Former Merrill market expert says this is different than in 1999

(Bloomberg) — The ongoing stock market rally this year has also claimed some famous bears, the most notable of which is JPMorgan Chase & Co. market strategist Marko Kolanovic.

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It’s a tale practically as old as Wall Street itself. Just ask Charles Clough, Merrill Lynch & Co.’s chief global investment strategist from 1987 to 1999, who remained pessimistic during the dot-com boom of the late 1990s but was only exonerated after he eventually left the firm.

Looking at the market today, Clough says it’s a far cry from that era. Now 82 and still running his eponymous hedge fund, Clough Capital Partners LP, he sees companies generating the cash flow to justify their rising stock prices. The economy is doing well. Inflation and interest rates are about to fall. And in his eyes, stocks still have plenty of room to rise.

When you compare today’s stock market to the dot-com bubble, “the differences are much more important than the similarities,” he said in an interview. “The cash generation and the size of these companies suggest that they’re going to be around for a long time and remain very profitable.”

Clough’s hedge fund is celebrating its 25th anniversary this year. Before joining Merrill, where he became one of Wall Street’s most respected forecasters, he worked at Cowen & Co., the Boston Company, Colonial Management Associates, Donaldson, Lufkin & Jenrette and Alliance Capital Management Co. He is also an ordained permanent deacon in the Roman Catholic Archdiocese of Boston and serves in that capacity at his local parish in Massachusetts.

READ: Kolanovic’s departure has caused echoes on Wall Street since 1999

The conversation has been shortened and clarified.

Despite some recent turbulence, the U.S. stock market has had an incredible run since last year. Does it have staying power?

We have a very positive picture. The most important thing that’s happening in the economy is that inflation is coming down again. It started in 2020 and 2021, largely because there was a series of huge simulation packages. At the same time, there were supply constraints because of Covid. We’re actually in the opposite of that dynamic. One of the things that makes us pretty confident that demand is going to be slow enough to help inflation come down is credit card delinquencies. Credit card usage has really skyrocketed in this expansion as the cost went from 12% to over 20%, so that can’t be sustained. We’re even seeing auto loan delinquencies. Meanwhile, the Fed is seeing immigration adding to the labor supply and more businesses using short-term labor. So if you add supply and demand together, inflation is going to continue to come down. If that’s the case, interest rates, especially on the short side, are going to come down as well. This is all positive for equities. We think that if you look beyond the volatility that is there now, the right strategy is to stay invested, particularly in equities. And with the amount of money that is now at the short end of the yield curve, there is plenty of fuel for equities going forward.

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With Big Tech stocks dominating market returns, there are many comparisons to the dotcom bubble. Do you see any parallels with that era?

It’s not at the point where it looks anywhere near what it did in the middle of the dotcom boom. The thing about that time is that it was really a result of aggressive Fed liquidity pouring into the market. It started in 1998 with the Asian crisis and the Fed’s response was panic. There was a huge amount of money pouring in just as the internet was taking off. That money fueled what we call today a dotcom boom. But these companies were losing money. There were dumb companies like Pets.com with the sock puppet, but none of them had business plans that made any sense. There was no path to profitability. They were huge consumers of cash and they were unable to generate cash flow. The Big Tech companies of today are generating huge amounts of cash flow. There were also hundreds of dumb IPOs. That really didn’t happen in this expansion.

Earnings growth is finally spreading beyond the Magnificent Seven and the Fed has begun its cycle of cuts. Will other groups take over the leadership of the stock market?

The big tech companies are in a world of their own. But that doesn’t mean there aren’t other opportunities when interest rates come down. You can see what’s happening in the aerospace and defense sector. It’s been a very quiet sector for the last 30 years, since the fall of the Soviet Union, and now there’s a lot of technology and demand to catch up. We look at the housing shortage. Builders have held up very well, and we think durable goods that are tied to the housing cycle will continue to do well.

How has it been since you quit your job at Merrill and started your own store?

We’re at 25 years of life, which is a long time for a small boutique. In our portfolio mix, we have both partnerships and closed-end funds. I think the popular term is a hedge fund. We have two: one in the medical space and the other, a broadly based long-short hedge fund. We think thematically about where the earnings cycles are going to happen and then invest heavily in those sectors. The closed-end funds have been around for almost 20 years and that’s been a pretty good balance of things. The hedge fund industry has been in a downturn for the last few years, although it’s a very efficient way to protect money, so I think it will come back. In the meantime, it’s been good to have both businesses. We acquired two exchange-traded funds a year ago, and they’ve done very well. Right now, it looks like the business is sustainable.

Towards the end of your tenure at Merrill, you were pessimistic at a time when Wall Street was extremely optimistic. What is it like to go against the grain?

That’s just part of the job. There was no reason to get upset because the market can do whatever it wants. We knew we were right and we could continue to analyze the situation. People were interested in what we had to say. And I think it worked out very well. I remember watching Cisco Systems pretty closely because at the time it was probably the biggest investment company for the dotcom boom with all the telecommunications infrastructure that had to be built. When I first started going negative, the stock went up six times before it fell 95% from its high of $82 in March 2000 to less than $10 by the end of 2003.

What are your customers concerned about right now?

What’s the Fed going to do? What’s the election going to do? How’s China going to work? There’s always something on the horizon. The most important thing is to have a basis for making investment decisions. What we’ve tried to perfect over the years is understanding the credit cycle. How money and credit move through the economy is ultimately the deciding factor. What the Fed does and what liquidity looks like is far more important than elections, international affairs, and most of the things people worry about.

What was the best investment conversation of your career?

The best prediction I ever made was that interest rates were going to come down, and that prediction still stands. We haven’t seen the low interest rates – the decline that started in the early 80s. The secular decline in interest rates is not over. It lasted through the 90s and early 2000s. It was interrupted by the government’s reactionary response to the Covid excess money expansion that happened in 2021. But that’s now starting to unwind. You have to ask yourself: interest rates were coming down for 40 years before Covid interrupted everything. What were the reasons and have those reasons changed? The interest rate cycle that started in 1981 has to do with global demographics. It has to do with the fact that there is so much balance sheet debt in private sectors in the developed world. And of course technology is a major factor in the decline in inflation. That’s why the analysis we do of credit cycles is so important to create conviction in our positions. I think that’s the most useful prediction because it still exists and people underestimate how far interest rates can ultimately fall.

Do you think Wall Street’s practice of setting S&P 500 year-end targets is helpful to clients?

No, I think it’s a stupid habit. If people could do that, they would call their broker from their yacht. Understanding the dynamics behind the economy and the impact on the capital markets is much more important than choosing a target.

What’s in your portfolio?

We own Microsoft Corp., Alphabet Inc. and Amazon Inc. We invest in some of the big U.S. defense companies, Raytheon Co. and General Dynamics Corp. in particular, because there is a clear profit cycle. We invest in the homebuilders, DR Horton Inc. and Lennar Corp. There are a number of ideas where we think there are cycles that are somewhat independent of the economy. There is a liquefied natural gas cycle and we are looking for companies that will take advantage of that.

Are there risks that investors are currently underestimating and that keep you awake at night?

Whatever it is, it will be fine. We have confidence in our strategies. Know what you don’t know and work very hard to understand what it is, but don’t lie awake at night worrying about things. As long as you’ve done the work and understand the dynamics of the market, the only thing you could possibly get wrong is timing, and that’s not a problem. The biggest problem for capital markets would be if the Fed kept raising short-term rates and kept shrinking the size of the balance sheet. I think the only thing that would keep you up at night would be erratic central bank policy.

There is currently debate about how much the Fed will cut interest rates in the coming months. How important is the size of the cuts?

Direction is more important than magnitude. If you look at the interest rate that a large money center bank is offering on regular deposits right now, it’s about 10 basis points. Some are lower. If you’re a really good customer, they’ll raise it. But the only reason they can raise it and get a spread is because they can buy back a deposit from the Fed and get Fed funds. That’s going to go away next year. So the bank is telling you what the real price of money is, what they’re willing to offer for a deposit. I think people are going to be surprised, maybe even amazed, in a year to 18 months’ time at how quickly short-term rates have come down. Because there’s no demand for deposits. The market feels that the demand for money is low. Rates are coming down and I think people are going to be surprised at how quickly that’s happening.

You’ve had a long and productive career in the financial sector. What still motivates you?

It’s fun. It’s important to stay alive. It’s important to have goals in your life. And I can’t imagine doing anything else. I just don’t know what I would do with myself if I didn’t have financial problems to talk about.

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