Investing During Unsustainable Economic Conditions
May 1, 2012
As the U.S. economy heads into its fourth year of economic recovery, the federal government continues to run a deficit of approximately 8% of GDP. The baseline assumption of most economists is for a continued strengthening of the economy in the coming years, with few entertaining the possibility of another downturn. However, if the economy were to weaken we would see the deficit widen considerably from where it stands today.
In an environment where global markets are keenly aware of unsustainable debt trajectories, it would not take much to trigger a very different market environment from the calm we have seen recently. Over the past few weeks we have seen just this type of rapid shift in Spanish markets, where, despite the huge lending program by the ECB a few months ago, bond yields have begun to rise again and stock prices have been sinking:
Investing during unsustainable economic circumstances
If the stock market today were already undervalued, we at Sitka Pacific would not be so concerned with many of these macro issues. Undervaluation comes with two crucial benefits: a financial margin of safety, and a negative sentiment backdrop that adds to that margin. When the market is undervalued, it can absorb a number of negative shocks and still provide a reasonable return.
However, when a market is overvalued, it is not in a position to absorb negative shocks and still deliver a reasonable return – or even a positive return. It’s during these circumstances, as we find ourselves in today, that we have to think about the return of capital as well as the potential return on capital.
If we think back to 1998 or 2006, shortly before the tech bust or the housing-induced credit bust, we can ask the question: how should an investor have been allocating his or her portfolio in the face of unsustainable market and/or economic trends, and an overvalued market? In both of those cases, what turned out to be good investment strategies started with an assessment of the likely impacts of the end of the unsustainable trend, the likely impact of the policy response, and a willingness to make the appropriate changes to one’s portfolio before they were recognized and priced in by the markets.
In both 1998 and 2006, that meant moving out of stocks and into safer assets like cash and Treasury securities in anticipation of economic weakness. It also meant buying precious metals in anticipation of the eventual policy response, which would likely include the Fed lowering interest rates and a significantly increasing federal government deficit.
Today, despite facing another unsustainable trend that will have significant consequences for the economy and markets at some point, we find ourselves in quite a different set of circumstances. The Federal Reserve already has short-term interest rates pinned near zero, and the federal government already is running a substantial fiscal deficit. This means there is no room for the Fed to lower interest rates, and any significant deterioration in the government’s budget from where it stands today may not be greeted with enthusiasm by the markets (to put it mildly).
This time, although we are facing a similar set of economic risks to those we faced in 1998 and 2006, Sitka Pacific’s approach to mitigating those risks has to be different. At this stage, there are fewer safe-haven positions available because, if the markets begin to react negatively to a deterioration in the federal budget and/or actions the Federal Reserve takes (most likely more quantitative easing), Treasury securities and the dollar would likely be at the center of the storm. Even if the Federal Reserve commits to buying enough Treasury debt keep interest rates low, it’s likely the small yields on Treasury notes and bonds would not compensate for the loss of value in the dollar. And given that the dollar will ultimately bear most of the costs of the Fed’s future easing actions, our firm views an exposure to gold as essential.
We would like to be able to say that we could choose a group of stocks that we feel confident investing in today, without concern of a significant drawdown when the market eventually comes to terms with the reality of the government debt situation in the U.S. Unfortunately, as 2001, 2002 and 2008 proved, there are few (if any) places to hide in the stock market during the selloffs within a long-term bear market. Investors who don’t want to subject their portfolios to the risk of a significant drawdown when the markets come to terms with this debt situation need to adopt a different strategy than staying invested and simply hunting for the best individual stocks.
Until the market reaches a valuation that enables us to invest without as much concern for the macro picture, our overall approach to this long-term bear market is very simple: try to avoid the inevitable large declines, and try to capture some gains from the larger market rebounds. This approach is hardly an exciting one during periods when there is a high risk of a decline in the market, so we remain defensive. But this approach isn’t intended to be entertaining – it is intended to generate a positive return through a long-term bear market that is defined by negative returns.
We have chosen to maintain allocations in our portfolios that we think offer a good chance to make it through the next turbulent period within this long-term bear market, when the markets adjust to the reality of our debt situation. That process could easily start this year if there is a downturn in the economy or a continued deterioration in Europe’s sovereign debt markets, or it could still be years away. However, based on the performance of a number of major equity markets outside the U.S. and a number of key commodities over the past year, it seems that process may have begun already. If so, any gains in the stock market from today’s prices will prove transitory.
Regardless of when that process begins, when it ends the market will most likely be very attractive from a valuation standpoint, and as we’ve discussed in recent letters, it would likely come at a time similar to when previous long-term bear markets have made long-term nominal lows. Under those conditions, potential returns will be high and risk will be far lower – a very different market environment than we face today.
Brian McAuley is the Chief Investment Officer at Sitka Pacific Capital Management, an absolute return-oriented asset management firm.
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