Risk, Reward and the Green Shoots of Spring

George Hosfield, CFA, is Ferguson Wellman’s chief investment officer and chairs the firm's Investment Policy Committee.

For the first time in more than two years, we believe it is now prudent to begin increasing exposure to equity asset classes. While the market has rallied strongly of late, in our view our decision is more about time than price. In other words, our shift in thinking (and our appetite for increasing portfolio risk) is a function of our heightened confidence that a bottom in economic activity is reasonably close at hand, and that a resumption in corporate profit growth can now occur within the next six months or so. Fundamentally, this is more important to us than a specific market price or level. In that context, gradually increasing equity exposure is prudent in our view.
 
Equity Market Recent Performance
In recent weeks, the market has mounted a very impressive rally (almost 28 percent from the March lows) albeit from deeply oversold, near “apocalyptic” levels. As fears of a complete meltdown of the core of the financial system have subsided, equities have responded accordingly. It is becoming increasingly evident that the primary catalysts for improvement in the operation of the gears of the financial system have moved beyond the direct beneficiaries of government aid. It now appears that genuine “healing” is developing (especially in the all important credit markets) and is somewhat more broad-based. This is good news, and a stabilizing financial system is evidence that the “keel” of the financial system is starting to work.
 
In our last email communication, “Stemming the Tide” (February 28, 2009), we thought equities could fall further. They did in fact, and declined a whopping 12 percent, reaching their nadir on March 9. We did not recommend an asset allocation change at that time, believing that equities were too cheap to sell, yet it was too early to buy. Our thesis was straightforward, equities would remain in a volatile trading range for perhaps as long as six months, as the market would continue to be buffeted by storms of negative economic data. We also stated that it was our opinion that late this year, equities would begin to discount an economic recovery commencing in 2010. This discounting process, and the associated firmer market (tone), would precede the arrival of improving economic data by about six months.
 
Green Shoots
The number of “green shoots” that have bubbled up over the last few weeks has been quite remarkable. While individually they are less than impressive, collectively they represent more than anecdotal evidence of (at a minimum) a moderation in the rate of decline in both U.S. and global economic activity. House price declines are slowing, consumer confidence is rising, U.S. durable goods orders have rebounded, and earlier this week the Federal Reserve announced that they would hold off their boosting of purchases of both U.S. Treasury bonds and mortgage-backed securities as they gauge the strength of green shoots (Bernanke’s words) of the emerging economic recovery.

Why Now?
We believe that adding to stocks is now appropriate for the following reasons: (1) There is mounting evidence that S&P 500 earnings could trough as early as Q3. (2) Investor expectations relative to those earnings have declined so precipitously that the risk/reward relationship for stocks is now much more favorable. In other words, Wall Street’s earnings expectations are now finally low enough that earnings could actually “surprise” on the upside. To that end, there is some evidence that this has already begun; with more than 70 percent of the companies in the S&P 500 now having reported their Q1 earnings, these companies have surpassed estimates by an average of 6 percent.
 
What are we buying?
Generally speaking, we will initially place emphasis on traditional “early cyclical” sectors and stocks. In terms of asset class preference, we favor both domestic small-cap stocks and emerging market stocks. In the large-cap universe, we are positioning for the “reflation trade;” that is, additional commitments to the technology, basic materials, consumer discretionary and financial sectors. All are generic beneficiaries of economic growth or (directionally) an increasing rate of economic growth.
 
How rapidly will we increase our exposure to equities?
The recovery we anticipate will be anything but a straight line. This week it was reported that the US economy contracted 6.1 percent in the first quarter. Coupled with a 6.3 percent decline in the last quarter of 2008, we have now endured the weakest six months for GDP since a six-month period from 1957 to 1958. Furthermore, with unemployment at 8.5 percent and rising, both the economy and the stock market will certainly walk a crooked road toward recovery.
 
With that in mind, we envision scaling further into equities in the months ahead. This will be achieved through perhaps as many as three or four purchases (tranches). Importantly, we believe that the weight of the evidence supports a reasonably strong case for recovery, and therefore any material selloff in the market would very likely precipitate an acceleration of our plans to add to equity asset classes.
 
As we have said many times before, we are grounded solidly by our respect for risk and reward, and it is therefore our desire to catch the major market moves, avoiding any attempts to time short-term fluctuations—a strategy, we believe, that is fraught with peril.
 
The information provided herein is for educational purposes only and should not be construed as investment advice or as an offer or solicitation. Not all securities are suitable investments for all investors; therefore, Ferguson Wellman Capital Management will not necessarily implement any particular strategies discussed herein for all clients. We recommend that you discuss questions regarding your individual portfolio and investment strategies with your portfolio manager.