How to introduce Barton Biggs? Why bother, especially to an audience of institutional investors? Traxis Partners, the $2 billion global asset allocation investment group the erstwhile dean of Wall Street market strategists runs with two former Morgan Stanley colleagues, Cyril Moulle-Berteaux and Madhav Dhar, celebrated its first birthday on June 1, having produced a 21.6% gain in its first stub calendar year of operations. This year, they’ve been “struggling mightily,” says Barton, as have most investors, to stay basically flat, but he still evinces confidence that Traxis’s yearend results will be reported with a plus sign. Indeed, Barton seems to relish the challenge. Still, Barton’s return to hedge fund land has left no small coterie of investment managers sorely bereft. Market-watching just isn’t the same without regular exposure to his highly literate musings on investment Sturm und Drang—or, at the moment, lack thereof. What better reason to give Barton a call?
KMW
Barton, you sounded pretty disgusted about something when you picked up the phone the other day. Hope it wasn’t my call.
No. It’s just that, obviously, the market isn’t as much fun this year as it was last. At least, not from the perspective of running a hedge fund. It seemed a lot easier to identify anomalies and to put on successful alpha-creating trades than it is this year.

Of course, you’re not exactly a typical hedge fund neophyte, considering that your first go-round in the hedge fund business garnered a mention in Jerry Goodman’s [A.K.A. “Adam Smith’s”] classic, The Money Game. Then again, the market itself is a lot different.
Yes, it seems like the first go-round was back in the Stone Age. But don’t forget that what my partners and I—what our team was doing at Morgan Stanley—is the same thing we are doing now. We weren’t running a hedge fund, but we were running asset allocation accounts in which the overweight/underweight decisions about asset classes, countries and sectors involved the same things that we are doing now. So there is not really a big change there. What’s different, of course, is the investment environment.

Which is what’s been making it challenging.
Definitely.

You wouldn’t have it any other way, would you? After all, you could easily hit the beach if you so chose.
Yes. I mean, I must be “mentally challenged” or something, but this are the best games I have ever discovered. The beach holds no attraction for me and my dermatologist. I am definitely not interested in golf and I have climbed all the easy mountains in the world. And, if I try to climb any of the hard ones, I am likely to injure myself—which is no fun, either. So investing is the best game. A great game. The only game where age doesn’t really hurt you.

Maybe not age, in and of itself. But I heard a lot of grumbling during the bubble years about experience being a real handicap.
I’m not sure that’s true anymore. But that’s the same old “Adam Smith” story, you know.

“Get yourself a kid.”
Even more recently the slogan was, “Get yourself an old man.”  But in this environment, I don’t know what the slogan du jour should be.

Frustration seems to be the rule, even—or maybe even especially—among hedgies. How ironic is it that you wrote that very widely distributed piece a year or so ago predicting a bursting of the hedge fund bubble—and now your fund and most of the rest are becalmed, instead?
I continue to be haunted by that particular piece, which I wrote about hedge funds and hedge fund bubbles. In it, I made reference to what I still believe: The hedge fund industry is prone to bubbles in its various sectors. Whether it is global macro or convertible arbitrage or whatever, if a sector is hot at the moment, a bubble is quickly created in that sector. But virtually by definition, when a sector gets hot, it is because there are not a lot of people working it and there is a comparatively substantial amount of potential return, or alpha, in it, so the few practitioners generate very high returns. The problem is that those high returns to the few almost immediately attract a big inflow of money into the sector, and the big inflow of money acts as a magnet, pulling a whole new group of practitioners into the sector. The result is that instead of there being six or seven beautiful horses drinking huge gulps of alpha out of that sector’s alpha pool, there are now 30 or 40 big, greedy horses drinking of that same sector’s same alpha pool. By definition, the returns have got to go down. That is what I meant by the hedge fund bubble. I continue to believe that the basic format of the hedge fund industry is the investment management format of the future. We are witnessing a major evolutionary change in the investment management industry.

What makes you say that? Hedge funds do throw off many of the silly style strictures the consultants have saddled more traditional investment managers with. But they’re scarcely perfect constructs.
It is a long, complicated story, but the bull market that lasted basically 20 years created immense changes in the investment industry. It generated generated excessively high fees—because the returns were high, people could charge high fees. Meanwhile, the lucrative levels of profits in the investment management industry generated huge infrastructures in the big investment management firms. Now we are evolving, entering into a period where the returns are going to be probably half or two-thirds, at best, of what they were in the golden era. But the infrastructure is still there—and meanwhile the mutual fund scandals have required whole new layers of overhead to be added. So the big investment management companies have a serious cost problem.

And there’s no such thing as job security in Wall Street.
Obviously, they are not dinosaurs but they are going to tend to migrate more towards index or index-plus type products. It’s inevitable, I think, that the talent in the business migrates into the hedge fund industry, because of its higher potential profitability and because it offers the flexibility that gives you a better chance of creating good returns. So I don’t think hedge funds are a temporary phenomenon. Yet as you and I know, there is a lot of anguish out there in the world of hedge funds. Everybody focuses on the great success stories. How somebody made so much money and raised billions of dollars and blah, blah, blah. But there is all kinds of pain out there.

The downside is wicked, when you’re performing without a net.
Yes. There were 1,000 new hedge funds created last year and 1,000 went out of business. A lot of people are suffering.

Investors, as well as hedge fund entrepreneurs.
Right. The life expectancy of a hedge fund is about the same as an NFL running back, 4.6 years.

One reason is that while they’re not usually burdened with enormous infrastructures to support, they do have cost issues of their own. Like fee structures that lushly reward managers in good times—and encourage them fold their tents quickly, if they hit a rough patch.
Again, it is complicated. It all depends where in the profitability cycle a particular hedge fund is, when the bad times come. I am not sure I want to pontificate on the hedge fund and the investment management industry. The issues are complicated. But I do think that the whole industry is going through evolutionary change. And it is just not completely clear how it is all going to sort out. There are very powerful regulatory pressures and very powerful performance pressures in the mix.

The crosswinds aren’t just buffeting the investment business, they’re hitting about everything that touches the market—except the market itself. Could it be that all the new hedge funds are succeeding in continually arbitraging profitability out of the market? Or at least putting a heck of a damper on volatility?
Maybe they are, but that is not the way I see it. The way I see it is that we had a big bear market for three years and then we had a 50% rally off the bottom, which really began in March of last year. So, just as you would expect after that big 50% recovery, we are in a consolidation period here. This consolidation has been going on for going on seven months now—and my guess is that it is about over. I hope I am right!

Which way is the exit?
My view is that we are going to break out to the upside. I don’t think this will be the beginning of a new secular bull market. But I expect pretty significant recoveries in some of the other markets around the world. In that environment, could the S&P 500 go up to 1250 or something like that? I guess it could. But I suspect that we are going to go through a major period during which non-U.S. markets are going to do significantly better than the U.S.

Then you’re focusing on Europe or Asia, rather than the U.S.?
Well, it sounds crazy but we are focusing on all three regions. But I especially think we’re entering what will be a very positive phase for Europe.

Most Europeans dispute that.
I know—and that is one of the reassuring aspects of it.
International investors have been selling Europe for the last five years, basically. But I see real signs that Europe is turning and that the socialistic environment that has prevailed there for the last 10 years is coming to an end. Partly because of forces of nature, but also partly because of the addition of these new countries in Eastern Europe to the European Union. It is very important stuff that at French companies, French workers are voting to extend the workweek from 35 hours to 36 hours—without taking additional pay. It also is important stuff that, across Europe, people are starting to realize that they are going to have to increase the retirement age by five years from whatever it happens to be now—because otherwise they are not going to get paid the pensions that the governments and the companies have promised them. This combination is very powerful. These are big, broad social changes.

Even some German unions have agreed to work a little bit longer each week for the same money.
Eventually they are going to go back to a 38 or 40 hour workweek, and they are going to get paid more for that. But the really big story is the savings rate across Europe. Let’s take France as an example, where the savings rate is close to 15%. Why are the French saving so much? They are saving so much because they are justifiably worried about whether the pensions that they have been promised are going to get paid. And they’re saving so much because they know they have to, if they are going to retire at 55. Well, if the environment changes and they work a longer workweek and get paid somewhat more and the retirement age goes to 60 and they become confident that their pensions are going to get paid, then I think that you’ll get a big, broad, gradual decline in the savings rate across Europe. Which should mean that domestic demand and consumption will be in a secular up-trend in Europe for 5-7 years, or so. And that Europe is going to have better growth than anybody expects. But we are at the very beginning of this period of growth. Right now, the good numbers in Germany are coming from manufacturing (which is driven by export demand). There has been no pickup in domestic demand. But Germany is a classic case.

Classic?
Well, consider this: house prices in Germany are at the same level they were at 20 years ago. Meanwhile, measured by all sorts of traditional sociological indicators, pessimism there is at an excessive extreme. There have been a huge number of books written about “Euro-sclerosis.” Everybody knocks Europe. It’s fashionable. The Secretary of Defense refers to it as “old Europe.” But when that sort of psychology becomes the conventional wisdom, just maybe change is beginning to occur. And when change occurs—if you look back at the U.S. when President Reagan fired the air traffic controllers or at the U.K. when Prime Minister Margaret Thatcher stood up to the British unions—what you see is that markets are smart. They figured out that meaningful change was underway, far ahead of time. So well before those changes started to be effected in the economic numbers, the markets started to do better. That’s what I expect to happen in Europe. Yes, we have entered an era of lower market returns, but considering the fundamental changes occurring in European economies, can the European markets outperform the U.S. for the next 5 or 7 years? I don’t think that is at all inconceivable.

That certainly would surprise a whole lot of people. What does that imply for the dollar versus the Euro?
On a trade weighted basis, I think the dollar is still about halfway through a secular decline. So the dollar will fall further against the Euro, but but much more gradually than what has occurred in the last 18 months; that deterioration is already in prices to a certain extent.

If Europe is going to surprise most investors on the upside, is China going to surprise on the downside?
I doubt it, in the short-term. Longer-term, it may be that China is going to have a big bust out there somewhere. But I tend to side more with the view that the Chinese have already engineered a soft landing.

Can you cite any evidence?
Well, the huge increase in the last three or four weeks in the Baltic Freight Index, after it fell so dramatically, is indicative that the Chinese have taken their feet off the monetary and fiscal and regulatory brakes. They haven’t really put them back on the accelerator yet, but they have taken their feet off the brakes. So yes, I think China has engineered a soft landing of sorts. Now, they may not really have resolved some of the big excesses that created developed. And it may be that two or three years from now they may have a more serious bust, perhaps just when everybody is babbling away about the 2008 Olympics that they are hosting. Maybe China has a real bust then. But over the next year, China looks like it is in pretty good shape.

Which I suppose means that the rest of Asia is also in fairly decent shape?
Clearly. We are big believers that some of the most attractive markets in the world are the smaller Asian markets.

The Tigers are coming out of hibernation?
The nations we used to call the Asian Tigers, absolutely. What has happened is that these countries have been through a real depression and deflation since 1997, in a cycle that began with the Thai baht crisis. They have all weathered very serious bear markets in not only their currencies but their stock markets. But the result is that they have implemented real—and necessary—reforms in their banking systems. Now these countries’ economies are emerging from those long downturns and they have very, very high savings rates, at low loan to deposit ratios, and very little consumer credit. They have simply tremendous deferred demand. They have an entrenched work ethic and their populations continue to grow. So in a country like Thailand, which is substantially bigger than France and is catching up with Germany in terms of population, there is a real domestic demand story. But that is not true just in Thailand.

What is Thailand’s population today?
There are something like 66 million Thais. It is a population growth story. Look, these are economies rising from very, very low bases. They are doing so with cured banking systems that have been partially nationalized. There was tremendous damage done there over the last five years. But those banking systems have been cleaned up. I’m talking about Malaysia, as well as Thailand. Singapore is in the same situation. Hong Kong is emerging from deflation and recession. Certainly the other big story in Asia is India. But then in the northern part of Asia, there are two cyclical markets—Taiwan and Korea—that just look to us to be unbelievably cheap. Yes, both of them have their unique cyclical problems. But at the kind of valuations that they are selling for, at 7-8 times earnings, they are very attractive.

You mention Taiwan and Korea’s “unique” problems. I suspect you’ve read some awfully scary pieces in Marc Faber’s Gloom, Doom and Boom Report about the geopolitical risks we are ignoring there, in favor of Iraq, just as I have. Yet you are buying?
You know as well as I do that there are a number of congenital bears out there—

Some of my best friends even have accused me of belonging to that camp—but I prefer “professional skeptic.”
Well, look. I am just looking at the valuations of those markets. On the 2004 numbers, Taiwan is selling at 10 times latest 12-month earnings and Korea is selling at 6 times. I like that kind of valuation. Korea is at 1.4 times book. Taiwan is trading at 1.8 times book. What those numbers tell me is that a lot of the worries about the cyclical economies of Taiwan and Korea, both the economic worries and the political fears, are already discounted in those valuations. So 10 years after it was supposed to happen, the “Asian Miracle” may be actually beginning now. It is happening in China, it is happening in India. And we are getting at least a cyclical recovery in Japan.

After all these years? Yet you are hedging by saying “at least a cyclical recovery.”
No. I think you will find that Japan is getting out of the pit it has been in. I think that deflation is ending in Japan. Nonetheless, the structural long-term growth rate in Japan is probably only 1.5%- 2% in terms of real GDP. Most likely closer to 1.5%, simply because there is negative population growth in Japan and productivity growth in Japan is just not that strong. By the way, that is what the Bank of Japan thinks, too. Japan just is not a high-growth economy. Now, we do have a macro position in Japan and in certain parts of the Japanese market. But it is not huge and we frankly are worried that Japan is too popular with investors; it is a crowded trade. If the market has sent one message to investors over the last six months, it is to stay away from crowded trades—and we have learned that lesson very unequivocally.

That would seem to be Investing 101. But on the evidence, few pay attention to it.
True. One of the things that is going on here is that there have been a lot of macro-trading—what they call CTAs, or commodities trading accounts—created. These are essentially dynamic-hedging momentum investors who buy strength and sell weakness. Ironically that particular strategy has worked very badly this year so that particular hedge fund bubble may be starting to get unwound. I doubt that we are the only ones who have figured out that crowded trades are something to avoid.

Duh. That strategy is straight out of the commodity pits. And lately it has done to investors just what those kinds of strategies often do to them—dug enormous pits in their portfolios.
Exactly.

Clearly, you’re ahead of the pack in betting on upside in Europe. But isn’t the Asia trade a mite crowded for your taste? Especially since those markets have a long history of enticing foreign investors to buy, gleefully selling their shares to them, but then refusing to let that money leave?
You’re right about the historical experience in Asia. The interesting thing is that the rise last year in the Asian markets was principally caused by international investors. The locals really didn’t participate in the buying.

Why am I not surprised? And it wasn’t a healthy sign, was it?
Well, those markets are all down roughly 20% from their highs, but still well above 2003 levels. And the locals have still not really gotten involved. But that is ahead of us. Look, I am a believer in the long-run. The fundamentals are what cause important moves. And as I see it, the fundamentals across non-Japan Asia are sufficiently strong—the earnings growth and the valuations are there—that both the international investors and the local investors who have still not come back in will return. Just to give you one example, look at Vanguard. There isn’t even one non-Japan Asian equity fund offering in the entire Vanguard Group. We are nowhere near where we were10 years ago, in terms of public or international investment interest in Asia.

Hasn’t anyone started a non-Japan Asian ETF yet?
There probably is something like that, I don’t know. But my point is that there is no big trend yet; the public isn’t pouring money into Asian investment vehicles.

“Yet.” You talk about investing for the long run, Barton. Can your fund actually do that and still show the sort of consistent short-term results that hedge fund investors generally tend to demand?
I don’t know if I can claim that we have any particular way to deal with that. I mean, we try. We do have a one-year lock-up on new money and we try to educate our investors. We try to make sure that our investors understand that we are not a long/short fund shooting for 7%, 8%, 10% annual returns. We are shooting for 15% to 20% percent annual returns over a five-year period. The reality is, if you are going to do that, you are going to have an occasional big year and you are going to have an occasional down year. You can also have substantial monthly volatility. It is crucial that our investors understand that.

I hear lots of moaning that no one is willing to accept even short-term volatility these days. Clearly, you must deal with a very savvy investor base.
That remains to be seen.

Well, tell me this: How long will your investors have to be patient before your stakes in the Asian Tigers and India for instance, bear fruit? Five years?
Five years is too long. It is more likely to happen over the next 1-3 years. But please, understand where we are invested now. We have substantial net long positions all across non-Japan Asia. In Europe, we have substantial positions, particularly in Germany and in France, principally via the CAC and DAX indices. Our bet is that the emerging markets are going to be the place to be over the next three to five years. They are going to be the techs of the next decade. That doesn’t mean that they are going to soar straight up every year, but they are going to be the strong performers. I also believe that markets like Russia and Brazil have a lot of appeal.

You haven’t mentioned the emerging countries of Europe—
We haven’t really found much that we want to do there. The valuations are not particularly cheap. They have already gone up a lot. So we are not terribly excited about them.

Yet you find Russia tempting? Despite the Yukos imbroglio?
It remains to be seen what happens with the Yukos affair. As of this moment, what is going on is very scary because the government seems to be threatening the property rights of investors. Even though Mikhail Khodorkovsky has basically said he will do whatever he has to do, he will pay the disputed $3.4 billion tax bill and so on, yet the government keeps wanting more. It almost seems like they are determined to re-distribute the wealth to a different class of people—and I don’t mean the common people. But I don’t believe that it is going to play out that way. I think Russian Prime Minister Putin is too smart for that. He is is too much of a Russian patriot for that. So I still think that this will be resolved in an equitable way. After all, the oligarchs did steal the assets of Russia. And Khodorkovsky made the mistake of breaking what Putin told him were the rules.

By trying to encroach on Putin’s political turf.
That’s right. The rules were that he couldn’t get involved in politics, but he did. So while what is going on now is messy, I think it will ultimately prove to be a positive step. Meanwhile, you’ve got a country in Russia where, except for the Yukos thing, they are doing everything right and the Russian market is very cheap.

And Brazil? Hopes that it would become South America’s sustainable engine of economic growth have been disappointed too many times to count.
But the Brazilian market is trading at 7-8 times earnings. I have been traveling to Brazil for years. I was just down there recently. I am convinced that the Brazilians are—in their own messy, sloppy way—making progress. In a way, it is a South American India. So its progress is not going to be neat and autocratic, the way China’s has been or Singapore’s. But progress is happening in Brazil. They are building a capitalist democracy down there, albeit by taking three steps forward and then two back. But it is coming. Meanwhile, you are not paying any kind of premium for it. It is a very cheap market and some of the best businessmen I know in the world are Brazilians.

Really? Simply because they’ve had to be, to survive?
The business class in both Sao Paulo and Rio is just as sophisticated as those in London or New York. It is just that it is not quite as large as London’s or New York’s. And, compared with other developing countries, Brazil has tremendous business talent. Nobody else even comes close.

So your South American investments are concentrated in Brazil?
Yes.

In what kind of stocks?
In Brazil? As a macro, top-down hedge fund we spend very little time on individual stocks. So we are not buying individual stocks in Brazil. We buy the Brazilian index. Now, in certain countries like India or Korea, we will concentrate on particular sectors that look very attractive, in addition to the index. We also do that in Japan, in Europe and in the U.S. But in a country like Brazil, we have stuck to investing via the MSCI index.

Putting all this together implies that you must be underweight or even net short the U.S. market.
We are not net short but we are significantly underweight the U.S. in terms of our net long position. Now, we also have various sector longs and sector shorts in the U.S., as well as globally.

Since you’re looking to emerging markets to be the techs of the next decade, I’m guessing you aren’t net long the tech sector—
Well that’s not necessarily a good guess. If the markets are trading here down towards the bottom of the trading range, we could have a hell of a bounce in tech if we make some kind of a bottom here in the next month or so. But over the next five years, I think—even though I am aware that this has become sort of the conventional wisdom—that the techs will prove roughly comparable to the Nifty Fifty in 1978-1980. What I mean by that is that you are going to be able to make money in individual tech names that work out, but I doubt that tech will take a big leadership role in the market. Don’t get me wrong, I’m sure that tech, in some guise, will rise again. Maybe 10 years from now there will be another tech bull market, but it will be under a new conceptual flag. Meanwhile, however, for the investable future, tech won’t be a big leadership sector.

Is that what Microsoft’s big dividend is really saying?
That is probably part of it, yes. But don’t forget, Microsoft has just been plagued with antitrust problems and with its size and so on. Also, as we know, there are some significant reasons to pay out a big dividend right now, while the tax rate is 15%.

Are you implying that political events may lead to a change in that tax rate soon?
Well sure. I don’t know who is going to win the election. Nobody else does either, obviously. But clearly there is certainly a risk that President Bush doesn’t win the election. And Senator Kerry has said that he doesn’t believe that that 15% is the correct tax rate on dividends. I doubt he thinks it should be lower.

There’s often a considerable gap between campaign rhetoric and what an elected official actually can do.
Absolutely. Nonetheless, if a company has a lot of money to pay out, it makes a lot of sense to do it now. And that is partly what is behind Microsoft’s payout. Also, there are still huge amounts of uncommitted private equity in the tech and especially in the venture capital part of the tech industry—which means that we are nowhere close to being back in the sort of environment in which tech bull markets begin.

What sectors do you think will be better in the U.S.?
Frankly, for years we were able to generate alpha by basically being long the best four or five sectors in the U.S. and being short or underweight the four or five worst. But so far this year, we haven’t generated any alpha doing that. We are at break even. But for better or for worse, the sectors that we think are pretty attractive right now in the U.S. are, first of all, the big drug stocks—pharma. Then the food and beverage, tobacco, software, the investment banks and the utilities as well. How many is that? That’s 6, actually, that we are net long. On the other side of the ledger, we are short the REITs. We are short the retailers, including Wal-Mart (WMT). We are short the U.S. machinery sector. We are also short energy equipment and services. That is really it, on the short side.

Short energy equipment? Ouch.
As I said, these sector investments haven’t been working this year. We are breakeven on them. But we also have a significant short position in oil.

I’m sorry.
Granted, it hasn’t been great so far. But we do a lot of economic modeling work and our very intensive work on the price of oil, which includes looking at a whole series of macroeconomic and industry factors, suggests that price of oil should be $28-$30 a barrel. So there is a very substantial terrorism premium in the current price, as well as the premium brought on by jitters over the availability of the oil Yukos has been supplying to the market. And, of course, there’s a long-term shortage thesis premium in the current price of oil. But it is our theory—which has not worked so far—that the price of oil is going to decline over next six months to a year, down towards the $30 to $32 a barrel range, as some of these near-term worries dissipate. And in that sort of an environment—even though there is a fine long-term case for the energy equipment and the oil service industries—those stocks are going to go down.

Certainly if the price reverts to what has been a more normal range. There is talk, though, that it has stepped up into a new range, given geopolitical realities and long-term supply issues. Even though Charley Maxwell also sees a big terrorism premium in today’s price, he doesn’t see it dropping back back down as low as it has in past cycles. Says the equilibrium level is several bucks higher now than it used to be.
I would settle for that at this point. Our modeling would put the equilibrium level around $28, but if it is $31-$32, that would be okay. Our shorts will work as some of the terrorism and supply concerns come out of the price of oil. But shorting oil is also a good hedge here, in a way, against the the bears on the world economy being right. Because if the global economy does turn out to go soft, then oil demand is not going to be as strong as people are expecting, and the price will go down. We’re not really expecting that, though. We think the global economy is going to be okay. Not too hot and not too cold.

Goldilocks again?
Goldilocks—well, in a different version. Maybe not Goldilocks in the U.S. or in Australia or in the U.K., because those economies probably will be softer than people would like. But we expect a reasonably healthy Goldilocks kind of story in Europe. Healthier than expected economies in Europe and Japan and the emerging markets.

Any thoughts on the divergent performance of small caps and large caps in this market this year? Will the small caps continue to outperform?
We can put on small-cap positions—and we have done that in the U.S. market to a certain extent. But I think that trend has pretty much run its course now. Everything that we do suggests that the big caps and especially big-cap growth companies are the cheapest part of the U.S. market, on a relative basis. I mean, just look at the the swings in the performance statistics. The small-cap value style, in particular, has registered tremendous moves. Large-cap value also has had a big move. So, on a style basis, the place to be is in big-cap growth. I guess that is reflected in our portfolio in the fact that we have a substantial position in a sector like the big drug stocks in the U.S.

You don’t buy the idea that the big drug companies are dinosaurs?
No. They aren’t the 14% annual earnings per share growth companies that they used to be. But are they 7-8% growth companies? Maybe even 9% or 10%? I think they are. But they are priced as though they were 4% or 5% growth companies. Come on. These are some of the great health research companies in the world. They are absolutely unique and a very good area for long-term investment—also for long-term dividend growth for wealthy individuals.

Speaking of dividends. Have you been surprised by how slowly U.S. companies have responded to the change in dividend taxation? Yields are still pretty puny by historical standards.
A little bit surprised. But not in a big way. These are big, long-term trends. It just takes a while. But that is the direction we are moving.

Even if Kerry wins and changes their tax treatment?
That is a different matter. But look, the great golden bull market is over, the era in which people focused exclusively on stock price appreciation has ended. Besides, institutional investors aren’t going to be affected by whatever Kerry does to dividend taxation, so the appeal of higher “fixed” returns isn’t going to go away. That is part of what I like in a stock like Merck (MRK), where you do actually have some yield protection.

You also like the investment banks? When you look at industry weightings in the S&P, aren’t the financials an area the contrarian in you would prefer to avoid?
Yes, but we are not in the true banks. We are in the investment banks and the brokers.

I’m not sure that’s not a distinction without a difference.
There’s a difference in valuations. In other words, we are in names like, Morgan Stanley, Goldman Sachs, Citicorp, that kind of stuff. Those stocks look very, very cheap. And the four big U.S. investment banks—Merrill Lynch, Morgan, Goldman Sachs and Citicorp—are the class of the world. I don’t understand why they have sold off as much as they have. I mean, I understand why in the sense that we’ve come to the end of the fixed-income trading cycle. But there are both pluses and minuses to a fixed-income trading cycle. The plus is, it makes big money. The minus is it requires a lot of capital. As I see it, these big investment banks are really diversified financial service companies. As such, compared with everything else in the U.S. market, they look very cheap and very attractive. If we are going to have a 10% rise in the U.S. equity market—which is what I expect—my guess is that the investment banks will go up by twice that much, which, incidentally is what always happens.

And the leverage—visible and invisible—they’re employing is okay?
Yes. I read all this stuff about leverage. I hope there is somebody out there who understands it all, but I don’t. Anyway, the most leveraged, in terms of derivatives, for example, is JP Morgan. But basically, the VARs, to the extent that you can measure the leverage and risk in these companies, are public record. So you can look at those value at risk measures and see how volatile their earnings are likely to be.

Unless they get hit by a long tail exposure the rocket scientists left out of that algorithm.
That’s true. You never know when there’s a long tail sitting out there. But the VAR is a calculable number based on daily, weekly or monthly, annual earnings variability. Look, there is always a bolt-from-the-blue risk–terrorism or something like that can happen. But I also think that any contraction brought on by a single act of terrorism in the U.S. would be a buying opportunity. That’s always a risk out there, I am afraid. But I would be more concerned if it started to look like the massive dose of fiscal and monetary stimulus has been applied, but it has worn off, and that economic growth is going to really slip and get soft here. And that there isn’t anymore fiscal and monetary stimulus to apply, so that the big engine of the world, the U.S. economy is going to tip over into very slow growth—or, as the bears would have it—into a shallow recession that begins in 2005. And that meanwhile, the high-growth engine of the world, which has been China, at the same time would have a hard landing. If those two scenarios played out, the outcome would be much slower growth and return to a deflation in an environment in which the central banks had already fired a lot of their ammo. That would be a very tough situation and it will be similar to the environment that has prevailed in Japan for the last 10 years, in other words, stag-deflation.

Your bet though, is that we’re able to avoid all that?
Yes. We are not positioned for that right now. At various times in the past, we have had substantial bond positions. We have made good money on bond hedges. But we don’t have anything on in terms of positions in the fixed-income markets at this time. I’m just pointing out that if that unfortunate scenario were to play out, you could have a major move in bonds. The 10-year treasury could have a two handle on it in 12 months and the S&P would go to new lows around 500 or 600, the way a lot of the bears still think. But there is also the risk that it could go the other way; that the fiscal and monetary stimulus causes a significant resumption in inflation and that interest rates are going to go up a lot higher than we think they are. I think that if we are going to run into really a big problem, it could be either one of those scenarios. But we are sort of in the—I don’t like to call it Goldilocks—but in the sweet spot, or at least in a decent investment environment in between those two extremes. I think it is the most likely case to prevail going forward. But that doesn’t mean that we are not alert to the possibility that either of those other two considerably less attractive alternatives could emerge. We have to rely on our wits and be able to change our mind.

But your money is on muddling along.
And so far this year, it hasn’t produced the sort of results our clients expect. We are down around 3.5%. But the year is definitely not over. I think we still have a good chance of having an up year. In the markets and for our investors. I mean, the S&P is down, what, 2% here? Ending up in positive territory isn’t all that much of a stretch.

No matter who wins the election?
We are sort of of the view that the election probably is not going to make a lot of difference. In fact, electing a Congress dominated by one party and a President from the other—which is probably a decent possibility here—is likely market neutral.

Here’s to the ultimate check and balance then.
Thanks, Barton.

Illustration: Ann Field

"The emerging markets are going to be the place to be over the next three to five years. They are going to be the techs of the next decade."