Leuthold Group downshifts to Neutral on stocks

Steve Leuthold is the Chief Investment Strategist for the Leuthold Group, a research boutique and mutual fund manager who charges pension fund and hedge fund managers thousands of dollars for his research. In business since 1981, his "green book" is a combination of original, thematic oriented technical and quantitative analysis, and some of the best jokes in town (for good measure). His core mutual fund (LCORX) was launched in 1987 and since 2000 has outshined its category average in 7 out of the last 8 years. It beat 98% of its peer group over the pat 3-year, 5-year, and 10-year time periods. Leuthold's Core Investment Fund has a very flexible investment mandate. It is a balanced fund, so it typically has some bonds in it to reduce risk, but Leuthold is willing to commit money to a wide variety of investment ideas, and typically looks nothing like the Vanguard Index 500 Fund, so Morningstar has it classified as a "high risk" fund.

I think manager flexibility is a good thing, particularly when your manager's insights are good enough that other fund managers will pay him thousands of dollars for his insights, so it doesn't bother me that the portfolio refuses to be a closet index fund. I figure that clients are paying him a fee to exercise discretion, but the Morningstar analysts see things differently.

(This wouldn't be the first instance where I have rejected conventional wisdom in setting Scout Partners investments discipline.)

In last weekend's Barron's interview, Leuthold notes that as a result of the recent run-up in the stock market, against a backdrop of rising interest rates and a slowdown on the consumer side of the economy, Leuthold lowered its stock allocation to neutral. Defensive a year ago, late last year the strategists warmed to stocks so they were able to benefit from 2007's run-up in the market.

More recently, though, he has written in his Green Book about some parallels to 1987. In 1987, leveraged buyouts were taking shares out of the public market, so Wall Street was talking about a "shortage of stocks" as valuations ran higher. Interest rates, too, were rising in 1987, although at much higher levels than at present. Inflation was rising, and the economic expansion was getting long in the tooth.

Leuthold notes that Leveraged Buyout (LBO) teams are paying 33% to 40% more to take over companies in 2007, based on cash flow, and commented wryly that "everybody and his brother is running screens as to who the next likely leveraged buy-out candidate will be." He wasn't so concerned that these private equity deals will cause a problem, but they represent a lot of potential equity issuance in the future that could cap any sort of future market recovery.

From my point of view, the LBO teams are making a classic end-of-cycle mistake, loading up on equities using borrowed money, just because market and economic conditions, at present, remain positive. Buying on margin after the market has already appreciated 50% isn't how the smart money gets rich, typically.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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