As the leaves begin to turn bright colors and drop from the trees (at least here in the northeastern US), a professional investor’s thoughts start to turn to preparing for the coming year.
the most important issue
The essential question, though equity professionals would never phrase it this way to clients, is whether stocks are likely to go up or down in the twelve months ahead.
My answer has two parts:
First, for 2011 the answer is relatively easy to arrive at, and
Second, I think stocks will go up, at least modestly.
next in line is…
The next task, in (what is to me the) logical sequence, is to figure out what elements of a successful investment strategy for 2010 will carry over into 2011 and which ones will surprise the consensus by reversing themselves.
This question is a lot harder. Giving concrete content to a general perception of trends is always difficult. Today it’s especially so, since the same portfolio-structural keys to a successful sector and individual stock strategy have been in place for almost two years. They’ve been: bet on near-death experiences; bet on cyclical sectors; bet on emerging markets–especially Asia, and against the developed world.
Experience suggests that at least some of this is bound have become pretty long in the tooth by now, despite the fact that conviction in them is probably much higher today than it was in March 2009. After all, the stock market does act to make the greatest fools out of the largest number of people.
…looking for non-consensus ideas
Knowing this, I’ve been casting about for a while for ideas that run counter to the consensus.
At the same time, as it turns out, I’ve also fallen behind on my daily financial newspaper reading. I still get paper copies of the Financial Times, which I think is by far the best single source of investment reporting written in English. The only virtue of paper, as I see it, is that you get all the news that came out on a given day in one package, so you don’t have to search. I’ve also found over the years that reading stories a week or two after the fact (clearly, a rationalization of my laziness) often shows you that stuff you thought was crucial ten days ago is actually irrelevant, or vice versa.
Anyway, in catching up I came across a column entitled “As bounce-backs go it’s all relative,” from September 29th by Jim Paulsen (I don’t know him), the chief investment strategist for Wells Capital Management, part of the Wells Fargo bank.
Mr. Paulsen argues that the US recovery from recession is ahead of schedule, using the 1992 and 2003 upturns as benchmarks, and that we don’t need dramatic policy moves to “rescue” the economy. All we need is patience.
The basis for his assertion is demographic. Its bare bones are as follows:
1. GDP growth comes either from having more people working or from having them work more productively. Gains in the size of the work force can come from either expansion of the overall population or from having a larger percentage of people in the country wanting to work.
2. The defining characteristics of the US workforce in the 1960s-1980s were the increasing participation of women in the workforce, and the coming to adulthood of the baby Boom. These factors both made the growth potential of the economy greater than it would otherwise have been. Over the past twenty-five years or so, however, the percentage of women in the workforce has plateaued and the Baby Boom effect has ended, meaning that the economy’s growth potential is now less than it was in those three prior decades.
3. Therefore, this recovery should be judged only against 1991 and 2001, not earlier periods when demographic conditions were very different. (As Mr. Paulsen puts it at one point, the “new normal” has been around for the past twenty-five years.) By this yardstick, the current recovery doesn’t look so bad. In the FT article, he continues:
“Despite a significant slowdown in the second quarter of this year, real GDP growth in the first year of this recovery was 3 per cent compared with first year recovery gains of only 2.6 per cent in 1991 and 1.9 per cent in 2001. Persistent private job creation took 12 months once the recession ended in the early 1990s and it took 21 months after the 2001 recession. This recovery began producing persistent private job gains only six months after the recession ended. Moreover, in the first 14 months of this recovery, 205,000 jobs have been lost. While this is surely disappointing, it compares with 220,000 and 935,000 cumulative job losses respectively at this point in the 1991 and 2001 recoveries.”
Mr. Paulsen elaborates on this theme in his November Economic and Market Perspective, of which the FT article is a shorter version.
I don’t know whether I believe him or not, but Mr. Paulsen’s is an interesting argument. It has several important implications for strategy. The principal one is that virtually everyone thinks the opposite. So if he’s right, this will come as a huge surprise to investors.
In particular, it means:
–stocks are cheap; bonds are very expensive
–further quantitative easing by the Fed may be unnecessary and may actually be harmful, resulting in a future problem with inflation
–stocks that benefit from US economic activity—especially consumer spending—may be much cheaper and have better earnings prospects than the consensus thinks
–as investors figure this out, asset flows into emerging markets and into fixed income might abate, or even reverse in favor of developed stock markets in the US and Europe.
What to do about this possibility?
I don’t think we need to actually change asset allocation for the moment. But I think it’s important to be on the alert for more information that bears on this question. We should identify stocks that would benefit—say, a financial with large credit car operations, or WMT or TGT—and watch their operations closely. Look at risk exposure, both positive and negative, under the assumption that Mr. Paulsen turns out to be right. Ask yourself whether you’re comfortable with where you are. We should also do some contingency planning–that is, think about what holdings we would change in the event evidence in Mr. Paulsen’s favor starts to pile up.
Dan; your comment on demographics is interesting (in fact I am very fearful of the aging of America and the demands it will place on our social services). But I wonder if part of your argument isnt already consensus. While i agree it often makes sense to zig while others are zagging, I fear that the pundits already believe stocks are cheap; bonds are very expensive (real yields have almost gone negative). I also think many fear that further quantitative easing by the Fed may be unnecessary and may actually be harmful, resulting in a future problem with inflation (isnt that one of the reasons gold has soared). Clearly the enthusiasm over emerging markets vs developed will be a key investment theme to ponder for 2011 (this will be a key theme to watch). Hope all is well with you.
Bart: Thanks for your comment. As always, you get down to the heart of the matter. And you’re so much closer to the pulse of the institutional equity market than I am, and especially now, that I’ve got to believe you’re right about what the consensus thinks.
Something eIse also seems to be stirring in the markets, however. If you look at the ICI numbers, every month, like clockwork, individual investors put $20 billion into bond funds and remove about $5 billion from US-oriented equity funds. I know some of the latter money goes into ETFs, but they too show better growth of bond offerings than ones holding domestic stocks. In addition to that, the ten-year Treasury, which was yielding 4% in April is now down to yielding 2.6%. The trade-weighted dollar has lost all its first-half gains, retreating by about 12% to return to around where it began 2010. Emerging markets like Brazil and Thailand are putting exchange controls in place to stop the inflow of unwanted foreign portfolio capital. None of this, except maybe the currency movements, seems to me to be consistent with the Wells idea that the US is going to perk up in 2011 all by itself.
Even so, it’s a reasonable question whether you’d be holding different stocks if you sided with Jim Petersen than if you thought the opposite (this is the portfolio manager trick of trying to figure out whether you need to take sides on an issue). I haven’t thought about this enough, but just off the top of my head, I think someone in the Petersen camp would want to shade his holdings toward pure domestic earners. I’d been interpreting the relative strength of telecoms and utilities in recent months to retail investors chasing yield, but maybe it’s evidence of changing consensus views.