Market Update:
Erring on the Side of Caution
March 7, 2009
By John Apruzzese
Partner & Equity Portfolio Manager
History suggests that stock prices are too low but a recovery depends on effective government policies.
A daily glass of red wine may be good for your health. A bottle a day is not a good idea.
2008 was an abject lesson in the dangers of excess. Leverage, derivatives, structured finance and hedge funds all have utility; it was their overuse and abuse that caused problems. Likewise, the self-interest that is the engine of capitalism was left unchecked by appropriate regulation and enforcement, putting the financial system itself at risk.
The economy today
As a result, today's economic environment resembles something not seen since The Great Depression. The nation's nominal Gross Domestic Product (GDP) decreased at an annual rate of 4.1% in the fourth quarter and it appears that reported S&P 500 earnings for the period will also be negative. The national unemployment rate looks to be heading toward double digits, after surging to a 26-year high of 7.6% in January. This-combined with the recent implosion of formerly blue-chip companies including Bear Stearns, Lehman Brothers, AIG and Citigroup-is resulting in an unprecedented loss of investor confidence and market volatility.
What this means for the markets
What does this mean for investors over the next several years? History shows that, at times like these, stock prices tend to be too low, with high future returns in the offing and we believe that current prices offset the current level of uncertainty.
But markets can go to further extremes in the shorter term and calling the bottom is impossible, particularly as we wait to see how efforts by Treasury, the Federal Reserve and Congress impact the credit markets and the overall economy. Our sense is that the Treasury's Toxic Asset Relief Program (TARP) and the Fed's expansion of its balance sheet are necessary steps while the stimulus program will not be as effective as hoped and may result in an undesirable level of inflation.
With uncertainty and volatility recently hitting historic highs, we believe investors must err on the side of caution and portfolios should be positioned with stocks and other risky assets at the lower range of our more conservative investment policy guidelines.
A shift in investment policy
In the current environment, we believe that a typical long-term investor-those seeking an after-tax return above inflation with some income-should have no more than 50% of their portfolios invested in stocks and other assets with equity-type returns, such as corporate bonds. This represents a shift from the past twenty years, when a normative asset allocation was as high as 65% in stocks or similar assets.
While we do not expect a dramatic change in this recommendation in the near term, we are prepared to tactically increase our stock weighting when volatility abates and corporate profits appear to bottom.
Income-oriented investors may wish to be even more risk averse and have a greater allocation to fixed-income until early signs of inflation appear. Well-researched municipal bonds are presenting opportunities as credit concerns, supply and demand imbalances, and structural changes in the tax-exempt market have led to increased price volatility. AAA-rated municipals offer taxable-equivalent yields that exceed comparable maturity Treasuries.
Establishing a core equity portfolio
To build our core equity portfolio for these years ahead, we are currently identifying companies that have the potential to limit losses amid present challenges and outperform in a recovery. We want to strike a balance between those with strong stable businesses that do not require outside financing and more cyclical companies that are being priced as if the economy will never recover. We expect to hold these companies for many years, as part of our tax-efficient strategy. The companies we like fall into three main categories:
Deeply discounted Microsoft (nasdaq: MSFT), MasterCard (nyse: MA), Monsanto (nyse: MON) and Abbott Labs (nyse: ABT) are high quality companies with staying power that are trading at levels not seen in decades. All four have the ability to grow earnings and dividends though the downturn, will have double digit earnings growth and are increasing dividends. Each sells for less than 15 times earnings per share.
Slow and steady Wal-Mart (nyse: WMT), Accenture (nyse: ACN) and Avon Products (nyse: AVP) will have modestly positive earnings growth this year and next, positioning them well for the economic recovery. They sell for no more than 11 times earnings per share.
The survivors Goldman Sachs (nyse: GS), CME Group (nasdaq: CME), and Noble Corp. (nyse: NE) are all in industries significantly impacted by the recession but will be the survivors. They are strong companies with the capacity to weather the storm and come out stronger. They represent unusual value.
The future of regulation
Of course, the markets can only recover when investor confidence is restored and a new regulatory regime must be a part of that. The financial industry has always required significant government oversight because of the potential for fraud and the excessive use of leverage. Bank runs were a common occurrence until the banking system was restructured in the 1930s, during which time more than half of all the banks failed. Federal deposit insurance was an effective solution for over 70 years, but innovation demands that regulation and enforcement catch up to the changed structure of the financial system.
John has more than 24 years of experience managing balanced investment portfolios for affluent individuals and their families. You can email him at apruzzese@evercore.com.