While I have felt that the language used in the last week has been, at times, excessive (“Averting Financial Armageddon” and “New World Order” seem to overstate the severity of the situation), several events, including the short term breakdown of the London Interbank Offering System and the decline of the value of the Reserve Money Market Fund below one dollar, are historic in nature and would have been deeply concerning had immediate action not been taken by the world’s central banks. The cost of the various bailouts requested by Secretary Paulson (including AIG and Fannie Mae / Freddie Mac) will understandably lead to a wave of government regulations with substantial impact on the financial sector, in turn affecting the overall economy and having implications for the long-term returns of various investments.
While my views have not been dramatically altered, they have been somewhat refined by the recent events. The likely responses by congress (and the legislatures of various western countries) do suggest that certain sectors and asset classes will face specific headwinds for several years. Most obviously, all firms, not just financials, will be under pressure to reduce debt. Accordingly, the advice that I will be giving to clients in terms of overall investment policy, and what returns I expect from various investments has changed, particularly in terms of what types of fixed income and what classes of stocks clients should own.
While each client has a differing financial situation, and thus, my advice is different for each client, there are certain observations that are likely to influence what I recommend each client do. Specifically:
• Value stocks are likely to underperform growth stocks. This will probably affect both large and small companies, as value firms are more likely to rely upon debt financing and be interest rate sensitive. While I don’t expect interest rates to increase massively, access to credit for borrowers large and small will be more difficult in coming years. Growth firms will likely find equity financing easier and there will be a demand for growth firms as allocations to debt by institutions and individuals favor the most conservative types of bonds and seek to get their growth from equities.
• Large stocks will likely bifurcate in terms of regulatory headache. The most admired companies are likely to benefit, while companies in the financial sector or with complicated business models will find a challenging political environment. With a whole wave of new regulations coming, it’s reasonable to expect that some companies (e.g. Apple or Toyota) are likely to benefit as “good corporate citizens” while others (e.g. Citibank and Morgan Stanley) are likely to face stiffer rules that limit their ability to grow earnings.
• Traditionally, I have over-weighted small companies in portfolios relative to the overall stock market. While small cap stocks continue to be attractive, large cap seems more so. Small cap equities seem expensive relative to large companies by most financial ratios, and while they have outperformed large companies over the last year, a correction seems due. Given that small company stocks seem fairly valued or overvalued and large companies are probably undervalued, my bias is to neither under or overweight small stocks.
• European stocks are less attractive than US. While foreign stocks have been a traditional source of outperformance in portfolios for the last several years, the credit crisis has probably not reached its high point in Europe yet. Accounting is considerably less transparent in Europe and there are less shareholder protections. A regulatory response to any credit crisis is likely to be more severe. Recent strength by the dollar suggests that despite higher interest rates in Europe, demand for the greenback is growing. Given the fact that demographic and labor trends tend to be more challenging in the most developed EU countries, there seems to be little long or short term attractiveness to western European stock markets. Eastern Europe, particularly Poland, the Czech Republic and the Baltic countries seem to be very attractive in terms of growth potential, but that must be balanced against increased geopolitical risks, which can have substantial impact on domestic investment patterns.
• Emerging markets seem to be overheated. We have recently seen these markets break from their multiyear pattern of outperforming the US and other developed markets. Historically these are either the best or worst performing stock markets and have been highly sensitive to interest rates. For portfolios with shorter time horizons, it seems risky to invest in an asset that has performed so well in the past and which has a pattern of wild gyrations. Regression to the mean seems the primary risk, but there are plenty of compelling reasons to think that this space is overvalued in terms of financial ratios relative to US or other developed stocks.
Over the next few weeks, we will be scheduling investment policy reviews with clients. However, please don’t hesitate to take the initiative and contact me about putting an appointment on the calendar or if you would like to discuss your portfolio before then. In the meantime, we will be using the market downturn as an opportunity to harvest capital losses in taxable portfolios, so you shouldn’t be surprised to see various trades take place.
Best, Mike
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