Bear On The Loose At Merrill Lynch

Why its investment-strategy team favors bonds over stocks

An old pro at handling live interviews with CNBC anchors, Charles I. Clough Jr. nonetheless found himselF on the spot one Monday morning late in January. Pointing out how the chief investment strategist at Merrill Lynch & Co. has been cautiously advising clients to keep most of their assets in high-quality bonds, CNBC's Consuelo Mack bore down. Fifty-five percent in bonds, she mused, was "a very gutsy call."

No, Clough protested, "this is not a defensive strategy at all." But next to Merrill's rivals on Wall Street, it's downright bearish (table). It also is a stance that Clough and his colleagues at the world's biggest brokerage firm must take pains to explain because, at least since last summer's swoon in stocks, it has been wrong.

Clough, Merrill's top guru since 1987, has been bearish for several years now. In early September, he suggested the Dow Jones industrial average might sink an additional 15% or more before stabilizing. Instead, from its closing low on Aug. 31, the Dow has leaped almost 24%, while the broader Standard & Poor's 500-stock index has surged nearly 31%.

"INTEREST-RATE BULLS." Even as such rivals as Lehman Brothers Inc. advised clients to continue holding as much as 80% of assets in stocks, Merrill Lynch last summer kept advocating just 40% in equities. More prominently, the brokerage firm directed its brand-new advertising agency, WPP Group's PLC's J. Walter Thompson, to buy a series of cautionary, full-page newspaper advertisements. One of them, "Putting the world in perspective," noted Merrill's preference for quality bonds and such defensive stocks as utilities. "The global marketplace," it noted, "is getting more complex and uncertain every day."

This is Merrill Lynch?

The firm's outlook is a far cry from the image Merrill has so long cultivated via its logo--a bull, ready to charge--and its venerable slogan, "Merrill Lynch Is Bullish on America." Charles V. Mangano, Merrill's senior director of marketing, describes the skittish ad instead as "an evolution" of the firm's trademark optimism, "a very, very tactical assessment of what was going on in the world, because the markets were gyrating the way they were." A new campaign set for early March, he says, "will be just as optimistic and hopeful as the bullish [on America] one was."

If so, the campaign will surely clash with the steadily downbeat advice Clough has been offering on stocks, which flows from his fundamental belief that the world economy suffers from too much capacity and, with it, price deflation. So, he says, profit margins will narrow, corporate investment will dwindle, and the U.S. economy will slow. That in turn will cut a point or so off rates on long-term Treasury bonds, creating the prospect this year of a 27% total return on long-term Treasuries--a better bet to Clough than the single-digit gain he sees for the major stock indexes. "I like to explain our position this way," Clough says: "We're interest-rate bulls and profit bears."

Merrill also may be sounding more cautious as its clients' needs change. Take Brent Burval, 28, a civil engineer in Phoenix who has had an account with Merrill for six years. The cash Burval periodically puts into his account gets invested automatically in mutual funds, a setup that suits him just fine. "I think they're a good outfit," he says. "They're pretty conservative." Burval says he pays little attention to the firm's research, and if he wants to buy an individual stock, he uses E*Trade: "They've got lower commissions and stuff." That fact, says discount broker Muriel Siebert, "is pressuring all full-service firms" to develop new roles.

UNAPOLOGETIC. These broader money-management goals of Merrill go well beyond the aims of simple stock trading that were at the core of the firm's business when it came up with its "Bullish on America" slogan in 1971. And they do bear on Clough's work. "Today," he says, "as Americans age, we are older, retirement is a little closer, and in an environment like that, I think money management is a much more complicated event. For one thing, preservation of capital becomes more important."

Of course, it never hurts for gurus to hold a contrarian view. More conventional--and a better money-maker--has been the advice of such strategists as Lehman's Jeffrey M. Applegate and Gruntal & Co.'s Joseph Battipaglia, who expect the economy, corporate profits, and stocks to remain strong this year. Applauding Clough's consistent logic and long-running correct bet on bonds, Battipaglia notes the Merrill model has nonetheless led Clough astray on stocks.

About all this, Clough seems little worried. He puts off a question about whether Merrill brokers are impatient with him as "silly stuff. All they're looking for from me is ideas." Ironically, the firm's "focus list" of 15 U.S. stocks, including such names as Pfizer and Johnson & Johnson, is up a solid 6% since being issued in December. Clough has suggested more aggressive moves overseas to exploit such beaten-down markets as Korea and Japan, which dovetails with Merrill's rapid foreign expansion.

As for preferring bonds to stocks, Clough is unapologetic. "It's the best spin on events we can come up with," he says. "We think it'll be a money-making strategy. And we'd argue it was in 1998. The 30-year Treasury actually outperformed the average mutual fund rather handily," 18% vs. 14% in total return. He views the big, red-hot stocks, names such as Microsoft and Dell, dimly. "Every mutual fund, every pension-fund manager, they've all wedged themselves into the same 15 stocks, and they're kind of expensive," Clough says. "Will they stay expensive? Yeah."

Clough's cautious views may yet prove sound. But that won't square it any better with Merrill's old image. "The day that Merrill Lynch doesn't come across as optimistic and confident," says chief marketer Mangano, "then we probably all have a problem."