The stock market’s unrelenting rally this year has claimed its share of celebrity bears, the best known being JPMorgan Chase & Co. market strategist Marko Kolanovic.

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Market expert who called the dot-com bubble says this time it's different Back to video

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It’s a story practically as old as Wall Street itself. Just ask Charles Clough, Merrill Lynch & Co.’s chief global investment strategist from 1987 to 1999, who stayed bearish through the dot-com boom of the late 1990s, but was only vindicated after ultimately leaving the firm.

Looking at today’s market, Clough said it’s nothing like 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 swelling share prices. The economy is doing well. Inflation and interest rates are poised to come down. And in his eyes, equities have plenty of room to move higher.

“The differences are far more important than the similarities” when comparing the current stock market to the dot-com bubble, he said. “The cash generation and the scale of these companies suggest that they’ll be around for a long time and continue to be very profitable.”

Clough’s hedge fund celebrates its 25-year anniversary this year. Prior to joining Merrill, where he became one of Wall Street’s most revered forecasters, he spent time at Cowen & Co., Boston Co. Inc., Colonial Management Associates Inc., Donaldson, Lufkin & Jenrette Inc. and Alliance Capital Management LLC. He also is an ordained permanent deacon in the Roman Catholic Archdiocese of Boston and serves in that capacity at his local parish in Massachusetts.

Here is an interview with Clough that has been edited for length and clarity.

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

Clough: We have a very positive view. The most important thing that’s going on in the economy is inflation is coming back down. It got its start back in 2020 and 2021, largely because there was a series of enormous simulative packages. At the same time, there were supply restrictions because of COVID-19. We’re really in the reverse of that dynamic.

One of the things that makes us fairly confident that demand will be sluggish enough to help inflation come down is defaults on credit cards. Credit card usage really boomed in this expansion as fees went from 12 per cent to above 20 per cent, so that can’t be sustainable. We’re even seeing defaults on auto loans. Meanwhile, the Fed is watching immigration add to the labour supply and more companies using short-term labour. So, if you put demand and supply together, inflation continues to go down. If that’s the case, interest rates, especially on the short end, will come down too. This is all bullish for equities.

Our thinking is if you look out beyond the volatility that is happening right now, the right strategy is to stay invested, particularly in equities. And with the amount of money sitting at the short end of the yield curve today, there’s plenty of fuel for equities looking forward.

Q: With Big Tech stocks dominating the market’s returns, there have been many comparisons to the dot-com bubble. Do you see similarities to that time?

Clough: It hasn’t gotten to the point where it remotely looks the way it did in the middle of the dot-com boom. The thing about that time is it really was a result of aggressive Fed liquidity flowing into the market. It started in 1998 with the Asian crisis, and the Fed’s response was to panic.

A tremendous amount of money came in just as the Internet was getting going. That money fuelled what we think of today as a dot-com boom. But these companies were unprofitable. There were silly companies like Pets.com with the sock puppet, but none had business plans that made any sense. There was no road to profitability. The companies were huge cash users, and they were not able to generate cash flow.

Today’s Big Tech companies are generating massive amounts of cash flows. Also, there were hundreds of silly IPOs. That really has not happened in this expansion.

Q: Earnings growth is finally expanding beyond the Magnificent Seven and the Fed has started its cutting cycle. Will other groups take over stock market leadership?

Clough: The large-cap tech companies are in a world of their own. But that doesn’t mean as interest rates come down, there can’t be other areas of opportunity. You can see what’s going on in the aerospace and defence sector. It’s been a very quiet sector for the last 30 years, ever since the collapse of the Soviet Union, and now there’s an awful lot of technology and demand to catch up. We look at the housing shortage. Builders have held up very well, and we think durables related to the housing cycle will continue to do well.

Q: During the end of your tenure at Merrill, you were bearish at a time when Wall Street was extremely optimistic. What’s it like to go against the grain?

Clough: That’s just part of the job. There was no reason to get upset about it because the market can do anything it wants. We knew we were right, and we were able to keep analyzing the situation. People were interested in what we had to say. And I think it worked out very well. I remember I watched Cisco Systems pretty carefully, because at the time it was probably the largest investment firm for the dot-com boom with all of the telecommunications infrastructure had to be built. When I first started going negative, the stock went up six times before it declined 95 per cent from its high of US$82 in March 2000 to less than US$10 in late 2003.

Q: What worries your clients now?

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

Q: What’s the best investment call of your career?

Clough: The best call I ever made was that interest rates were going to come down, and that call still stands. We have not seen the low in interest rates — the decline that began in the early 1980s. The secular decline in interest rates is not over. It lasted all through the ’90s and through the early 2000s. It was interrupted by the reactive government response to the COVID-19 excess of money expansion that happened in 2021. But that’s unwinding now.

You have to ask yourself: Interest rates went down for 40 years before COVID-19 interrupted everything. What were the reasons and have those reasons changed? The interest rate cycle that began in 1981 has to do with global demographics. It has to do with the fact that there’s so much balance sheet debt in private sectors throughout 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 in creating conviction in our views. I would say that’s the most useful call because it’s still out there and people are underestimating how far interest rates can ultimately fall.

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

Clough: No, I think it is a silly practice. If people could do that, they’d be calling their broker from their yacht. Understanding the dynamics behind the economy and the impact on the capital markets is much more important than picking a target.

Q: What’s in your portfolio?

Clough: We own Microsoft Corp., Alphabet Inc. and Amazon.com Inc. We are invested in some of the major U.S. defence companies, Raytheon Co. and General Dynamics Corp. in particular, because there’s a clear profit cycle. We are invested in the home builders, DR Horton Inc. and Lennar Corp. There are some ideas where we think there are cycles somewhat independent of the economy. There’s an liquefied natural gas cycle, and we’re looking for companies that will exploit that.

Q: Are there risks investors are underestimating right now that keep you up at night?

Clough: Whatever is out there, you’ll be fine. We are confident in our strategies. Know what you don’t know and work very hard to understand what that is, but don’t lay at night worrying about things. As long as you’ve done the work and understand the dynamics of the market, the only thing you might be wrong on is timing, and that’s not a problem.

The biggest issue for the capital markets would be if the Fed continued to raise short-term interest rates and shrink the size of its balance sheet. I think erratic central bank policy would be the one thing that would get you awake at night.

Q: There is debate right now around how much the Fed will cut interest rates in the coming months. How important is the magnitude of cuts?

Clough: The direction is more important than the magnitude. If you look at the interest rate any major money centre bank is offering on regular demand deposits right now, it’s about 10 basis points. Some are lower. If you’re a very good client, they’ll up it. But the only reason they can up it and get a spread is because they can repo a deposit with the Fed and get Fed funds. That goes away next year. So the bank is telling you what the real price of money is, what they’re ready to go out and bid for a deposit.

Within a year to 18 months, I think people will be surprised, maybe even astounded, at how fast short-term interest rates have come down. Because there’s no demand for deposits. The market has a sense that the demand for money is low. Interest rates are coming down, and I think people would be surprised at the speed with which that happens.

Q: You’ve had a long and prolific career in the financial industry. What continues to motivate you?

Clough: It’s fun. It’s important to stay alive. It’s important to keep objectives 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 issues to talk about.

Bloomberg.com