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.

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