First Pacific advisors sometimes seems like the black cloud marring the perfect blue sky of a bull market. Its mutual fund managers, such as Steven Romick and Bob Rodriguez (who is now CEO of the company), provoked scorn — and then renown — for anticipating both the millennial tech crash and the financial crisis. FPA’s funds earned a reputation for protecting capital while delivering nifty results. Romick’s $11 billion Crescent Fund has averaged 10.4% annual returns over the past decade (vs. 8.7% for the S&P 500), even as he keeps a hefty 25% of its assets in cash to limit risk. Romick, who is 49 and has been running his fund since 1993, isn’t predicting disaster. But he’s circumspect, as the Dow Jones industrial average racks up a series of record highs. He spoke to Fortune about staying sober in a time of increased expectations.
Fortune: Should investors have faith in the rally?
Romick: They can believe the Dow has gone up more than 10% for the year. Those are the numbers. Should they believe it’s time to buy stocks, especially now while they’re just not that cheap? We compute price/earnings ratios the way [economist Robert Shiller] does: by dividing the current stock price by a company’s average 10-year earnings. By this measure, the market is trading well above its average since 1970.
I believe corporate profit margins could decrease. They’re at an all-time high, driven in large part by a global decline in tax rates. U.S. companies have more sales coming from overseas and have benefited greatly from this trend. But if the government can drive employment higher, it could create wage inflation that will be very hard to pass on in the form of price increases. This will pressure margins.
Economic growth is middling at best. A perfect example is the jobs statistic. We’ve been told that 2.4 million jobs were created in 2012, which sounds great. But 1.9 million more people became eligible for food assistance last year too. How strong, really, is this economy at its core?
So what should investors do?
Ideally, you want to invest when there’s a lot of fear and prices for good assets fall enough to provide a margin of safety. I was investing in 2008 and into 2009 against a very negative backdrop. Unfortunately there isn’t a lot of fear today. The VIX index [which measures the volatility of stocks] is at 11.5, about half the average level since 1990. It hasn’t been this low since Dec. 29, 2006. By the end of 2007 it shot up to 22.5.
How dire is it?
I’m not saying we’re facing another 2008. I’m just saying things are not as good as people want to believe they are. China could roll over. Foreign investors could finally get fed up with the central bank’s money printing and go on a buyers strike. Who knows? When could any potential disaster happen? I have no idea.
But retail investors face low rates and the need to find yield. Many professionals who may not believe things are all peaches and cream still feel the need to be invested and keep up with the markets. For a period, these trends do push a market higher. Who knows when things will turn?
As a loose guideline I’d say avoid long-dated government or corporate bonds. Don’t reach for return. Avoid MLPs and REITs. And I wouldn’t invest in equities if you need the money in the next few years or if you can’t handle a negative mark in your portfolio in the near term.
What areas might hold up better?
Look for global franchises that are less economically sensitive. Companies that are shielded from [economic volatility] are not currently very cheap, but at least they provide a little margin of safety in their ability to generate earnings during shaky times.
What stocks should people buy now?
While I don’t have anything I could pound the table on, since things are so expensive, I do like AON, a large insurance brokerage. That’s a company that is protected a bit from an economic downturn. Or WPP, the global advertising company, which won’t be as affected as some others during a downturn. If the stock dropped 20%, I’d be a happy buyer. We bought shares of an Oslo-based company called Orkla in the middle of last year. It’s a leading branded food company in the Nordic region, and it’s getting rid of its noncore assets and redeploying the capital back into the food business. It’s controlled by a Norwegian billionaire who made his fortune in the supermarket industry. I also like AB InBev.
What’s your biggest concern about the economy?
The Federal Reserve cannot keep managing interest rates at these levels forever. It’s an incredibly dangerous strategy. Since the beginning of time, I don’t think an economy has successfully grown with government involvement to this degree. Here’s another way to look at it. Overlay an equities chart over a chart of the expansion of the Fed’s balance sheet. I’m pretty sure the risk assets will move higher just after the Fed makes its moves.
Eventually interest rates will have to rise, and that move could choke off the recovery. If rates rise, you’ll finally be able to see how the zero-interest-rate policy perverted capital allocation by pushing investors to do things they normally wouldn’t do because they need or want to find yield.
This story is from the April 8, 2013 issue of Fortune.
Update: An earlier version of this article incorrectly described Aon as the world’s largest insurance company. It is a global insurance brokerage and provides risk management and other services.