Gastbeitrag Martin D. Sass
A good Time for Reallocation
Investors should reevaluate their portfolios in view of the risks and rewards of likely scenarios. The stock market is one market where people run away from “fire sales”, instead of using them as opportunities to invest in great companies at bargain prices.
of M.D Sass Investor Services Inc.
In my 49 years of investing experience I have always found it profitable to invest more aggressively when the environment is fearful and panic selling leads to steep discounted valuations for great companies. The highest degree of fear results in capitulation and market bottom.
The plunge in global equity markets since July reflects rapidly decelerating economic growth and a loss of confidence in the ability of politicians to resolve today’s issues. The U.S. and Europe are facing a challenging liquidity trap (like an engine flooded with fuel but lacking a spark) at a time when there are limited available fiscal and monetary responses. There is a threat of a vicious negative feedback loop, wherein businesses and consumers become more defensive and slash spending at a time when economics and financial markets are deteriorating.
Policymakers are behind the curve and face a delicate balancing act that requires powerful short term fiscal stimulus (i.e. job creation measures and coordinated global action) and strong medium to long term fiscal austerity. Unfortunately, politics on both sides of the Atlantic are presenting barriers against quick resolution. Investors are understandably wary in the absence of ultimate and credible solutions. Markets are beginning to price in the risk of bad political decisions in these uncertain times.
Eurozone debt crisis
Investors should reevaluate their portfolios in view of the risks and rewards of likely scenarios, including reversions in risk aversion. Investors should thoughtfully prepare to reallocate to sectors that offer exceptional investment opportunities while reducing risk in crowded trades and potential bubble areas.
I will discuss the outlooks for the debt crisis and economic slowdown in the U.S. and Europe as a backdrop for evaluating the risk and reward of three potential economic scenarios and then discuss specific investment ideas.
The worst of the problems lie in Europe’s lack of an ultimate solution which is coming closer to the end game in the 2 year sovereign debt saga. The new Managing Director of the IMF, Christine Lagarde, has called for an “urgent recapitalization” of European banks to prevent a global recession.
European banks have sizable cross exposures with each other and sovereign debt markets and are having trouble financing because many would go bankrupt if they had to mark to market their sovereign debt holdings. The 17 Eurozone nations are too diverse and their lack of a unified fiscal policy, political structure and governance is threatening the common euro currency zone. The time to act is now since there is a worsening vicious circle between sovereign debt and the European financial systems at a time when economic activity is deteriorating
Fears of double-dip and political gridlock in the U.S.
There is heightened risk of a U.S. double-dip recession, with the recent loss of economic momentum. Surveys are flashing warning signals. These weak sentiment survey have moved in the opposite direction of more direct measures of activity (i.e., consumer spending, store sales, rebounding vehicle sales and jobless claims), which has resulted in increased economic uncertainty. Regardless of what President Obama proposes to stimulate the economy, he won’t do much more than extend current policy. The Federal Reserve has now implemented Operation Twist at the FOMC meeting on September 20-21, in which it sells short-term Treasury notes maturing within 2 years and buys longer-term Treasuries maturing in 10 to 30 years. However, with long-term interest rates already at historically low levels, pushing them lower won’t materially change the outlook.
The macro environment is driving U.S. equities currently
U.S. stocks have been moving in tandem, with the S&P 500 index of cross- correlation having spiked to a record over 80 %, even higher than the peak reached during the financial and economic crisis in late 2008. Record high cross-correlation in the S&P 500 reflects macro driven markets which are unrelated to fundamentals of the individual companies, exacerbated by computer trading which account for about 70 % of overall trading volume. This has left equities of several great companies with strong balance sheets, attractive growth prospects at extremely undervalued levels.
U.S. Treasury yields briefly declined to new lows just below the panic low of 2.03 % in December 2008 following Lehman’s failure, in a flight to safety and fear of recession. Money market funds bought T bills instead of short-term European bank paper which drove 1 and 3 month T bills negative for the first time since Lehman’s collapse. Until leading economic indicators improve and forceful policy measures are taken, markets will remain unsettled.
Fair value for the S&P 500
The painful market decline will serve as an alarm that compels more significant policy actions. Once policymakers get a firmer grip on the problems and the economic outlooks becomes clearer, investors will again focus valuation underpinnings. With markets deeply oversold, they can experience relief rallies at any juncture, but the future trend for equity markets will depend on the fundamentals.
The chart shows the “fair value” for the S&P 500 index over the next 12 months, using our equity valuation model, depending on what economic outlook materializes. The moderate growth and our base case scenario of “stall speed” (which provides for a moderate decline in earnings in 2012) provide attractive potential returns to fair value over the next 12 months. In a U.S. recession scenario all risk assets would suffer. The Conference Board’s leading economic indicator (LEI) has always led a recession, but it remains in positive territory.
"Undervalued": MD Sass' equity model based on the economic outlook shows a current undervaluation of the S&P 500.
Equity market sectors and stock selection
Earnings estimates for the S&P 500 are being slashed in a reversal in expectations from 2 years of “beat and raise” by U.S. corporations. S&P profits declined an average of 17.8% during recessions since WWII, excluding the steep profit collapse of 56.7% during 2008-2009 which reflected huge losses in the U.S. financial sector.
The S&P’s sharp decline since its late April peak of 1364 now exceeds the average 18% decline during 10 % + stock market correction since 1960. This, like our scenario analysis, suggests the U.S. market is likely in a bottoming process if there is no recession over the next 15 months. Corporate insiders (who have a very good track record in buying their own stocks) are buying stocks in their own companies in a ration of two buyers for each one selling , whereas for the last decade there were two sellers for each buyer (insiders get stock options). If a recession ensues, this correction would be substantially greater. At the bottom in March 2009 the stock market traded at 12 times trailing 12 months earnings for the S&P 500. If the S&P earnings fall to $75 per share (our recession scenario) the bottom at 12 times would be 900.
A major transition is likely underway to high quality, large cap corporations, which are the most undervalued after having underperformed small and midcap stocks for the previous 12 years. Large cap equities of superior quality companies are not trading at a premium to other lesser quality companies with less attractive prospects - a discontinuity which cannot endure for long. Three sectors in particular - healthcare, information technology and energy - offer compelling opportunities and should be overweighted.
Investors should be seeking to opportunistically reallocate on further selloffs during the next couple of months, while maintaining diversification amongst equities, fixed income, alternatives and cash reserves. Crowded trades in U.S. Treasury bonds and relatively expensive defensive stocks (i.e., utilities, telecom and consumer stables) should be trimmed.
Reallocating Assets
Gold and gold stocks have a role as a hedge against recession and a global financial crisis. Investments in undervalued high-quality stocks healthcare (particularly beneficiaries of the patent cliff), information technology (beneficiaries of the internet everywhere theme )and global energy should be overweighted. Dynamic long/Short equity hedge funds have the flexibility to shift asset allocation while insuring against “tail risk” , which offers special appeal at this time.
U.S. Agency mortgage-backed securities offer good value for conservative fixed income portions of portfolios with their option-adjusted spreads back to the high end of the range before the Lehman debacle, and they provide low correlation with equities. (We like Agency mortgage REITS for the same reasons). Also alternative, non-correlated strategies (i.e. Asset-backed securities, tax liens and commodity lending) can provide compelling absolute returns and attractive diversification of portfolios.
Vita
Martin D. Sass is Chairman and Chief Executive Officer of M.D. Sass, one of the nation’s leading independent registered investment management firms. M.D. Sass manages hedge funds, private equity fund and separate accounts utilizing a variety of equity, fixed income and alternative investment strategies.
Before launching M.D. Sass in 1972, he was President, Chief Investment Officer and a principal shareholder of Neuwirth Management and Research Corp., where he managed mutual funds, hedge funds andsubstantial separate portfolios. He earlier was the Founder and Director of the Special Situations Division of Argus Research Corporation, providing independent research to leading financial institutions. He has been an investment manager and securities analyst since 1963 and has been quoted extensively on the subject of investments.
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