Shaping a Portfolio for 2010 (II)–Where We Are Now

The first step in figuring out how the economy develops from here is to try to describe the forces that are shaping it today.  I think the most significant are:

1.  For almost two years, we have been in a domestic housing slump.  This is the aftermath of a long housing boom fueled in it last days by extreme levels of speculation–by individuals buying houses they couldn’t afford (or intended to quickly sell to a “greater fool”), and by banks making mortgage loans to unqualified borrowers.  There are signs that the worst may be over for single-family homes, but not for apartments.

2.  Last year, the public, the regulators and the financial companies themselves discovered that the securities trading desks that the financials had established over the past ten years were not the immense profit centers that the company accounts had portrayed.  Instead, these trading desks had lost so much money, with top management unaware of what was going on, that they had driven their firms–big institutions like Citigroup, AIG, Lehman or Merrill Lynch–into bankruptcy in all but name.  Since many of the securities being traded were either backed by worthless mortgages (para. 1) or were IOUs from the now-defunct firms, even the “winning” side of these trades were money losers.

The realization, late last year, of the extent of the losses made financial companies effectively stop making new loans of any type, shutting off the life blood of economic growth.  This is by far the largest problem we have. Since then, governments around the world have been taking all sorts of extraordinary measures to restart the normal process of credit creation.

We’re probably well past the worst.  From a stock market perspective, several issues remain:

the credit creation process still isn’t back to anything near normal.  Lack of credit continues to send negative ripples through world economies

the north-east US, the epicenter of the problem, will likely struggle economically for a considerable time

confidence in US institutions has been damaged.  This is not only the banks.  Investors seem to regard Congress as dysfunctional and to worry that, as a result, the government will not be able to fix the banking problems.  I’ve never seen this kind of lack of confidence before, so I find the phenomenon tough to evaluate.

in the longer term, the financial losses will be underwritten by taxpayers

3.  The internet continues to do its work of creative destruction.  The economic downturn has accelerated the pace of change.  Newspapers and local TV stations are the current focus of rapid change.  Book publishing may be next.

4.  The Detroit-based “Big Three” car companies have been losing market share for thirty years.  For almost that long, they have been standard studies for MBAs on how not to run a business.  Ford appears to finally begun restructuring a few years ago.  It appears restructuring will be forced on GM and Chrysler.  I don;t think this is the significant stock market issue it might have been four or five months ago.  But Michigan will likely find the economic going hard over the next few years.

To summarize:

Bad News:       credit crunch

housing slump

decline of paper-based communication

problems will take some time to fix

Good News:      the problems are out on the table,

their rough size is understood, and

the government is working to fix them

stocks are cheap

we can guess economic growth will resume in late 2009

the economy in the US isn’t doing as badly as feared

a perverse plus:  anger at bank bailouts = less political

pressure for a potentially disastrous bailout of

Detroit

Shaping a Portfolio for 2010 (I)

The most important practical thing an investor can do at any time, but particularly during a period like this of great emotion in the markets, is to step back and try to take a longer view of events.  We are highly unlikely ever to be able to out-execute a hedge fund that concentrates on short-term trading.  On the other hand, that approach brings with it enormous pressure to focus on near-term results, leaving the much more fertile field of seeking long-term winning companies and economic trends for us to try to exploit.

In a series of posts under the title of “Shaping a Portfolio for 2010” I’m going to talk about what I think are the key factors to consider.  The idea is to develop a set of conclusions about what the future will look like and use them as the basis for a stock market strategy.  These conclusions should be regarded as working hypothesises to be monitored and tested.  But articulating what they are and how to judge whether they are correct or not will give us a key to altering strategy as events develop.

The Overall Market–Up or Down?

Perhaps the most basic question about investment strategy, but the one portfolio managers never talk with their clients about, is whether the economy most important for their stocks (i.e., the US, Europe, the Pacific, the world…) is likely to be expanding or contracting overthe next couple of years–and therefore whether stocks are likely to be going up or going down.  (Why this is so is the subject for another post.)

Yes, I think it’s true that successful investing is not about timing the market, that is, trying to sell at the top, hold cash for a while, and reenter the market at the bottom.  But the strength of the overall economy has a profound effect on what kinds of stocks do well.

If the economy is expanding, for example, then profits are rising and the more economically-sensitive stocks, like those in consumer durables, technology, and industrial sectors, are likely to be outperforming.  If, on the other hand, the economy is contracting, defensive areas like consumer staples, medical services or utilities are typically the market stars.

Not only that, but relative market shares within industries can shift considerably with the business cycle.  In good times, the #1 supplier may not be able to meet all the demand from even its best customers.  So, out of necessity,  orders flow to second- and third-tier vendors.  In bad times, #1 may have spare capacity.  If so, orders will shift back to the perceived higher quality and service, possibly hurting lower-order vendors severely.

Also, companies with very high operational or financial gearing (therefore, very high fixed costs to cover before they can show a profit) can show huge profit swings in response to small changes in demand or pricing.

Where are we now?  I think that in stock market terms we’re just past the worst of a vicious downturn.  (Global economic growth won’t resume until late this year, at the earliest; some industries won’t recover for much longer. Remember, though, the stock market is a futures market that discounts economic performance in advance.)  This would mean the next significant move for the markets is up.  The markets are in the earliest stages of preparing for this, but expressing guarded optimism in only the most generic way by selling defensive groups and buying more aggressive ones.  I think this is more an unwinding of a fear-driven excessively defensive posture, and calculation that such a posture is unlikely to provide outperformance, rather than strong belief that resumption of earnings growth is close at hand.

Today’s Market

I think we’re entering an important time for the market.  We’ve crawled, maybe “sprinted” is a better word, out of the hole the market made for itself in February and early March.  Some of the bank stocks are starting to slow down.  We’ve had a couple of yo-yo days, where stocks have been both up and down a lot.  Yesterday, not only were smaller stocks strong outperformers, but small laggards did a lot of catch-up.  In other words, the patterns that have shaped the market action during the rally seem to be changing, and at a point where a load of selling has occurred in the recent past.

Today may tell us a lot.

Typically, the first surge in a new up market is a mad rush to cover shorts and get money back into stocks.  Buying is relatively indiscriminate, but with a significant tilt toward larger market cap stocks, for no other reason than they can accept large amounts of money.  After that phase, however, buying becomes more focused and new leadership areas emerge.

For us, several questions:

1. are we at that stage now?

2. if we stall at this level of the market, do we have to reverse direction and “test” the early-March low?   

3. what are the new market themes?  In particular, how badly have irresponsible bankers weakened our future economic prospects and out reputation in the world?  and what implications are there for stocks?  has the clueless behavior of Congress in the crisis added to the damage?  (Answers shouldn’t involve any ranting.  The key  issue, I think, is how heavily does one want to be exposed to the US economy in the next year or two:  do we concentrate on American icons, or look past them for niche  names with unique products serving a world market; how seriously do we look at non-US markets, given that the epicenter of banking destruction is the US?)

More on these topics over the weekend.

I’m in Florida watching spring training, so this will be brief.

The market continues its strong rotation away from defensive stocks and toward economically sensitive stocks.  This pattern is very evident in almost every day’s trading.

Financials have been the stars, but one must ask when this will end.  Why?  Balance sheet losses show the historical growth rate of profits was actually much lower than the companies reported.  Future growth may be slower still because of stricter regulation.  Bailed-out banks will likely be forced to compete against each other in the home market, lowering margins.  Also (not a really good reason), leadership in a new bull market rarely, if ever, includes the leadership of the prior bull market.

Why the furious rally in financials so far?  Typically, in times of national economic stress, the market declines, fearing the worst economic outcome,, until the government announces it recognizes the problem and intends to deal with it.  The market immediately rallies.  Not this time.  It’s clear investors feared the government in the US lacked the competence to understand and address the banking crisis.  So the market waited until many concrete plans were already under way–including the original plan to reomove toxic assets from bank balance sheets–before bidding the banks back up.  

A new bull market requires credible belief about upcoming eranings growth.  I don’t think we’re there yet.  I read the current market action as investors slowly moving away from extreme defensive positioning.  So I think the current market rotation and a gradual upward drift of the markets will continue.

At some point soon, this very general idea won’t be enough to guide an investment strategy.  The key questions, as I see them, are:  how badly has the continuing demonstration of cluelessness by our legislators damaged investor pereceptions of the attractiveness of investing in the US?  (it’s bad, but is it life-threatening?), and where will the strongest earnings growth be in 2010.?  More on these topics later.