Cover Story

Time to Slip into Something Less Comfortable?


During the great credit party that raged around the world for the five years leading up to 2008, a few economists and investors studiously avoided the punch bowl. They stood in the corner, muttering darkly about how it would all end with the hangover of the century. They were outcasts. "I was lambasted and ridiculed as an idiot," says Michael Panzner, a stockbroker and author who began calling the collapse in 2005. "Like one of those guys holding a cardboard sign predicting apocalypse."

By the time Lehman Brothers collapsed and worldwide markets did their synchronized nosedive, Panzner had already published a book called Financial Armageddon: Protect Your Future from Economic Collapse and would soon follow up with When Giants Fall: An Economic Roadmap for the End of the American Era. Bearishness is a countercyclical asset; as the economy fell, the professional reputation of doomsayers soared. Suddenly they were the party animals. Gary Shilling, a veteran investment guru based in New Jersey, was feted for nailing all 13 of his investment guidelines for 2008, most of which involved shorting banks and housing. Banking analyst Meredith Whitney, who had shocked her peers with a devastating report on Citigroup (C) when it was still widely viewed as fundamentally sound, started her own firm on the basis of her newfound celebrity. An obscure New York University professor named Nouriel Roubini, aka Dr. Doom, became a headliner on the international conference circuit, attracting actual groupies.

Then the ground started to shift. For most of the last year the U.S. economy has been inching toward recovery. While far from sunny, 2009 didn't bring with it much in the way of tent cities or snaking breadlines, as some of the most extreme bears said it surely would. The U.S. Labor Dept. reported that payrolls grew by 431,000 in May, marking the fifth consecutive month of gains. In April, sales at U.S. retailers edged up 8.8 percent from the same month last year. The major investment banks beat analysts' (admittedly depressed) earnings expectations, and the markets gained 80 percent in just over a year. Consumer confidence is up, and gross domestic product, though hardly robust, is growing at around 3 percent. Gradually the bears lost airtime, and most—although not Roubini—slipped from view.

Now, as the markets show fresh signs of panic, much of it emanating from the sovereign debt crisis in Europe, the spotlight is swinging back their way. Despite evidence of improving conditions, most bears have changed their outlooks only marginally, if at all. Which raises the question: Is their persistent pessimism a mark of brave, nonconformist thinking, or has their negativity become a kind of crisis schtick—contrariness for the sake of notoriety? To find out if they should be feared or ignored, Bloomberg Businessweek assembled a cast of the most prominent bears from 2008, traced the development of their dark outlooks, and assessed where they see the economy going from here.

THE GRIZZLIES

As early as 2004, Roubini, now 52, predicted an imminent recession caused by yawning U.S. trade deficits and a spike in oil prices and interest rates. It didn't come. In 2005 he again called for a recession. It didn't come. His revised prediction was for 2006. That year he spoke at an International Monetary Fund meeting and predicted the coming housing bust, saying the "United States was likely to face a once-in-a-lifetime housing bust...and ultimately a deep recession."

After Roubini's predictions finally came true and the world staggered into 2009, he said oil prices would remain low through the year, sinking to between $30 and $40 a barrel, and that the S&P would dip to 600. Neither happened. Oil jumped to $70 a barrel in November and the S&P hit bottom at 676, then blew past 1000. Still, Roubini sees doom almost everywhere, including Brazil, one of the world's best-performing economies over the past year; he diagnosed it as at risk of "overheating" at an event last month in São Paulo.

Back in the U.S., where he recently celebrated the publication of Crisis Economics: A Crash Course in the Future of Finance with a lavish party hosted by Ken Griffin of Citadel Investment Group, he remains skeptical of the banks, as well as the debts run up by the federal government to resuscitate them. In a May 11 interview with Charlie Rose, Roubini pointed out that the government had picked up roughly $40 billion of soured debt from now-deceased Bear Stearns and said "this buildup of public debt is something I worry about." He called the bailout of AIG (AIG) "a mistake," and when prodded by Rose said that "zero interest rates are leading to an asset bubble globally." In the first chapter of Crisis Economics, Roubini argues that financial crises are predictable and not merely random events. In discussing this with Rose, he said: "When you live in a bubble, everyone is delusional." Present company excepted, naturally.

Roubini is the leading brand name in the community of market prognosticators who pride themselves on being outside the Wall Street Establishment. This independence, they say, allows them to see the fictions that people inside the system are blind to. Compared with the others, Roubini's forecast is mild. Most tend to view a double dip as a near certainty, with the second leg more brutal and destabilizing than the first.

One of the most famous of these extremist outsiders is Robert Prechter. In the 1970s he revived an old system of measuring investor psychology called the Elliott Wave Principle and used it to advise subscribers of his investment newsletter on Oct. 5, 1987, that they liquidate their stock holdings. Two weeks later, the market crashed. Prechter was hailed as a genius—though the label didn't stick. In 1993, The Wall Street Journal ran a page-one story headlined "Robert Prechter Sees His 3600 on the Dow—But 6 Years Late." He stayed pessimistic through the 1990s, and in 2002 said the Dow Jones industrial average would fall below 1000. It surged 25 percent the following year and kept going up until 2007.

According to Prechter, 61, the market's failure to crash as he predicted only set it up for more devastating blows down the road—which could be right now. Last March he correctly called the market bottom and predicted a rally. That has now run its course. The Standard & Poor's 500-stock index, he says, will dip below its March 2009 low. "From a peak in 2010, the stock market should fall for six years," he says.

Although his pessimism remains the same, the basis of it has changed. This time around it's rooted in the actions of governments. "Government is acting like the last drunk at the party. Government is spending at an unprecedented rate, regulating the minutest areas of our lives, and strutting around as if it's solving problems as it creates them." Coming up next, according to Prechter? Another crisis in real estate and stocks. "The next crisis will encompass markets that are already off their highs: stocks, commodities, and real estate. But it will also extend to areas that have so far sailed through, namely corporate and municipal bonds, asset-backed bonds, and even many sovereign government bonds."

Money manager Peter Schiff was born an outsider—his father was a famous tax objector who is serving a lengthy sentence in an Indiana prison. Like Panzner, Schiff had a book on the shelves (Crash Proof: How to Profit from the Coming Economic Collapse) when the financial panic struck. His thesis, which revolved around the major structural flaws of the U.S. economy as well as what he saw as the inevitable collapse of the U.S. housing market, proved to be half correct. The second part of it, that investors could protect themselves by plowing their cash into foreign stocks, didn't pan out so well.

Schiff, 47, became a fixture on business television, fanning the flames with bold pronouncements that economic conditions were actually worse than people thought. Now he's attempting to leverage his notoriety into a run for the seat being vacated by Senator Chris Dodd (D-Conn.) Monetary policy, or what he sees as the colossal mismanagement of it by the Federal Reserve, is the centerpiece of his fledgling campaign. "Everything the government has done has been dead wrong," he says. "They have compounded the underlying problems in our economy."

On the campaign trail, Schiff gets worked up about the government's mishandling of the economy, especially the quasi-public mortgage agencies Fannie Mae (FNM) and Freddie Mac (FRE) that have consumed $125 billion in government aid so far. According to Schiff, the Obama Administration's decision to save companies deemed too big to fail exacerbated the problems facing the country because it created an unmanageable federal deficit. "We bought some time, but the cost of the borrowed time is a great recession," he says. "Those who think otherwise were just fooled by phony economic growth produced by stimulus funds."

Schiff believes that frivolous personal spending has corrupted the U.S. economy and that it must be reformed by reconstituting the manufacturing sector. "We have to spend less and we have to invest more because there is going to be a depression that spans the Obama Presidency," he says, "and it has the potential to be really horrific." When asked about immigration, on the campaign trail—where he barely has made a dent against former World Wrestling Entertainment executive Linda McMahon in the Republican primary—Schiff answers that he's more worried about the opposite: "Ambitious, smart people are going to want to leave the country. No one is going to want to stay here."

Like Schiff, Panzner is an evangelist on the evils of debt, and finds confirmation of his views in the Moody's Investors Service (MCO) statement in March that the U.S. government was at risk of losing its pristine AAA credit rating and might have to so drastically alter fiscal and monetary policy that it "will test social cohesion." Also like Schiff, he faults the government for not forcing Americans to reckon with the real consequences of the recession. "What makes this so much worse is that the government has been assuring people that everything will be O.K. and that a solution to this didn't require pain," he says. "That's just not true." Without a period of genuine austerity, he argues, the economy will never properly recover. "So yeah, I am a perma-bear," he says proudly. "Because none of the fundamental problems have been addressed, the government is still enabling companies to make risky loans, and even some of the same kinds of loans that helped contribute to the downturn in the first place."

Among the outsiders, Nassim Nicholas Taleb, 49, is the polemicist-in-chief. Famed for hectoring audiences of bankers (who invite him to speak and pay his five-figure speaker fees) and aggressively countering negative reviews of his work, Taleb gained a cult following when he published Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life in 2001. It was, naturally, a screed that detailed how Wall Street deludes itself and investors with neat predictive models that regularly get blown apart by reality.

In 2002, Malcolm Gladwell profiled Taleb in The New Yorker, focusing on his investment in cheap, out-of-the-money options, betting that the market underestimated the likelihood of crashes. Then he shot to stardom with the publication of The Black Swan: The Impact of the Highly Improbable in May 2007, which extended his critique of risk management on Wall Street. Taleb argued that the models used to measure and contain risk were inherently flawed because they did not—and could not—take into account the existence of black swans, or unpredictable, potentially disastrous events.

Taleb's timing was exquisite: The book hit shelves just months before banks started announcing billion-dollar writedowns on their subprime holdings. The Black Swan hovered at the top of the New York Times best-seller list, was translated into more than 27 languages, and won Taleb an appointment as Distinguished Professor of Risk Engineering at New York University, a custom-fit title he's quite proud of. "It's the highest title that they bestow in the department," he says.

To Taleb's way of thinking, the worldwide response to the 2008 crash has only made the economy more vulnerable to black swans. "The same analysis I made in 2006 holds stronger today with even more force," he says. "It's worse on both fronts. We have a swelling of contingent liabilities and hidden risk. We may be, cosmetically, growing things, but our liabilities and our debt are growing, too. I am expecting that things will only get worse because we wasted too much time not repairing the system. We are in an unprecedented time."

For pure bombast, Taleb's only rival is Marc Faber, who publishes the Gloom, Doom and Boom Report from his home in Hong Kong. Since 2002 the 64-year-old, Zurich-born economist has been predicting that the dollar would plummet in value, and since 2005 that an economic meltdown was about to hit the U.S. Faber now expects a sovereign-default domino effect, and he's not much rosier on China, saying in a Bloomberg Television interview that its economy might "crash" within the year. As for the S&P, he expects it to drop as much as 15 percent in the next six months. How will we cope with all this turmoil? In the June 2008 issue of Gloom, Doom and Boom, he recommended that Americans can help themselves by partaking in "prostitutes and beer" because they are "the only products still produced in the U.S."

BEARS WITH LESS BITE

When he last worked on Wall Street a quarter century ago, Gary Shilling, now 73, had a hard time being the bull his bosses wanted him to be. He believed the U.S. economy was in a long-term deflationary period and that bonds would prove to be a better bet than equities.

The last two years haven't shaken his certainty. He believes American consumers can't avoid a fundamental downshift in their spending habits. "It's not about perception at all," says Shilling, who was the chief economist at Merrill Lynch (MER) and has published an investment newsletter for the past 25 years. "I am a realist."

For someone who rejects the title of bear, Shilling has an unfortunate hobby: He keeps bees and frequently hands out jars of honey to friends—gifts far sweeter than his outlook on the global economy. After his stunning success in 2008, he kept investment advice unchanged heading into 2009, bluntly predicting "the worst global financial crisis and deepest world worldwide recession since the 1930s will continue throughout 2009," which Business Insider editors translated succinctly into "We are still screwed." He forecast a continued boom in U.S. Treasuries, as capital worldwide sought safety, and predicted that the S&P would end the year between 500 and 600 points. Not quite. It turned out to be almost double that, with Treasuries performing worse than the junk he warned investors away from.

Shilling holds to the view that recovery is a mirage whipped up by government stimulus, that the economy is held in check by declining home prices and contracting credit. Even though consumers had more personal income in March, according to the U.S. Commerce Dept., spending patterns didn't follow suit. The personal savings rate has been increasing, reaching 3.6 percent of disposable income in April. "With the decline of housing prices, consumers went off a cliff," he says. "They just don't have the kind of spending power or desire that they did in the past."

While many have focused on how the European debt crisis will effect U.S. trade with the Continent, Shilling sees it reigniting the banking crisis, which he contends has been papered over. "U.S. banks have $1.5 trillion in exposure to the euro zone and the U.K.," he says. "That's 48 percent of their total exposure, so the risk to the U.S. is predominately financial." Shilling doesn't mind one bit that 2009 returned him to the outskirts of popular opinion. Consensus around his views is bad for business. For his advice to be worthwhile to his newsletter subscribers, he says, "it's got to be something the herd doesn't see."

For Stephen Roach, traveling outside the pack is professionally precarious. Unlike most of the 2008 bears, he works within the financial Establishment, serving until recently as chairman of Morgan Stanley Asia. (He is now returning to New York, where he will split his time between Morgan Stanley and teaching at the Yale School of Management). "It's never easy, especially when you are working on Wall Street, especially when there is an awful lot at stake for the good times to continue," he says. "It's one thing to be an academic who can make points purely for academic purposes. It's energizing to think and rethink your position."

Roach, 64, has been warning Wall Street of imminent pain since 2004, based on his conviction that runaway housing prices were feeding an unsustainable boom in consumer spending. When he moved to Hong Kong in 2007, he focused his consternation on the East, arguing that for the world economy to achieve stability, Asians would have to start spending more and American consumers would have to start saving more.

Although he concedes that "the world is definitely in better shape than it was a year and a half ago," he believes, like Shilling, that the European debt crisis will smack the U.S. hard. "No one wants to talk about the possibility of a double-dip recession," he says, "but it's very much there." The $962 billion aid package hammered together by the E.U. "is not going to be enough," he says. "Multiple contractions will inevitably follow." Monetary policy is a particular bugaboo for Roach because he believes that the preponderance of easy money led to the bubbles and bursts. "Fiscal and monetary policymakers haven't given me any confidence that they have adopted or even thought deeply about an exit strategy from zero interest rates and massive deficits."

Like Roach, Meredith Whitney made her dire predictions from within the financial Establishment, which is one reason they caused such a stir. As an analyst for Oppenheimer, Whitney, 40, put out a research report with the seemingly innocuous title, "Is Citigroup's Dividend Safe? Downgrading Stock Due to Capital Concerns." The conclusion, however, was jarring: Unless Citigroup raised $30 billion by chopping its dividend or quickly unloading assets, Whitney opined, it would surely fail. Citi's shares promptly swooned, and within days the bank's CEO, Chuck Prince, resigned.

Whitney left Oppenheimer and launched Meredith Whitney Advisory Group in February 2009, where she continued to predict trouble in the banking sector. The market judged otherwise. In the spring of 2009, as the banking sector rallied strongly off its historic lows, Whitney made no calls as unambiguously prescient as her Citi analysis. She was skeptical of the government efforts to revive the banks and maintained her bearish stance. She remains extremely cautious, contending that U.S. lenders face a tough second quarter because of rising capital requirements that will undercut their profitability.

"A vast majority of last year's profits for the banks were government-induced," she told the Bloomberg Markets Global Hedge Fund & Investor Summit in May. "The government is putting a lifeguard on duty so that people will play in the pool." Still, she indicated that if prices fell further, she might dip a toe in the water and fish out some bank stocks. As for the housing market, "I'm steadfast in my belief that there's going to be a double dip," she says.

David Rosenberg, chief economist at Gluskin Sheff, has been as consistently bearish as Whitney, though he's less certain of a double dip. His is the cool, calm, and collected voice of doom, cautioning restraint and a dispassionate assessment of the markets. In his former job as chief North American economist at Merrill Lynch, Rosenberg was persistently wary of the boom surrounding him. In 2006 he circulated a research note called "Reassessing Hard Landing Risks" in which he argued that "you can't blindly look at a 4.7% unemployment rate and draw the conclusion that the labor market is tight enough to generate accelerating wage growth when there are as many as three potential job seekers out there for every available position."

As the subprime mortgage market contagion spread into 2008, Rosenberg estimated that the economy would barely notch any real growth, pegging his estimate at 1.6 percent. By the end of January, he'd already cut his forecast in half. He has long been more negative than most. In a 2008 Bloomberg survey of 55 forecasters, he ended up in the bottom 10 for his predictions on GDP, inflation, unemployment and the federal interest rate for 2006 to the middle half of 2008. Rosenberg has spent most of the past year casting doubt on the market rally, which he saw as a product of government stimulus and false hope. "Still no sign of organic private sector growth," he wrote on Feb. 3, 2010.

For now, he says, investors should understand that a "corrective phase is completely normal." The movement of the markets so far, he says, is pointing toward some "visible growth moderation toward the end of the year, but not a double dip recession." Rosenberg, 49, hasn't yet settled on the magnitude of the contraction. For now he's focused on the stability of whatever growth we've seen. "Mortgage applications for new purchases are down to levels we haven't seen since 1997 and there is a downdraft of jobs, so the recoveries are extremely fragile." But he allows that economic data don't tell the whole story. "The problem, of course, is essentially one of human emotion," he says. "We are essentially somewhere between Armageddon and Nirvana."

That's called a hedge.

THE DOMESTICATED

Even the most sophisticated people have difficulty switching world views, especially after their views have been affirmed. "Outlooks tend to be fairly deeply ingrained," says Julie K. Norem, an associate professor of psychology at Wellesley College. "Pessimists will pay attention to information that is punishing, not rewarding, and that's their fundamental outlook."

Some bears understand that—and are trying hard to change. Take Jeremy Grantham, the erudite 71-year old head of Grantham Mayo Van Otterloo, who trotted out his negative predictions to much public ridicule at the 2006 meeting of the IMF in Davos. While he has been predominately down on the economy since 1997, he has to balance his negative view of the economy against the demands of his day job, which is about making money for clients. During a January speech to investment advisers, he reflected on the price of his past bearishness: "We lost business like it was going out of style."

While he's certainly not a bull this time around, Grantham has taken a gentler tone on the U.S. economy's future. He says it won't be disastrous and is advising his clients to pick up stocks of U.S. companies with little debt and stable returns, which will beat out other large-cap firms. His latest newsletter, called "Playing with Fire (A Possible Race to Old Highs)," expresses both hostility to what he sees as the Federal Reserve's careless monetary policy and a flirty acknowledgment of the investment opportunities out there. Fed Chairman Ben Bernanke, Grantham writes, "is begging us to speculate."

James Grant, the 63-year-old publisher of Grant's Interest Rate Observer, also refuses to stick to pessimism merely for consistency's sake. Grant's reputation also soared in the 1987 crash—and fell during the two major bull markets since. The Wall Street Journal lampooned him in 1996 for being "a foolish idiot who was way behind the times," he says. "That's what I remember most about the errors of my impetuous youth, having an unshakable conviction that the credit difficulties were never really resolved, therefore the stock market was on shaky ground. It makes me very humble about what one can know about the future, and makes me less dogmatic."

Where not so long ago he saw inflated prices everywhere, he is now enthusiastic about undervalued assets, recently advising his newsletter clients to buy the despised stock of Yellow Pages publishers and steering them away from bonds ("bundles of promises to repay debt with valueless currency," he called them). The bookish investor, in jaunty pinstripes and tortoiseshell glasses, is actually optimistic about the economy—or at least optimistic for him. "I am a skeptic who is trying to be less the prisoner of his own neurological makeup," he says, before citing historical precedent: "There is a well-documented tendency for steep and ugly recessions to give rise not to weak and profitless recoveries, but to strong ones."

Peering out his office at a picture-perfect view of 300-year-old Trinity Church, Grant continued: "We observed this in the recessions of 1991 and 2001, which were meek and mild, and so were the corresponding recoveries." The deep recession of the early 1980s, on the other hand, led to a spectacular recovery. Based on that, Grant believes the rebound from this recession will be job-rich and strong, a position he has stuck to for nine months now. His bear suit has been sent out to the cleaners, and he doesn't know when it's coming back.

Silver-Greenberg is a reporter for BusinessWeek.com.

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