The bull-market tune has been playing for 12 years now, and when the music finally stops, many investors will find themselves chairless. But Barron’s Hall of Fame advisor Jim Stack knows how to play this game: His 28-year-old investment firm, Stack Financial Management, focuses on avoiding big setbacks. It moved client assets entirely to cash prior to the tech crash of 2000 and was safely positioned before the financial crisis later in the same decade.
Stack, whose 11-person team manages $1.5 billion from Whitefish, Mont., says many investors are dangerously complacent right now. “I’m afraid there is a lot of money in today’s stock market that is not prepared for the potential risk of loss ahead,” he says. Speaking with Barron’s Advisor, Stack explains why he still has a 75% allocation to stocks. And he argues that highflying stocks aren’t the only investments that could plummet in a market crash; Bitcoin, he says, could drop 90%.
Illustration by Kate Copeland
You and your team saw trouble coming in the late 1990s and 2000s and moved client money to safety. When you look at the stock market today, do you see a bubble? That is, and will continue to be, a hotly debated topic, simply because bubbles are only identified with 100% certainty in 20/20 hindsight. But when you live and work near Glacier National Park, one quickly learns that if it looks like a bear and growls like a bear, then you’d better assume it’s a bear. And historically speaking, today’s frothy market has all the characteristics of past market bubbles. It’s not just the overvaluation, but also the psychology. The perceived absence of risk causes speculation to reach extremes that spill over into other asset classes—including cryptocurrencies, NFTs [nonfungible tokens], and even real estate today. This is one of the nuttiest and broadest extremes that I’ve seen in my 48 years of investing experience and over 100 years of research.
What does your allocation look like right now? After the pandemic bottom in March of last year, as the weight of the evidence confirmed a strong new bull market and imminent recovery, we incrementally increased [equity] allocation to a high of 84% earlier this year. Today, we’ve stepped down to 75% and have plans in place to reduce that allocation further, if warning flags continue to increase. I think the past few months have been telling in terms of a shift in psychology and internal market strength.
How overvalued is the stock market right now? In terms of the Buffett Indicator, which is one of our favorite valuation indicators, we’re in the 99th percentile of overvaluation. [Proposed by investor Warren Buffett, this indicator measures stock market capitalization as a percentage of gross domestic product—Ed.] At the same time, it’s important to recognize that values are driven by interest-rate levels. The danger is that today’s stock market is undoubtedly one of the most interest-rate-sensitive markets in Wall Street history. With inflation pressures deeply ingrained in the tight labor market and inflated housing prices, any surprises on the interest-rate front next year are likely to be unpleasant ones.
What could turn this bull market to a bear market? Historically speaking, overvaluation by itself doesn’t cause a bear market. It simply tells you the level of risk when the next bear unfolds. And that means the level of risk in this market has seldom been higher.
To be clear, this is a monetary-driven bubble. That is not just from the Fed’s asset sheet, which has ballooned to over $8 trillion, but also the perceived guarantee that Fed officials will not take away the punch bowl anytime soon. By dropping short-term rates to zero, the Fed has created a TINA environment—”there is no alternative”—that has pushed stock market valuations $14 trillion higher than prepandemic levels. I’m afraid there is a lot of money in today’s stock market that is not prepared for the potential risk of loss ahead.
And I suspect the end will probably be a monetary trigger—just as it was at the end of the tech bubble and most previous bubbles. But until the Fed takes more decisive action to normalize rates, one can only guess where the final peak will be. Any strategy needs to view the year ahead in terms of surprises. And with underlying inflation pressures so entrenched, those Fed surprises are most likely to be bad ones.
Does the Fed’s announcement this week that it will accelerate the tapering of its bond-buying program, and the fact that it has penciled in three rate hikes in 2022 mean it’s now reaching for the punch bowl? The Fed is reacting, but still clearly behind the curve—note the surprise overnight rate hike by the Bank of England. And technically, reducing bond purchases is still adding liquidity. The question is when will investors realize that the Fed is quietly trying to remove the punch bowl without getting blamed for the hangover. And unfortunately, that’s a battle the Fed has almost always lost in the past.
If you’re so nervous, then why are you still 75% invested in stocks? We made a high-cash mistake during the tech bubble of the late ‘90s by being too defensive too early. In the end, our clients didn’t regret that, but we could have taken better advantage of that aging bull market. So this time we have followed a “benefit-of-doubt” approach. That means a defensive strategy in stock selection and sector allocation, with a comfortable cash reserve that allows sleeping at night.
But we do have one foot in the door and are closely watching the tools we’ve developed to help identify when the final top is in place. Those tools include our Gorilla Index of big-cap momentum stocks, our Housing Bellwether Index that proved so valuable at the 2007 market peak, and our Canary-in-the-Coal-Mine Index to monitor speculative stocks. That index, which is already sending a warning signal, is a composite of 20 of the more speculative stocks in today’s market that are driven very often more by hype than fundamentals.
And of that 75% allocation, 12% is in gold stocks, which I think represent a defensive hedge today, and we also have a position in international stocks, which I think are more defensive than the U.S. market today. And there are even more important steps that we’ve taken, both in sector allocation and in what we’ve chosen not to own, that have made our portfolio the equivalent of probably 50% invested or less.
Please explain how 75% exposure to stocks can be the equivalent of 50%. We have significantly reduced exposure to technology and consumer discretionary sectors compared to the S&P, and increased exposure to more defensive sectors, including 12% in healthcare and 8% in staples, plus 9% in energy stocks, which is characteristically a late-stage bull market sector. In addition, we have 7% in an international fund. On recent down days, our accounts have fallen less than one-half the S&P, so we know our exposure is more limited than allocation alone suggests.
What are smart sectors to be in right now? One of the most important things to know today is what not to be invested in. Avoid those areas that might have potential bubble consequences. And as popular as it is investing in the real-estate sector and extrapolating the strength in real-estate into the future, it’s an area in the market that I just don’t want to have our clients positioned.
In addition, we have reduced allocation in big-cap momentum stocks. We’re not completely avoiding those “gorillas”: We have a position in Microsoft that is up tenfold from where we entered it, after the bottom in 2009. But we have reduced allocation in that. And I will continue to reduce allocations in the biggest-cap momentum stocks. Those are selling at valuations somewhere north of 30, and many are quite a bit higher than that.
And of course, stay out of the speculative arena. I think that’s where a lot of the young investors are trading today, in the new areas of IPOs, the hot story stocks. Those are the ones that, as the door closes, there’s going to be little or no opportunity to get out.
Where are you overweight? We are overweight in some of the more classic inflation sectors like energy, materials, and industrials. We also like the stocks that are going to benefit from a potential increase in interest rates. The trick there is buying those that are going to benefit from rising interest rates without having exposure to the real-estate market.
Yes, stocks you’ve said you like in this environment include Chevron , EOG Resources , Bank of New York Mellon , and State Street . What are some key attributes you’re looking for at the company level? When you get down into individual stock selection, ask yourself, what does the balance sheet of this company look like? And what is their pricing ability? In other words, buy the stocks that have a strong balance sheet rather than the strongest earnings projections. And also buy those that, if [inflation does] continue to go up, can pass the prices along to customers without a loss of revenue.
What would cause you to adopt a very defensive positioning? To understand how the upcoming bear market will likely unfold, I think one needs to step back to the inflationary bear markets of the 1960s and ‘70s. In every case, Fed policy was behind the curve, and inflation turned out to be far stickier than forecast. That’s exactly where we are today. This is a monetary showdown that the Fed is going to lose. We’ve already seen two shots across the bow of this bull market, with speculation peaking and downside leadership starting to broaden. If more divergences appear and those warning flags worsen, we will decisively move to a more defensive stance. I’d rather leave money on the table than get caught in what could likely be a very crowded exit.
Can you say more about your inflation outlook? Any surprises are going to be with higher rather than lower inflation. We’ve been saying for over eight months that this time, inflation is going to be stickier and more persistent than the Federal Reserve thinks.
I think the evidence today supports that, particularly along two lines. One is wage inflation: Whether you’re looking at the NFIB Small Business Survey, or the Employment Cost Index or the job quits, which have hit a recent high, they all point to upward pressure on wages. And that’s going to pressure profit margins. Nothing is stickier on the inflation front than wage inflation, because then it becomes a wage-price feedback phenomenon. And that usually requires a recession to cure.
The second contributing factor, one that the Federal Reserve has not paid enough attention to, is the feedback from the run-up in housing prices that’s been fueled by excess liquidity and record-low mortgage rates. The run-up from prepandemic levels—not the lows, but from the prepandemic levels in the first quarter of last year—has been 26.5%. That’s almost five years’ worth of home-price increases.
Home prices are not factored into the consumer-price index or the PCE [personal consumption expenditure index], the Fed’s favorite model. But what is factored in are two components: owners equivalent rent, and the rent of primary residence. Together those two components make up over 31% of the CPI. So the significant rise in housing is going to be pushing two major components of inflation up.
You’re not afraid to retreat completely into cash, correct? Our move to defensiveness is generally very methodical and gradual. The tech bubble of the late ‘90s was one of only two times we moved to a 100% cash position. The other was in 1987, prior to Black Monday. [At the time, Stack ran his research and newsletter business, InvesTech Research, but Stack Financial Management did not yet exist–Ed.] In the 2007 to 2009 bear market we never went under a 45% equivalent investment position.
Assuming we’re in a bubble, how bad could things get if it pops? It’s important to understand the misconceptions about bubbles. We recognized that Wall Street was in a bubble in the last 18 months of the 1990s. In those 18 months we waived all management fees for our managed account clients, because we basically told them, “We don’t know how to play in this, but we know it’s going to end badly.” In reality, it unfolded in a two-and-a-half-year bear market. As long as you weren’t invested in the heart of the internet stocks, the speculative stocks, you had time to batten down the hatches and evolve a strategic defensive strategy.
So one of the misconceptions is that if the market’s in a bubble, it has to pop. Historically, bubbles don’t pop. There is often an initial knee-jerk selloff or sharp decline in the stocks or sectors that are leading the bubble. But bubbles unwind, often over a protracted bear market. In the tech bubble we definitely saw a crash in internet stocks. And the Nasdaq index lost half of its value in barely nine months. What investors don’t remember is that the S&P was only down 14% at year-end 2000. In other words, two-thirds of the bear market was yet to come.
What do you make of the explosion in popularity of cryptocurrencies? A lot of it is a result of sloshing liquidity. By taking interest rates to zero, the Fed changed the market dynamics from FOMO, fear of missing out, to TINA, there is no alternative. No one wants to sit in cash or savings or CDs. So liquidity is pushing into areas like the cryptocurrencies and the NFTs.
What would happen to cryptocurrencies in a market crash? When we talk about cryptocurrencies, there is going to be a very dynamic and widespread washout. Does that mean Bitcoin is going to disappear? No. Does that mean it could drop 90% in value? Absolutely. And that’s not a forecast, it’s just a potential risk.