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Recalibrating risk and reward after the last month's market rout
08/19/2011 2:28 am EST
It’s not just that the U.S. Standard & Poor’s 500 fell 18.3% from its July 21 intraday high to the August 9 intraday low. Or that the German index, the DAX, is down 15% in two months. Or that emerging markets such as Brazil and Shanghai spent time in actual Bear market territory.
But we’ve also seen EuroZone leaders unable to put a period to the euro debt crisis. We’ve seen the Standard & Poor’s credit rating of the United States go from AAA to AA. (Fitch Ratings re-affirmed the U.S. as AAA on August 16.) Japan has slipped back into recession. Inflation has topped official targets and shown itself stubbornly resistant to central bank policies. Economic growth has slowed or threatened to slow in most of the world’s economies.
Trends that investors depended upon to value stocks—or to tell them where and when to chase momentum—have been broken, damaged, or threatened.
Stocks are cheap in most of the world’s stock markets—if past trends are going to reassert themselves after a short interruption. If the trends are truly broken, however, who knows? What’s a Google (GOOG), or a Vale (VALE) or a Baidu (BIDU) worth if domestic and global rates of economic growth are about to drop by a percentage point or two points or more—or less?
You do have the option of stubbornly insisting that “things” are headed back to normal. Or that growth and stock prices will revert to the mean. But that’s just begging the question of what normal is and where the mean might be. Unless you’re willing to throw out the data from the last decade (or more, I’d argue) on economic growth and the performance of individual asset classes, it’s hard to come up with a long-term trend that can be convincingly projected a decade into the future. And even then your trend line would still have to come to terms with changes in global demographics and the global economy that, to me, say for the next decade it will indeed be different this time.
To the degree I can I prefer not to make investing a matter of faith or a gamble on alternatives with unknowable odds of success or failure.
“To the degree I can” isn’t a very large measure right now. For example, I think the most likely range of U.S. economic growth is somewhere between 1% and 2.5% for 2011 and 2012. Doesn’t sound like much? Just 1.5 percentage points? Certainly but the swing is 150% from the minimum and 60% from the maximum. And, of course there’s no guarantee that the actual outcome will fall within that “most likely” range. (We've got some recent experience in results that fall into the narrow tail of improbable outcomes but that nevertheless turned into very real outcomes.)
And the United States isn’t by any means the hardest economy to handicap right now. Brazil is inflating its own credit bubble, the government’s will to restrain wage increases is certainly questionable, and inflation is not under control. In the EuroZone the European Central Bank has seriously damaged its credibility leaving the restoration of confidence to political leaders who won’t lead and an untested European Financial Stability Facility that isn’t yet ready to go into operation. Indian politics make U.S. politics look like a model of rational discourse and while the Reserve Bank of India may be the last adult in the room, any parent will tell you that batting the children around doesn’t usually produce good behavior.
I could go on. But I think you get the point.
I don’t think there’s a magic method for bringing reasonable certainty to our projections about the global economy and about most national economies. We’re stuck with the fact that these are uncertain times. The result of that, unfortunately, as that I think it’s very hard to tell in most parts of the financial markets, and especially in the global equity markets, what the risk might be. You can calculate the reward, but not the risk. That’s the investing equivalent of dividing by zero.
But I do think there are three pieces of the global equity markets where the risk/reward proposition is not just calculable but is actually running in investor’s favor at the moment.
First, there are dividend-paying stocks. If the global economy continues to slow, global interest rates will be headed down and that will make dividend yields worth more. (The value in a 3.5% (or better) dividend yield on a stock such as EI DuPont (DD) or Abbott Laboratories (ABT) when the 10-year Treasury is hovering near 2.2% should be clear to most investors.) The proposition gets even more attractive when the dividend is paid in a strong currency such as those of Norway, Sweden, Switzerland, Australia or Canada. Take a look at the 5% yield from Norway’s Statoil (STO in New York and STL.NO in Oslo.) Australia’s Westpac Banking (WBK in New York and WBC.AU in Sydney) pays even more, 7.3%.
I can think of two kinds of downside risk. The individual company won’t be able to keep up dividend stream. I think you can minimize this risk by buying shares with strong cash flows behind them. The global economy might do better than expected leading to higher interest rates and higher inflation, both reducing the value of your dividends. Which is why you’re also looking to buy strong businesses—shares of these stocks should go up if the economy grows more quickly than is now anticipated.
Second, there are shares of domestically-oriented Chinese companies. I’m not sure I’d say that China is enjoying the global economic slowdown—Chinese exporters are seeing sales fall—but the Chinese economy—and especially the Chinese domestic economy--comes out on the plus side when everything is added up. A slowing global economy probably means an end fairly soon to China’s interest rate increases. The consensus, which can, of course be wrong, is that the People’s Bank won’t risk China’s economic growth during a global slowdown by raising interest rates more than once more. (And end of rate increases would remove a big weight from stock prices.) The government in Beijing seems to be picking up the inflation-fighting slack by allowing the yuan to appreciate slightly more quickly. That has the effect of reducing the growth of the country’s money supply—and of increasing the buying power of Chinese consumers. I think adding to positions in domestically-oriented Chinese companies such as Baidu (BIDU) and Tencent Holding (700.HK) or in overseas companies that sell to Chinese consumers such as Yum! Brands (YUM), Sands China (SCHYY), and Coach (COH) would be a good way to play China’s relative growth advantage.
Third, there are the shares of U.S. exporters, especially those that sell to China. A stronger yuan—and a weaker dollar (How long can the safe haven effect balance out a slowing U.S. economy?) elsewhere in the world—makes U.S. products cheaper to customers. I think this will help U.S. companies pick up some more market share, which in many cases should be more than enough to offset any slowing in an economy such as China’s. That is, in fact exactly what Cummins (CMI) said in a recent conference call where the company talked about a temporary slowdown in Chinas sales but a gain in market share over the slightly longer time frame. Besides Cummins I’d look to shares of Johnson Controls (JCI), Joy Global (JOYG), Borg Warner (BWA), and Timken (TKR).
No guarantees that these stocks will go up. If there’s a global sell off, they’ll go down with everything else. But if the global economy just stumbles along, these shares should beat the market indexes. And, in my opinion, the risk/reward ratio comes out on the right side of the wager.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Baidu, Coach, Cummins, DuPont, Johnson Controls, Joy Global, Statoil, Tencent Holding, Timken, and Westpac Banking as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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