It was the worst August for the stock market in nine years, as the glow from backward-looking second quarter earnings reports quickly faded into mounting evidence of a weakening economic recovery. The strong corporate profits were largely fueled by cost cutting, which will ultimately run its course. At that point earnings will be in trouble, and investors appropriately have begun to factor it in well in advance.
As I have been repeating for quite some time now, the events of 2008 were not simply an isolated crisis. Rather it was the beginning of a long deleveraging process. The leveraging process occurred over the course of many years, and so the deleveraging process will also take years. I believe the best case scenario going forward is that the economy continues to muddle along, with anemic growth but still growth nonetheless. We also must be prepared, however, for some dire circumstances including the precedents that were set during both the Great Depression and Japan over the last twenty years. Government intervention in the economy has been extreme, but it is now out of ammunition. On the monetary side, the Fed is already at zero percent short-term rates while also buying longer term securities as well. On the fiscal side, political will has turned firmly away from stimulus and deficit spending.
My stock market outlook is less grim and more mixed than my economic outlook. While stocks still appear to be overvalued in the aggregate, there are plenty of quality stocks of companies with household names trading at cheaper levels than ever before. These companies have strong pricing power, do business all over the world and are highly profitable. As one would obviously expect, they usually trade at a premium, but today they trade at a discount to the overall market. It appears that conservative-minded investors are shunning investments with any degree of short-term volatility in favor of the certainty of bonds, both treasury and high grade corporate. This provides opportunity for rational, long-term investors to take advantage of the significantly more attractive pricing of the equities over the debt. Tempering my enthusiasm for quality stocks, however, is the understanding that there can be long periods of valuation contraction and the present environment seems ripe for just such an occurrence.
Adaptability is a key component to successful investing. Over the last few years, and most likely the next many years as well, the importance of monitoring the macro economy has completely overwhelmed the significance of stock selection. Performance is mostly dictated by being correct in one’s broad overall views. With that in mind, if you agree with my economic view then you should be extraordinarily conservative and defensive in constructing your investment portfolio and allocating your assets.
The information included in this article is not intended to be used as a basis for making investment decisions nor should it be constructed as a recommendation to buy or sell any specific security. Consult your investment professional for additional information and guidance.
Michael H. Berlin, CFA, CPA, is the founder and portfolio manager of MHB Equity Partners, a value-oriented private investment partnership. He previously worked at Lehman Brothers, and before that at Ernst & Young. Mr. Berlin holds an MBA from Columbia and a BBA from Michigan.
Michael can be contacted at firstname.lastname@example.org and at (631) 629-4928.