J.P. Morgan


Doug Cliggott

, who's been eating a bit of crow lately (Monday he included

Procter & Gamble

(PG) - Get Report

among a number of attractive stocks, a day before it tanked), is worried about the equity market. He currently views it as a high-risk, low-reward investment.

The strategist, who's had a sell signal on the stock market for about a year now, is most concerned about what effect a


crash would have on the economy. A correction there, he says, "which could have been a market event nine months ago, now I fear will be an economic event."

He links the run-up in technology stocks in the face of rising interest rates to increased flows into stocks and stock funds from Americans and foreigners alike. It's something he doesn't foresee changing until people "start getting disappointed," he says. The

Federal Reserve

had been reluctant to tighten credit with Y2K approaching, and cheaper borrowing costs have helped consumers save money, more of which has been invested in the stock market.

Now, with interest rates rising, he believes that will ultimately result in downward pressure on technology stocks.

What He Does Like

Cliggott's model is currently heavily overweighted in just two sectors: consumer staples, such as food and beverage companies, and energy stocks, which are currently benefiting from higher energy prices. As interest rates rise, and the economy slows, consumers will begin to spend money more defensively on items they view as necessities, instead of throwing their money away on adult-toy monstrosities like SUVs.

Cliggott joined J.P. Morgan as U.S. equity strategist in 1996, which was a new position for the firm. He spent three years at

Merrill Lynch

, where he was manager of the global investment strategy team. Previously, he worked at

Alfred Berg Securities

in Denmark as head of research.

-- David A.Gaffen

Cliggott met with members of


editorial staff, including Associate Editor Justin Lahart, Staff Reporter Dane Hamilton, Managing Editor Geoff Lewis, Executive Editor Jonathan Krim and Markets Reporter David A. Gaffen. The transcript of that interview follows.

Justin Lahart:

Doug works a lot with the evaluation stocks relative to the bond market, to interest rates. He has a model that worked like a charm for awhile, telling you to sell around the top in '98, telling you to buy -- I think almost to the day -- at the bottom in September of 1998 and then, in January-February of 1999, to sell. And that was not, in fact, the case.

One of the things that's interesting is why is the model not working? Is it going to revert back to that sort of traditional tie between interest rates and earnings?

Doug Cliggott:

Thank you, Justin. This graphic is structured to try to get at why the earnings yield vs. the bond yield has broken down as a good guide to the market. After much effort -- and I wouldn't again want to pretend that we've got it nailed -- but I think we can at least understand why it didn't work.

This graphic shows a very esoteric measure of money. It's the monetary base. In fact it's the only thing

U.S. Federal Reserve

really controls. It's currency plus reserves in the banking system. What is noteworthy about it is that it exploded in the fourth quarter of last year, even though supposedly the Fed was tightening.

I put three circles on the chart: April 1987, February 1994, June 1999. Those are months that the Fed initiated periods of monetary tightening in the past. And you'll notice the difference between what happened in 1987 and 1994, and what happened in 1999.

Domestic Liquidity Is at an Extreme
Growth in the monetary base (y/y). Above 10 = high risk. Below 4 = low risk.

Source: J.P. Morgan

TheStreet Recommends

Doug Cliggott:

I think we lowered our recommended rating of stocks when the

S&P 500

was at 1272 in February of 1999 and I felt not too bright in March, April, May, June. I started getting excited in July and was euphoric in the first couple of weeks of October, because the S&P was actually down. But then, in mid-October, something strange happened. I think this is part of that something strange.

The Fed went from having its measure of money grow 9% in July, 9% in August, 9% in September to 10% in October, 12% in November, and 15.5% in December. If this chart went back another 15, 20, 25 years, you would never get a growth rate above 12%. Ever. And so it just highlights how extraordinary is what the Fed did in the fourth quarter.

And what we know from the past is when this measure of money was growing faster than 10%, stocks only went up. As the Fed normalizes at least its part of the liquidity equation, that'll exert a meaningful amount of downward pressure on stock prices, just like it exerted a great deal of upward pressure on stock prices in the fourth quarter.

Geoff Lewis:

This anomaly -- this Y2K liquidity -- is a result of that?

Doug Cliggott:

Yeah. And I think drawing the picture and walking you through the transmission mechanism of how the Fed aggressively supplying reserves to the banking system makes its way into the Nasdaq, is a lot tougher. But I don't think it's a coincidence that a lot of well-known hedge funds that have been short tech suddenly, in October, November became long tech. I think a lot of banks trading on their own account suddenly found themselves with a lot of extra reserves, a lot of extra capital that they went in the market and played with.

To give credit where credit is due, a young guy who works over at

Merrill Lynch

, equities derivatives analyst

Steve Kim

in research, I think has phrased it really well: It's as if the Fed was writing free puts with the floating strike price. It was a one-way bet, and I think the smarter market participants caught on pretty quickly. Maybe in that context, maybe their task for 2000 is to try to make the Nasdaq a two-way bet again.

Another anomaly besides this money measure is shown in the Domestic Mutual Fund Average Weekly Inflows chart. What we've done here is taken mutual funding flows into technology sector funds, health care sector funds and aggressive growth funds and summed them. Those are the gray bars. These are weekly averages by quarter, except for 2000, which is the first, I guess, nine weeks of the year.

Domestic Mutual Fund Average Weekly Inflows
Cliggott says the media is responsible for this phenomenon.

Source: J.P. Morgan

Doug Cliggott:

On the other side, you've got flows into other types of domestic equity funds. I think Keynes is right, you need to be a psychologist to explain this. I think my educational background doesn't equip me to fully understand this.

Dane Hamilton:

I think it's also when you're charting your savings rate, all that savings is not going into these growth funds, instead it's going to the banks because these interest rates are so low.

Doug Cliggott:

Or the other way around -- that since we're hardly saving anything, what little we are saving, it's gotta go up. And that's the reason for thinking that we're past the point where a breakdown in stock prices will be a market event, and we're now in the realm of it being an economic event.

The "Economic Event" -- or Bad Things Happen to Good Stock Markets

Doug Cliggott:

If you look at this saving rate chart, what I think you'll see is, at least in the past 30 years, whenever it's gone up, the U.S. economy has gone down. You can look at 1990, 1991, 1981, 1979-1980, 1973-1974. Bad things happen to good people when the savings rates are going up. And it seems to me at some point, it's going to go up. I don't know when. It can clearly go down, zero is nothing magic. In Sweden, I think it got as low as negative 5% when they had a huge asset inflation, like we've got right now.

So there's certainly precedent around the world for negative numbers. Zero doesn't give you a floor. And the reason I think bad things happen to the economy is the arithmetic of the 1990s is personal income and it has grown at about a 5% rate, compound, in the 1990s. Consumer spending grew at a 6% compound rate. So if we ever try to start actually saving this thing, then we're going to have to slow spending to 4%, assuming income stays at 5%. If we slow spending to 4%, income won't stay at 5%, it'll slow.

Then we're going to slow consumption more, and then income will slow, and so what's been extraordinarily virtuous has the potential of being vicious instead. And then maybe, getting back to why we think there's this earnings-yield/bond-yield relationship growth, there's one more extraordinary outlier, and that's illustrated in the black bars on this chart.

Cross-Border Net Equity Purchases
"Wow!" Cliggott wrote in the margin of this chart, which he showed to TSC.

Source: J.P. Morgan


What we've done here is looked at merger and acquisition flows. The bars represent foreign buying of U.S. companies, minus U.S. buying of foreign companies. You can see the explosion that occurred in 1998-1999. Again, I can't really explain this, because I think the way it usually shows up as being explained is, Oh, that's because return on investment is higher in the U.S. than it is any place else, our labor markets are more flexible -- the litany of all true things. But the reality is these things were true in 1995, 1996, 1997, so the only thing that really changed is people's view about investing in Asia.

When all confidence in that vanished, capital focused on the U.S. These numbers are huge. The gross numbers in 1999, foreign buying of U.S. companies, equal $265 billion. That's $5 billion a week. And you look at total inflows into equity mutual funds, which were $2 billion a week. I think this flow has very little to do with the earnings-yield/bond-yield relationship. I mean, this isn't driven by relative value, at least not in that sense of the word.

So our best explanation of why, as we call it, the EY-BY relationship goes down is these massive global inflows that are marching to a different drummer. We think that as the rest of the world gets healthier, global flows into the U.S. are probably going to slow down. So two of the things broadly supporting stocks in the U.S. are probably going to lose some momentum. The next piece of the puzzle for us is, OK, if that happens, then what?

The last time we became very, very dependent on global inflows was 1986-1987, and when they turned, it got pretty bumpy. Our dependence on foreign capital is essentially the same right now. The other thing is, it's been a 40-year trend of getting a little bit more, a little bit more, a little bit more dependent on foreign capital as each year goes by.

The domestic actors in our economy, the household sector and the business sector, as each year has gone by, have gotten a little bit more dependent on debt. So right now, essentially, we're taking on about $1.30, $1.35 in new debt for every dollar we're getting in GDP. I wish these things were trending the other way, but they're not.

For part two of the transcript, click here.