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What's that they say about time flying when you're having fun?

After a half-century in the investment management business, one of the preeminent practitioners of the trade, Steve Leuthold, is relinquishing his roles as chief investment officer and co-portfolio manager of the mutual funds and private accounts at Leuthold Weeden Capital Management, the firm he founded in Minneapolis in 1987 and that now has $3.5 billion under management. He will continue to run the Leuthold Concentrated Core fund, which makes big bets on certain industry groups and asset classes, and is known as the CC fund, after one of Leuthold's favorite beverages, Canadian Club. The investment veteran also will remain on the boards of Leuthold Weeden and of its mutual funds.

Students of market history will be glad to know that he will continue to have a hand in shaping the proprietary research on which the firm's reputation was built. In addition, his card-carrying contrarian musings will still be available in his "View from the North Country" column, published in the firm's indispensable monthly "Green Book," otherwise known as "Perception for the Professional."

The good news is that Doug Ramsey, the firm's director of research and a longtime behavioral strategist, ascends to the post of chief investment officer, responsible for making asset-allocation decisions, running portfolios and overseeing the portfolio-management team. Eric Weigel, a veteran of such firms as MFS Investment Management and Pioneer Investments who recently joined Leuthold, becomes director of research.

Steve and Doug spoke with Barron's about the changes and their defensive stance on the market.

Barron's: You got defensive at just the right time in August.

Leuthold: Thanks to a signal from our major trend index. We both believe numbers are more significant than opinions, including our own, and it worked this time pretty well. When the index turned negative, we reduced portfolios to a 33%-to-34% net equity exposure.
Ramsey: We added a more global perspective within the major trend index, and it couldn't have been more timely. If you look at the Dow Jones Industrial Average and the Standard & Poor's 500, the Dow is off 16% from its high, and only 7% year-to-date. The S&P is down 17% from its high and only 10% year-to-date. Those numbers are completely misleading in terms of the scope of this global decline. Most developed countries and many emerging-market countries are down on the order of 25% to 35%. If you strip out the U.S. from the Morgan Stanley All-Country World Index, or look at the emerging-markets index and compare the U.S. action relative to those, the U.S. trades a lot like a big consumer-staple stock. The weights in consumer staples, and in health care and utilities—the traditional defensive sectors—are so much higher in the U.S. than they are in the rest of the world that the U.S. holds up relatively well throughout much of a typical bear market. That was exactly the case in 1990, when I started in this business, and what we are seeing right now reminds me of then, because the U.S. markets are giving a falsely optimistic view and belying how serious this decline has been.

We haven't reached the technical definition of a bear market on the Dow or the S&P, which would be a 20% decline, and so there is still debate as to whether this is a cyclical bear market, which we strongly believe it is, or just a serious correction. If you broaden your perspective to include markets outside the Dow and the S&P it is very, very clearly a bear market. The typical stock is down 20 to 35%. Some of the financial groups, the brokers and the banks, are down 35% to 40%. The S&P 500 High Beta Index is off 35% from its peak.

For a bear market, corporations seem to be in pretty good shape. Is it more a crisis in confidence driven by politics?

Leuthold: We've got three things going on that are really negative, not considering the major trend index. I have been very concerned about the U.S. and its fiscal responsibility and the problems in Congress. Then there is the euro problem. The crisis in Europe certainly affects the world. Then there's the possibility of a recession. These are major issues getting in the way of a new, significant bull market.
Ramsey: We recently examined the difference between what we call recession-related bear markets in the U.S. since 1945 and what we call noneconomic or stand-alone bear markets that are not immediately associated with recessions. There have been eight economic bear markets since World War II and five noneconomic bear markets. A classic example of a noneconomic recession would be 1987. There were a couple in the 1960s: 1962 and 1966. Interestingly, the magnitude of the decline in a noneconomic bear market is almost the same as it is in an economic bear markets. The median decline of economic bear markets is 30%. The median decline in the noneconomic bear markets is 27%.

Within your major trend index, are there any particular signals that stand out?

Leuthold: A whole section of the index is attitudinal measures. The more pessimistic people are in terms of put-and-call ratios and mutual-fund flows and so on, the more positive it is for the market. Vice versa, when those indicators show exuberance, it is a negative for the market. Those attitudinal measures are very, very positive now. Our intrinsic-value work, which consists of all different kinds of relationships to earnings and book value and cash flow and so on, is now somewhat positive. If we get to between 950 and 980 on the S&P 500, about 30% down from the April 29 peak, that would historically be a good time to start buying stocks, even if the major trend index remained negative.

Do you feel comfortable investing in the bond market?

Ramsey: No. Bonds are an accident waiting to happen. But I think we have grown tired of hanging around that intersection watching for the accident. In a bubble, there is always that final frenetic phase that I'd like to think is mostly completed. This bear market has unfinished business on the downside, and if the S&P is to get back to three-figure territory, which we think is likely, I don't know what the potential low yield would be. The best thing to do is to avoid bonds, rather than to try to actively short them at this point.
For me, one of the long-term tragedies is that the stock market is trading today at a level that we first crossed on the upside back in 1998. I was so bearish then, that had you told me that prices would be unchanged 13 years later, I would not have been surprised. But I certainly would have expected better value would have been re-established in the U.S. stock market by virtue of 13 years of flat action and improving fundamentals. It shows how extreme those late 1990s valuations were.

With the S&P at 1130 as we speak, that's 16.5 times normalized earnings, which is the exact median of the S&P multiple back to 1926. That's a little bit cheap, relative to the past 55-year history, but you would think that after 13 years of going nowhere, albeit in an interesting way, that valuations would look much better. The good news is there is some very good value right now outside the U.S.

Five-year normalized earnings on the MSCI World index are at a multiple of 12.5 times. Emerging markets are at 15.5 times, and I would argue they should trade at a premium valuation, and in the next cyclical bull market they will trade at a higher valuation.

Stunningly, Europe trades at 10 times normalized earnings. The U.S. is trading at a 65% P/E premium to Europe. The historical average has been more like 15%. You could argue maybe there should be some additional premium in this environment, given what Europe is going through, but the odds are that this is going to narrow here in the next 12 to 24 months.

Why has the broad market not fully reflected the viciousness of this correction?

Ramsey: The U.S. is a relatively defensive market. Safe havens are the last to fall, and we are starting to see some of that. That is encouraging. We have seen gold falling in concert with the stock market.

This overall cyclical bear market could be in the seventh or maybe the eighth inning. While the typical noneconomic bear market is almost as great in magnitude, at 27% versus 30% for the economic bear market, the positive news is that the typical noneconomic bear market is much shorter. It tends to last six months, compared with 18 months for recession-related ones. Since the peak at the end of April, we are five months into it.

So we could be seeing a reversal soon?

Ramsey: There could be a fourth-quarter bottom.

What are some positives for the market? Do you view mergers and acquisitions as an area to be enthusiastic about? What's going to provide some support?

Ramsey: The key positive on which I focus is housing. Time has marched on from the housing bubble peak, and currently we are putting up about 600,000 units per year versus a rough estimate of household formation of about 1.2 million per year in this country. We are building about half of what we need. There was clear overbuilding, but each month that goes by we are rectifying that. We are closing that gap by about 50,000 per month. Now the question remains: What was the ultimate scale of the overbuilding? What's the shadow inventory? I don't know, but we were writing about this in 2007 and '08. The cure to an overbuilt housing market is the only reliable cure to any busted asset bubble, and that is time. I don't think the housing market is going to go any lower.

Acquisitions are another positive. Corporations have the cash to expand and make acquisitions. We just saw the largest ever, all-cash industrial acquisition with United Technologies [ticker: UTX] agreeing to pay $16.5 billion for Goodrich [GR]. It's all about rekindling animal spirits, and if this bear market comes to a conclusion here over the next couple of months, and we get a nice bounce, the market itself has a way of firing back up those animal spirits.

What sectors should people focus on?

Ramsey: A couple of health-care groups are on the top of our quantitative rankings. Managed health care, the HMOs, is a group that we have held for quite some time. They are still very cheap stocks. Also, the pharmaceutical stocks. Those would be a couple of more defensive-oriented groups that stand a chance to maintain leadership when the market reverses to the upside. That's as opposed to the classic defensive safe havens like the electric utilities and tobacco, groups that are probably just getting a breath of life more because of the market mayhem than any real fundamental turn.

What about technology?

Ramsey: I am intrigued by the action in the technology sector throughout this correction. Those big Nasdaq stocks, on the whole, tend to underperform in a declining market but they have held pretty firm. The 10 largest tech stocks are down to about 10 times cash flow.

Semiconductor equipment is also a group within technology that looks attractive in part based on valuations, and in part based on the long period of retrenchment that the technology sector has gone through now really over the last eight to nine years, combined with the recent market action of holding up well in a market in which you'd expect them to be downside leaders. In looking forward to the next cyclical bull market—and we could witness the beginning of that within the next month—tech has as good a chance as any sector to be the leader of that.
Leuthold: One concern with the tech group is that their record profit margins are beginning to fade some. On the other hand, they are cheap, and some, like Microsoft [MSFT], are really cheap. There is lots of liquidity. Besides that, for many of them, more than half their earnings are coming from overseas operations and so they are really a global play and not just a play on U.S. technology.
Ramsey: We need to get through this bear market before we start planning for the next bull, but we would expect something fairly similar to what we have just gone through. This was a 26-month run, which isn't too far off the historical median. We need to disabuse ourselves of this recently adopted notion that bull markets and economic expansion tend to last six to eight years. The historical norms are much shorter than that.

What about the financials? Can we begin a bull market again without leadership from the financials?

Ramsey: I would argue that you can see a cyclical bull market take off without the leadership of the financials. You would certainly want some participation but, quite frankly, financials underperformed for most of the length of this recently completed bull market. There was a massive six-month bounce from March through September of 2009, but they have underperformed from there. We've done a fair amount of work looking at busted asset bubbles and also busted bubbles at the sector level and, unfortunately, the financial sector is following the path of the tech sector on a relative basis almost to a T in terms of the wipeout in market losses— 80% over a 2-to-2½-year period.
Leuthold: I wouldn't be surprised if we return to submarket multiples in the banking industry.

Thanks, gents.

By SANDRA WARD

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