amount of debt is different. The financial crisis was all about debt and when you have a crisis like that what you generally do is you reduce debt. But the central banks came in and the policy to solve the problem was 50% more debt. That’s not going to work.

And what’s similar to the dotcom bubble?
What’s similar is the insane valuation of some stocks in the tech world. Just look at the so-called group of FANG stocks: Facebook (FB 209.36 -0.3%), Amazon (AMZN 1842.92 -0.05%), Netflix (NFLX 375.13 -1.15%) and Google (GOOGL 1212.91 -0.01%). The cheapest of those stocks is Google with a P/E ratio of more than 30. But Google isn’t growing anywhere near that rate. Then you look at Amazon which trades at 200 times earnings. In the case of Netflix the valuation is even higher albeit the company actually burns an enormous amount of cash. So you have the same kinds of crazy valuations today that you had in the late nineties.

What’s more, big tech caps like Apple, Google and Facebook are carrying the whole stock market. How healthy is that?
This tells me it’s a very narrow market. When everyone is piling into a small number of stocks and the breadth of the market starts to the deteriorate like this it’s oftentimes a red flag before the market declines. We’ve seen that before. The other thing that’s causing this great concentration into the largest tech stocks is the ETF phenomenon.

What do you mean by that?
Many investors got burned badly during the turmoil in 2000 and then again in 2007/08. Because of that, they gave up on active money managers and went into ETFs. That’s why you have this huge stream of money out of active managers into passive investments and into ETFs. But the problem is that all the ETFs are investing in the same stocks. So the more money that goes into ETFs the more money goes into stocks like Apple, Amazon and Facebook. That lifts these stocks further up and they attract even more ETF money. That’s the cause for this pyramid effect which is very dangerous.

Why is this so dangerous?
Despite all the money printing, central banks haven’t outlawed the business cycle and they haven’t outlawed recessions. The bull market and the economic expansion in the US are already very old. So what’s going to happen when the selling occurs? One problem is that ETFs don’t hold any cash and when the market starts to fall, we are going to see huge outflows. There is no cash cushion because there will be no buying from ETFs. So everything is set up for a reversal: You have tremendous over valuations in these stocks and the looming possibility that all of a sudden the floor is falling out from under the market. At the same time you have the Fed and other central banks trying to “normalize” monetary policy by either raising interest rates or by pulling back on their balance sheet. So it’s basically tick, tick, tick and the only question is when the bomb is going off.

What’s going to happen when the big bang comes?
History shows that all these tech stocks will lose a lot. Microsoft (MSFT 105.12 -0.78%) and Google are probably the ones which would hold up best but the most vulnerable ones are those which have to highest valuations. For instance, as great as a company Amazon is, it got clobbered in 2008. The stock lost 65% of its value in just three to four months. That could happen again and Amazon would still be trading at a P/E ratio of almost 70 and therefore would still be tremendously overpriced. A stock like Tesla could even lose 95% or 100% as it happened to those kinds of companies in 2000/02 that don’t make any money – and I don’t know about Apple.

Apple’s stock just got another boost after the company quelled some concerns about potential delays regarding the launch of its 10th-anniversary iPhone.
Some people – I call them Appleholics – will buy anything new from Apple. If Apple brought out a dishwasher they would buy it. So if Apple brings out another iPhone they are going to buy it no matter what, even if it has no new features. That will give the company a bump in sales at the end of this year and into next year. But then what happens next?

So far, investors seem quite optimistic.
The vast majority of Apple’s profits comes from one product and that’s the iPhone. But in most parts of the world, the market for smartphones is saturated now. So the problem with Apple is what do they do for an encore after the iPhone upgrade cycle peaks early next year? It’s hard to justify the more than $800 billion market cap that Apple’s stock currently carries when the only new thing that Apple has built in the past five and a half years since Steve Job’s death is its swanky $5 billion new headquarters. So because of the new iPhone generation you are going to get an upgrade cycle that will last a few quarters. But then it’s over and if that’s the case the market will anticipate it and investors will be exiting stage left since it will be clear to everyone that there isn’t anything else there.

Are there any safe spots in the tech sector at all?
Semiconductor equipment makers. They are benefiting from an increase in general spending among their traditional customers. Additionally, there is a huge push by China to establish its own domestic semiconductor industry. That’s very bad news for the western semiconductor manufacturers, especially for memory chips makers like Western Digital (WDC 78.78 -0.27%) and Micron (MU 57.45 0.86%) Technology because you have this huge Chinese players which are backed by the government. It will be worse than when Japan and Taiwan came into the market. But the point is that there is a lot of business coming to the way of semiconductor equipment manufacturers over the next years. Some of the best companies in that business are Applied Materials and ASM International. But then again, you want to be cautious. It’s a dangerous moment in the stock market right now and nothing goes up when things go down.

In the investment community, you are well known as a contrarian. How do you position yourself in this raging bull market?
Actually, it’s a lot easier than you might think. That’s because I have an been in a bull market since 2002 and that’s gold. I was lucky enough to have missed the twenty year bear market in gold before that since I had no interest in metals at that time. My interest was in technology as it should have been. But then I was forced into the gold world because the central banks and particularly the Federal Reserve started their radical experiments, first with very low interest rates and then with large scale money printing. So I realized that should be good for gold and there should be a long secular bull market in gold – and it has. That’s why it’s easy.

Then again, since the peak of 2011, gold has lost a little bit of its shine.
You have to understand that since the beginning of the bull market in 2002, gold has grown at 10% on average per year. That is better than the S&P 500 (SP500 2815.62 0.22%). Of course, we had a peak in 2011 and then we had a cyclical bear market within what I consider to be a secular bull market in gold. Was it easy to endure that? No, but it allowed me to buy things at very low prices. And just as the last secular bear market in gold lasted for 20 years this secular bull market is going to be just as long. Also, looking at all the historical work, I found out that there is sort of a Yin and Yang relationship between technology stocks and gold. When gold goes down tech stocks go up and vice versa. So If you think the stock market is a very dangerous place to be right now, a very good place to be is in  gold. And that’s where I am today.

So how exactly are you positioned?
The gold price is close to breaking a long-term downtrend. But despite that, there is no interest in gold right now. For instance, at the US mint they’re shipping gold coins at the lowest rate in 10 years. So just as this is an extraordinarily dangerous moment in the tech world and in the overall stock market it is just as an extraordinary moment being long gold and especially the gold mining stocks.

Which miners do you favor?
What I think it’s going to happen is that gold is going to go up several thousands of dollars. So even if it’s not wanted today it will be when the secular bull market picks up again. In a gold bull market almost all the gold stocks will rise. However, there are higher-quality names and others. With respect to that it’s very important where a company’s mines are located. Many parts of Africa and South America are politically unstable and governments can be possessive towards mining companies. South Africa is a current example and Tanzania another one. What’s more, the Fed’s and other central bank’s money printing have encouraged many of these emerging markets countries to take on enormous amounts of debt and I’m sure they are going to grab whatever assets they can get. That’s why you don’t want to be in those locations.

What are better quality names then?
If you’re in Canada, Australia, Finland, Mexico or in the US you are in places where there is law and order and respect for property rights. So in contrast to the big herd in the stock market I don’t own the bubble FANG tech stocks. But I’m involved in a group of alternative FANG stocks, the gold FANGs: Franco Nevada, Agnico-Eagle Mines, New Gold (Gold 1227.51 0.05%) and Goldcorp (GG 13.38 0.98%). That’s a list off FANG stocks that is a little bit different than the FANG stocks everybody is talking about.

What makes these mining stocks so attractive?
During the secular bear market in gold which ended in 2002 prices had been suppressed for so long that company managements had to get lean and mean. They had to reduce their expenses to survive. So when the secular bull market started, their earnings went up dramatically higher than the price of gold and those mining stocks had a 1600% run. Today, conditions for these companies are similar as in 2002. During the last few years, we have been going through this cyclical gold bear and the mining companies have been under tremendous pressure once again. Now, there is a tremendous amount of leverage on their bottom line when gold kicks in into higher gear again. I think it will be soon and the fact that these stocks are so hated, underowned and underpriced makes me even more excited about the moment we are in right now.