Bear Markets Ahead: An Interview With Market Expert Axel Merk

Axel Merk is the President and Chief Investment Officer of Merk Investments and Directing Manager of the Merk Funds.  He is a globally recognized expert pundit on macro trends as well as an innovator in gold and currency investing.  Axel is a sought-after speaker, contributor and author. He holds a B.A. in Economics (magna cum laude) and an M.Sc. in Computer Science from Brown University. Axel Merk is founder and chief strategist of Merk Investments, whose site is located at:  http://www.merkinvestments.com

Gold-Eagle is proud to interview one of the world’s leading economic forecasters and investment advisors, Axel Merk.

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Gold-Eagle:  In 2008 the world experienced the worst economic collapse in 80+ years. This collapse triggered a global stock market crash that erased $30 trillion in wealth…when US stocks plummeted more than 50% in only 16 months.  Since that time the US Fed has pumped up the money supply like a drunken sailor, which fueled irrational exuberance in creating one of the longest periods of rising stock prices in the history of Wall Street.  Moreover, collectively Central Banks have cut interest rates over 600 times and have printed over $15 trillion in new money… money that has failed to generate sustained economic growth…but rather has been successful in propelling stock prices to all-time highs. In light of the above, do you believe we are paving the way for another stock market crash?

Axel:   In 2007, I warned about complacency in the market as a leading indicator for major turmoil; I sold just about all my equity holdings at the time. In a bubble, investors under-appreciate the inherent risks in investments, bidding up risky assets. And why shouldn’t they: rational investors perceive investments as relatively safe, borrowing money to boost returns. And just as rationally, when investors – professionals and retail alike - realize their investments were risky after all, they reduce their leverage. In 2008, there wasn’t sufficient liquid collateral and a major selloff turned into a financial crisis.

Today’s environment isn’t all that different: for years, equities were rallying on the backdrop of low volatility. Investors were ‘buying the dips’ because what could possibly go wrong? As this bull market has lasted for many years, investors afraid of not keeping up, have not rebalanced their portfolios; they are left with an outsized allocation to risky assets. As volatility surges – for whatever reason – I believe investors will realize that they did not sign up for this, heading for the exit. They will be increasingly concerned about capital preservation rather than losing out on rallies.   

A key driver of the complacency that has built up in the markets is the Federal Reserve: excessively accommodative monetary policy lowers “risk premia” – one sees this in low yields for bonds and low volatility in equities, amongst others. As the Fed is trying to extricate itself from its policies, risk premia should rise again.

If my analysis is correct, then the great undwinding started last summer. The surge in volatility in August was the first jolt. Any rally since has been rather meager in a classic sign a serious top has formed. How it will unfold should be interesting, as this bull market had many professionals that were bearish on the markets are loading up on stocks: based on my discussions with some of them, they went against their own principles because they scrambled to retain clients as their defensive strategies were under-performing.

You are asking me whether we will see a crash?  Last summer, I started to short equities. I have since increased my short position. I believe the stock market is ready for a major downturn; we should see much higher volatility, higher than last August. Crash may well be a word that historians will use for the simple reason that Dodd Frank is discouraging banks to speculate; that’s relevant because this has taken liquidity out of the markets. So who is supposed to buy when the selling starts? 

Gold-Eagle:  In light of the US Fed driving up US stocks prices via the levitating action of Quantitative Easing (QE), do you foresee an imminent crash in the DOW and S&P500 Indices during 2016?  And If so, what percent do you expect US equities to crash? 

Axel: Imminent is a strong word. My own process in getting ready started earlier: I first decided to hedge my equity portfolio with put options – I did that for about 18 months. But I wasn’t the only one trying to buy protection: indeed, lots of people wanted to participate in the upside, but buy protection in case things turn sour; as a result, such protection was not cheap. Ultimately, the much simpler – and possibly more “honest” strategy is to pare down risky assets; so I did. As indicated, I have since gone even further, and not only sold my equities, but started to short the markets. (Note that none of this is investment advice, and both options and shorting the markets can be rather risky strategies).

When I look at the markets, I see an overwhelming number of warning signs that a crash may be coming soon. I already mentioned the Fed. Corporations missing revenue estimates is another. Earnings struggling to beat despite bright minds at work conducting financial engineering. Rising rates (the argument that it’s only after a couple of rate hikes that the market is in danger doesn’t convince me as this rate hike has been signaled better and longer than any that I remember). Rising rates, by the way make share buybacks less attractive; they may also be associated with multiple (P/E ratio) compression, i.e. lower prices for the same earnings.

But imminent? I have no crystal ball. But, speaking for myself, I would rather be prepared as if it were imminent.

Gold-Eagle: And in the event of a US market crash, how will this affect stocks in the Euro Union? Indeed, can the Euro Union even survive?

Axel:  Two very different topics. The U.S.  markets still drive the world. As such, when “risk is off” in the U.S., all risk assets around the world tend to suffer. Geographic areas or asset classes with less liquidity tend to suffer more – hence the threat to emerging markets in a major downturn. With regard to the eurozone, we have Mr. Draghi, the head of the European Central Bank (ECB), who continues to print money. I don’t think Mr. Draghi can stem against the tide, but he won’t give up trying. This may well lead to European stocks outperforming U.S. stocks, but I’m not willing to put any money down on that forecast.

The euro is a more interesting story. There is Mr. Draghi who appears hell-bent on sending it down, yet that feisty currency is showing amazing resistance. The euro is showing resistance because it is so very difficult to suppress the currency of a region with a current account surplus. At the same time, Mr. Draghi himself has said that the credit markets are not the main transmission mechanism in the eurozone. Without digressing too much, numerous absurdities result from his policies. One of them is that the euro has tended to rise when markets tank. That’s not supposed to happen, remember: in a flight to quality (away from risky assets), the greenback ought to be the safe haven. Yet, for about 18 months, the euro has benefited quite frequently when markets have sold off. The reason is that when investors feel good, they borrow in euros (they use euros as a “funding currency”) to buy risky assets; when the tide turns and they sell risky assets, they have to buy back euros. If you now add to that ingredient that I’m rather negative about risky assets, I can’t help but be positive about the euro. Added to that, by the way, is that I believe way too hawkish a Fed and dovish an ECB has been priced in to exchange rates. Mr. Draghi was recently held back implementing more extreme policies, a sign that the market doesn’t buy anymore into the story of increasing policy divergence between the U.S. and eurozone (in order to get the euro to sell off).

The question of a breakup is really a completely different one. And, frankly, I don’t lose sleep over it. That’s because when I buy euros, I don’t buy Greek or Spanish debt. If you are asking whether the issues in the eurozone have been resolved, then the answer is no. But neither have they in the U.S. or Japan.

Gold-Eagle:  The NYSE Margin Debt is at an all-time high shouting BEAR MARKET. In fact Margin Debt in real terms is now 20% greater than it was at the peak of the DOTcom bubble!  What may any prudent investor glean from this fact?  See chart.

Axel:  I have little to add to this, other than to point out the obvious: it’s yet another indicator that we may be closer to the top than the bottom.

Gold-Eagle:  And if indeed US stocks commence a new secular Bear Market, where might prudent investors seek safe haven?

Axel:  There is no easy answer, except to say that there may not be a safe haven. I’ve already told you that I’m shorting stocks, but it’s not something I can recommend to others because the risks inherent in  shorting stocks go beyond what most investors are likely to be comfortable with.

So let’s start with the basics: I encourage every investor to stress test their portfolio. At the very least this includes an honest assessment whether one has rebalanced one’s portfolio, i.e. trim the winners.

One of the biggest challenges is where to re-allocate such money to. Just about everything that hasn’t chased the markets has under-performed. And much hyped alternatives have gone sour – just think of those Master Limited Partnerships investing in oil exploration.

Investors may want to look at strategies that – by design – have a low correlation to equities. The classic that comes to mind are long/short strategies, be that in equities, currencies or other segments of the markets. However, many otherwise solid alternative strategies have disappointed. My view is: with any investment product, look at the process more than the performance, as a good process may prove invaluable in the rocky waters ahead.  

The simplest choice may be cash. Dollar cash should come to mind first. And indeed, that may be a good choice for many. However, I can’t warm up to dollar cash too much, as I feel the dollar rally has run its course, and I don’t see the greenback preserving my purchasing power. Hence also my assessment that there’s no “safe” choice, as even cash bears risks. It’s a key reason why I spend so much time on currencies in my research, as I see opportunity in taking on currency risk while trying to mitigate equity, interest rate and credit risk.

In my book, the greenback doesn’t get more attractive with rising rates, either, as long as real interest rates, i.e. rates after inflation, are not moving firmly into positive territory. I just don’t see that happening anytime soon. On that note, I don’t see how we can afford positive real interest rates in the U.S., Eurozone or Japan in a decade from now. Let’s call it what it is: financial repression.

One cannot complete this discussion without saying a few words on gold. Gold has historically had a zero correlation to equities over the long-term; as such, investors may want to consider it for inclusion. The competitor to gold is positive real interest rates. When it comes to bear markets, since the early 1970s, the only equity bear market in which gold declined was the one induced by Volcker’s policies in the early 1980s to drive real interest rates to the stratosphere. As such, anyone who believes real interest rates will be significantly positive in the coming years, may want to stay away from gold. As far as I’m concerned, you may not be surprised to learn based on my comments that I recently bought more gold. But “safe” it is not, either, as our daily expenses are in U.S. dollars and the price of gold fluctuates and can decline, as we have seen in recent years.

Gold-Eagle:  In your opinion what asset classes are grossly over-valued today? And which are historically under-valued?

Axel: In my assessment, just about everything is over-valued these days – that’s a big part of the problem – from bonds to equities. On the cheap side, one should look at anything that has under-performed. 

Take gold miners: they are finally focused on cost. I think many are cheap – but it doesn’t mean they won’t get cheaper. I’ve taken some small positions. I’m talking about majors here; minors are a different beast, notably because many of them are highly dependent on access to credit.

And of course, there will always be opportunities. Markets in distress can bounce back. Safe they are not. One could have made money buying the Russian market at the right time; and the time will come to buy oil once again. Maybe Argentina shows potential with its new government. Rather than committing to a forecast on these, though, I’d rather keep it simple: I short equities and buy gold. Then I spice it up with a long/short currency strategy.

Gold-Eagle:  As you well know the US Greenback has been the world’s reserve currency for many, many decades.  However, China’s rapidly growing influence internationally…vis-à-vis the Sino nation’s covert desire to replace the US Dollar with the Renminbi (yuan) as the world’s Foreign Reserve is gaining momentum.  As a recognized currency expert, do you believe China will be successful in achieving this daunting objective?  And in this case what might be the impact on the US economy...and especially on US stocks?

Axel: The most noteworthy aspect about the Chinese yuan admission as a “reserve currency” may be the amazing pace of reforms undertaken in 2015 to make the admission possible. This includes an opening of their credit markets, and an easing of certain capital controls. They’ve of course tightened others, and only history will show the path they choose.

However, China’s influence in the world will only rise, and with it the relevance of its currency.

With regard to U.S. stocks, it’s been amazing the extent to which U.S. markets have been hostage to economic developments out of China. If (or when) U.S. markets crash, we’ll likely blame China. But after reading this interview, I hope investors will realize that the reasons are found in many places, and China is only a piece of the puzzle.

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Gold-Eagle’s staff and its global readership are very grateful to venerable Axel Merk for taking the time to share his insightful and timely wisdom with us.  Follow him at twitter.com/AxelMerk and sign up for his free newsletter at merkinvestments.com/newsletter. Visit his website at http://www.merkinvestments.com