Get Ready For: Declines, Recoveries, And Growth - Blog #537

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by: Mike Lipper, CFA

One of the prior major stock market declines was signaled when the O'Hare airport authorities would not let United Airlines (NASDAQ:UAL) sell its gate positions to reduce its debt. We may be approaching a similar signal. Media reports that after 31 years of owning the management company for Oppenheimer Funds, Mass Mutual Insurance is considering putting it up for sale at around 2% of assets under management. While this may be a fair price, many professionals would treat this result as negative because it is below full bull market valuation. At the same time, the much respected T. Rowe Price (NASDAQ:TROW) (*) is reducing its commitment to large-cap in favor of small caps and international on the basis of valuations. Both of these elements are good reasons to prepare for future declines, recoveries, and growth as discussed in this blog.

As a long-term investor in search of other long-term investors, we are confident that we collectively will experience declines, recoveries and growth. So much for recorded history, but the value of history is primarily the recognition that these types of events happen. Far too many look for history to be repeated exactly, without adjusting for the dynamic changes of the past. My task is not only to understand history, but to also understand the changes that will modify future paths.

We know that declines, recoveries and growth will happen because greed and fear exaggerate the natural cyclicality of nature. Successful predictors can use this for future events or dates, but should never predict both. That is why I can envisage the three events mentioned, but I clearly don't know when they will occur or their magnitude. However, what I can do is prepare my thinking for each of these inevitabilities.

Declines

There is no question that there will be future declines in both the stock market and the global economy, which are often related, but not always.

As with most wars, there are underlying causes of critical imbalances which can be readily observed, but there are also unpredictable flash points, e.g. the assassination of the Arch Duke. Populations and their governments can manage through declines reasonably safely, or they can overreact and try to correct both the imbalances and the bad actors. Based on the historical record in this country, overreactions can lengthen and deepen declines. Many of those who lost lots of money in the stock market crash of 1929-1932 and 1937 discounted their prior gains on paper then swore they would never return to investing in stocks. They and their families missed out on participating in the benefits of the long bull markets of the 1960s and post 1980s.

Strategies and Tactics

Essentially, there are two strategic approaches: abandon or ride through. Neither works particularly well if they are followed minimally. The abandon strategy promotes a misplaced sense of safety because it does not recognize inflation. As long as governments spend more than they take in, we will have inflation eroding currency values.

The ride through the crisis approach assumes more than a full recovery, including perhaps some inherent gains for the loss of income during the period. Clearly, even under the best of circumstances, not all commercial entities will survive, but most will. However, it may take time. One of the high flyers in the excitement of the radio era (read mobile phones or the Cloud) was the old Radio Corporation of America (RCA). The stock price of RCA did not reach its pre-depression price until the 1960s, on the back of the promise of color television. Also, many farmers lost their lands to foreclosure due to leveraged borrowing.

Few investors fully subscribe to the two strategies of abandon or stay put, utilizing tactics that address some of the concerns and opportunities of each. Some build up cash reserves, but there are two drawbacks to that approach. Firstly, a study of mutual fund portfolios and performance suggests that unless cash reserves exceed 25% of the portfolio near the top, it will only satisfactorily cushion a typical cyclical decline of 25% or less, not a secular decline of 50% or more. The second drawback, which a study of portfolio manager behavior reveals, is that there is too much comfort in cash and these portfolio managers miss out on buying cheap bargains.

There is another approach that probably works better for long-term investors, that is to gradually move equity portfolios into more defensive stocks. These stocks are generally absent in most market commentary and are often found by examining the rosters of relatively underperforming sectors and stocks lagging near the peak of the market. To me, two of the better hunting grounds for these searches are international and dividend paying "value" stocks.

International

There are two long-term reasons to invest internationally. First, it is a hedge against the larger domestically traded stocks/funds in your portfolio. If one looks at our rank in terms of standard of living in the US compared to other countries, we have been slipping for some time. The main reason for the relative strength in the dollar is that we are living in a period where almost every other country has threatening dissident groups, whereas our currency is perceived as safer than others.

Using mutual fund performance averages based on their investment objectives, of the 18 global and international fund objectives versus their US focused peers, only in real estate is the foreign fund better. I suspect that at least half the performance superiority in the first seven months of 2018 is the direct impact of the strength of the US dollar, which is unlikely to continue forever.

In many ways, the more hopeful and sounder reason is that selectively there are many more opportunities outside the US than in it. There are world leading companies beyond our borders in technology and natural resources. Occasionally, these stocks are priced more attractively and their younger populations create an attractive market opportunity. Educational standards and wealth are rising both in Asia and Africa, which should be fertile for investments long term. Thus, for defensive (hedging) and aggressive (demographic) reasons, investing internationally makes sense, particularly if one uses select funds for administrative and liquidity reasons.

Value

In utilizing value for diversification purposes, I am excluding "deep value", which requires corporate actions, mostly mergers or acquisitions (M&A) to work out. Most M&A occurs during expansionist periods, not declines, so it may not provide much downside protection. For diversification purposes, the ideal value stock must have a history of paying dividends with an average payout ratio of about 50%-75%, with a history of raising the dividend rate at least as much as recognized inflation. "Trust quality" or above BBB credit rating would also be good. Some strong institutional ownership would be a plus, as would a reasonably liquid stock. Some and all of these characteristics are found in average in some mutual fund portfolios.

Recovery Candidates

Product or service providers that are likely to be considered essential in the future include those that have sufficient management depth beyond the CEO to be the next generation of sound leadership. Also attractive are those companies that have surplus borrowing power to take advantage of product and corporate opportunities which may occur in troubled times.

Growth Candidates

Growing target markets rather than growth in market share is an important growth criteria. A multi-generational attitude also helps in the selection for legacy investment accounts. Sufficient internal research & development open to external sources would be best.

Fund/Manager Selection Tips

If the bulk of one's assets and dreams are tied up in one asset, diversification should lean toward a couple of portfolios with a reasonably large number of securities, with the portfolios different in investment style. For the asset owner that is more liquid, a portfolio of concentrated funds that complement each other rather than compete for attention is preferable.