"Sleepwalking Toward a Precipice":
Our Observations and Outlook, Part 3
WHAT WE WILL COVER...
OPPORTUNITY IN CRISIS: In Parts I & Part II of Sleepwalking Toward a Precipice, we delineated myriad, decades-in-the-making, structural (i.e., long-term) problems in the U.S., Europe and China that were unmasked by credit crisis and the Great Recession.
We outlined how, in the critical years following crisis, political leadership in the three largest economies in the world failed to implement productive, strategic, long-term policy responses in favor of tactical, short-term solutions.
We discussed how central planning was ceded to central banks to prop up beleaguered and battered economies and markets through reflationary and distortionary policies that encourage misallocation of capital, prevent needed purging of the system of bad assets, bad actors, and bad ideas, and ultimately sow the seeds of even greater crisis in the future.
We also delineated a number of unknowns in an increasingly connected, fast-changing world that enhance uncertainty going forward.
All of this was intended to illuminate, in one series, the wide possibilities for growth and thus market returns in coming years. In crisis lies opportunity. What follows are our some of our investment recommendations.
THE REALITY: secular bear
WIDE POURS: The U.S. economy is a 2% real GDP growth economy (down from 3% trend over the last century). Following crisis, significant government intervention helped maintain 2% growth, but structural problems, central bank distortions, and myriad unknowns make the range of future prospects for GDP growth doubly wide. As nominal GDP (real GDP plus inflation) is highly correlated with corporate earnings, future earnings growth prospects are also highly uncertain.
THE P/E COMPRESSOR: The U.S. stock market is in a secular (long-term) bear market that began in 2000. Secular bear and bull markets average 17 years in length and are driven by trends in market P/E multiples. Secular bull markets start with P/E below 10x, with the multiple rising to over 20x by the end of the bull market. In order for a new secular bull market to begin, market P/E should "compress" from 16x today to below 10x. Unless this time is different, this equates to multiple compression of around 50% within the next few years.
ACCORDION IN E-FLAT: Given the wide prospects for growth and earnings, and probable P/E compression to below 10x in order to end a secular bear market and begin a new secular bull market, U.S. equity markets are likely to be volatile "accordion-shaped" markets in coming years, with multiple cyclical bull and bear swings, that in sum, offer little more than flat returns.
RECOMMENDATIONS: rent don't buy
Tactical, "rent don't buy" strategies should outperform traditional "buy and hold" over a second decade of sideways markets filled with inordinately high risks and potential secular bear market capitulation (P/E moving below 10x). The purpose of "rent don't buy" during a post-crisis deleveraging and secular bear market is achieving strong returns through nimble strategies that take advantage of waves of sentiment, mean reversion, and distressed situations, emphasizing performance over diversity, and providing for capital preservation.
RENTING REFLATION: Momentum strategies allow for "renting" various asset classes or styles (growth stocks, commodities, real estate) during periods of central bank reflation (QEs, LTROs), "returning" them for other classes or styles when there is a change in sentiment (post-central bank stimulus reality), and moving into safe havens (treasuries, cash) during periods of extreme stress (Euro Zone debt crisis, Chinese hard landing, Middle East tensions, U.S. recession).
EVENT PLANNING: Event-driven strategies allow for "renting" public assets, capitalizing on temporary price distortions and mean reversion around corporate events (earnings, mergers, etc.), where risk is defined, holding period is short, and market correlation is low.
LONG & SHORT OF IT: Select long-short strategies are attractive "renting" vehicles, particularly those that target market neutrality (hedging out market risk), focus on particular sectors, take advantage of short-term mispricings and mean reversion, and those that provide simple long reflationary market exposure with hedges for protection.
WADING IN DISTRESS: During a prolonged credit crisis balance sheet deleveraging, distressed situations provide opportunities for "renting" fixed income assets (e.g., asset-backed securities) at a discount, with additional margin of safety provided by new regulations (bank capital requirements), insurance (wraps), and over-collateralization.
RECOMMENDATIONS: essential essentials
PRIVATE 1ST CLASS: In addition to "renting" public securities, certain select private investments allow for: (i) investing in emerging themes, (ii) generating multiple streams of uncorrelated cash flows, (iii) interacting with, vetting and profiting from proven management teams, (iv) negotiating investment structures that provide sufficient margin of safety (collateral, captive buyers), and (v) avoiding the vagaries of increasingly correlated and manipulated public markets. Themes may include government budget gaps and infrastructure needs, energy, and healthcare.
ESSENTIAL ESSENTIALS – MINDING THE GAP: One example of a theme we favor investing in currently is essential services in the United States. Federal, state and local governments are over-indebted and overcommitted. Private enterprise may fill gaps where governments are unwilling or unable to fully provide essential services for citizens. Investments may be separated by geography, industry, and population centers (multiple uncorrelated cash flow streams), provide services that would be needed on a daily basis (captive buyers), management teams may come from previous successful ventures (proven management teams), and investment exit would ideally be through sale to another private investor (avoiding manipulated public markets).*
|* (Note: Illiquid private investments are not suitable for all investors and John Cravens and/or Cravens Family Limited Partnership may invest in private opportunities alongside clients).|
Structural problems revealed by crisis have not been resolved. Central banks "managing" economies and reflating markets is hazardous. The world is awash in complexity and unknowns. Economic growth and earnings are highly uncertain, and the beginning of a new bull market may first require significant P/E compression. Tactical investing and direct private investments present opportunities to navigate turbulent times, as nations and the world, it seems, may be sleepwalking toward a precipice.
– Jason B. Leach, CFA
See this article as slide show with complete graphics at the Craven Brothers website.
Previously in this series:
(c) Cravens Brothers Wealth Advisors