The future rarely unfolds according to popular expectation.
That is certainly true if we look back to last January when most professionals expected a shallow economic downturn marked by a quick “v-shaped” recovery.
We warned of a much more significant recession as a result of the unwinding of a massive credit bubble, years in the making, and advocated a more cautious investment approach. Things turned out far worse than even we expected.
The entire financial system went into severe distress, and many long-held beliefs about the way things are, were turned upside down.
Our client portfolios and mutual fund weathered the storm relatively well. But it was a difficult year none-the-less and has caused most people to question the assumptions they once took for granted.
So where to now?
There are many countervailing forces at work, good, bad and otherwise, and it is unclear how they will resolve themselves, especially in the near-term. Big gears are in slow motion.
This is not a typical downturn, nor will the recovery be typical. Those that claim to have easy answers are likely wrong and should be treated with skepticism. Simplistic analysis based on recent history ignores the scope and complexity of the circumstances.
But despite the uncertainty, many things are knowable and it is possible to plot a sensible investment course forward governed by both a short and long-term perspective, and a keen focus on fundamentals, valuation levels, and current conditions.
We proceed with caution, with a current bias towards capital preservation and income.
We had become more positive last November and increased our exposure to domestic equities significantly. The stock market has had an impressive rally off of its bottom, reflecting hope for new government and a quick, massive and effective dose of fiscal stimulus. In our view, expectations have once again, gotten ahead of reality.
There are attractive opportunities to be found - especially in the area of domestic high quality dividend-paying stocks and corporate bonds - but we suspect there will be more opportunities down the road.
In this commentary, we review our current outlook and identify twelve guiding ideas that reflect our current point-of-view and shape how we are managing client portfolios into the New Year.
Sickness and Cure:
The world economy is sick, suffering from a chronic dependency on easy credit, excessive consumption, instant gratification, and a rampant disregard for risk. In the United States, we have built a consumer culture of excess and gluttony, and charged it all on our credit card. Outstanding consumer credit is over $14 trillion, or roughly equal to GDP. This is a very large problem, a long time in the making, and it won’t be cured quickly.
The U.S. economy is the posterchild for the disease, but the problem is truly global, as high hopes and cheap capital have financed overindulgance and overcapacity from Iceland to Dubai. Already, banks around the world have written down over $1 trillion in assets and raised almost as much in new capital. There are more write-downs and capital raises to come.
The problem is made worse by securitization and financial engineering. All the debt has sliced and diced into an impossibly complex jigsaw puzzle of tiny pieces and scattered across the globe. Like Humpty Dumpty, it is very hard to put them back together again.
The result of the sickness is a colossal unwinding of private sector debt, a precipitous drop in demand for goods and services, and a resulting deflation of asset values. Put simply, there is too much stuff in the world relative to the demand for that stuff.
Prices for stuff of all sorts – homes, buildings, cars and trucks, commodities, and financial assets, will continue to fall until they reach a point where buyers are attracted into the market and demand balances with supply.
The result of the economy and markets finding this new point of equalibrium will be a major transfer of wealth from sellers with too much debt who are forced to sell, to buyers with ample cash who choose to buy.
The symptoms of the disease are not only economic, but also societal and political, threatening to cause social unrest and destabilize governments from small municipalities to large countries.
A massive amount of cure is being thrown at the sickness, and with it a corresponding increase of public sector debt.
Although many vital signs continue to deteriorate, there is a growing sense that the disease is chronic but not fatal. We will get through this. Problems beget solutions. Economies and markets will bottom and begin a long, slow and difficult process of healing and rehabilitation. Corporate balance sheets are strong and there are large pools of cash on the sidelines waiting for the right opportunity and greater confidence in the future.
Despite the substantial amount of monetary and fiscal stimulus, it will take time for many of these policy measures to take root and sprout. In the meantime, we will very likely see things get materially worse before they start to get materially better. Hence our current preference for cash and caution.
The following 12 guiding ideas govern the types of investments we are selecting for our clients, and how we are allocating them in their portfolios.
1. Back to fundamentals: We do expect more rational and orderly markets this year with less panic and forced selling, and more discrimination between assets based on their fundamental virtues. Good assets will rise to the top.
2.Tailwinds are now headwinds. The combination of easy credit and rising home and asset values inflated GDP growth. Debt served like a performance-enhancing drug, helping to boost corporate profitability as well as expectations for future demand. With tight credit and deflating asset values, corporate profits and profit growth will be under pressure, as will the multiple that investors are willing to pay for them.
3.Deflation before inflation. Inflation and escalating government debt will be long-term challenges for the economy. But not yet. The deflationary pendulum has further to swing before it reverses course.
4. Innovation is key. We cannot borrow our way out of debt. The solution to our problems is not to go back to the way we were. We need to innovate and grow our way back to economic health and prosperity and we won’t accomplish that by subsidizing and protecting wastefulness and inefficiency nor by squelching innovation. The forces of innovation remain strong in the United States and elsewhere in the world and should not be underestimated.
Still, the deficits created by the cure will be a large ball and chain on the economy for years to come. It will take a lot of electric cars, windfarms and other innovations to pull this load along.
5. Cash is king. Corporate balance sheets are in better shape than the government and the consumer. Companies with substantial cash reserves have a huge competitive advantage over those with debt. They can invest in new projects and acquisitions that move them further ahead while their competitors struggle for life. Emphasize cash rich companies with strong balance sheets.
6. The strong get stronger. Much stronger. Well-managed and well-financed companies will emerge from the downturn in much stronger competitive positions. They will have fewer competitors, more customers, and greater capabilities. Emphasize the best of the best.
7. Dividends are back in vogue. Quality companies with high dividend yields provide attractive current income at favorable tax rates and the potential for capital appreciation over time. Like in the 1970’s and early 1980’s, dividends will likely represent a large part of a stocks’ total return to an investor. Emphasize companies with strong balance sheets and secure dividend yields.
8. The U.S. consumer economy is over-borrowed, over-shopped, over-stored and under-saved. The spending glut will give way to a savings boom. Beware companies dependent on discretionary consumer spending.
9. The U.S. economy is underinvested in infrastructure, alternative energy, healthcare technology and education. The governemnt will direct a large portion of its fiscal stimulus program into these areas. Get in the way of new government spending.
10. Corporate bonds offer attractive income and potential for appreciation. Yields are at historically high levels and offer good potential for income and appreciation. Municipal bonds also offer attractive tax-free income although we are more cautious in this area and are focused on general obligation bonds.
11. Developing markets continue to develop. In the near-term, the economic crisis has yet to fully play out in developing economies like China, Brazil and India. Over the long term, these economies have strong balance sheets and the greatest potential for sustainable GDP growth. They will attract a growing amount of the world’s capital. Favor China and Brazil and avoid Europe.
12. Defensive driving is the rule of the road. This is not a textbook recession and should not be treated as such. Recent history will likely be a poor predictor of future events. The problems are bigger, the solutions are bigger, and events and institutions around the world have never been so closely connected as they are today. We plan to stay nimble and drive defensively, adjusting strategy quickly in response to changing events.
Although the declines in value in global equity and credit markets have been dramatic, it is wrong to assume that past levels were rational and will be regained any time soon. What matters now is what is and what will be. Past is past. Tomorrow is a new and very different day.
Growth will be harder to come by and valuation multiples will shrink. Balance sheets, book value and free cash flow yields will rule.
And so despite their dramatic drop, we do not find U.S. stocks to be a particularly compelling bargain based on near-term fundamentals. We are more a fan of individual companies and sectors that reflect our guiding ideas. Relatively speaking, bonds still look very attractive to us.
We have therefore recently reduced our overall exposure to domestic equities and increased our exposure to fixed income, especially in the area of corporate bonds and bank loans. For taxable investors, general obligation municipal bonds also offer attractive yields. Treasury bonds are very overvalued and should be avoided.
We expect markets to be volatile and to rise and fall with waves of hope and disappointment, and we will continue to make changes to asset allocation in response to changing conditions.
Our clients will therefore likely see a higher level of turnover than they have traditionally experienced in their accounts, but these are not ordinary times. We have our own money invested alongside our clients and would rather err on the side of caution. Our caution served clients well in 2008 and it is our intention to lead them successfully through 2009 in similar fashion.
As always, we welcome your questions, referrals and the ability to be of service.
Jurika, Mills & Keifer,