Stemming the Tide

George Hosfield, CFA, is Ferguson Wellman’s chief investment officer and chairs the firm's Investment Policy Committee. In addition, he is a member of the equity team with responsibility for management of the consumer discretionary sector on a global basis. He is a principal of the firm.

The recent equity market sell-off: Amid continued concerns over the health of the economy and warnings from the government that there will be no quick fixes, the major equity averages have now fallen to near six-year lows. As we indicated in our 2009 Outlook entitled “Stemming the Tide,” we believe 2009 will likely prove to be a transition year for the equity markets. In short, we expect equity prices to remain in a volatile trading range the first six to nine months as they are buffeted by unsettling economic data. However, late in the year, we believe it is likely that equity prices can advance as investors begin to discount an economic recovery beginning sometime in 2010.

Economic vs. Market Timeline: Historically, stocks have proved to be a good and reasonably reliable discounting mechanism, moving approximately six months in advance of the underlying “real” economy. That said, our challenge is to identify the approximate trough in economic activity. Contrary to current consensus estimates that call for an end to the recession by the third quarter of this year, we believe the recession will not end until sometime in the first half of 2010. A study by the International Monetary Fund (IMF) of the last 60 recessions that have occurred in the so-called “G-20” developed nations since 1980 revealed that recessions preceded by “financial stress” (i.e. banking crises or credit market failures) were significantly more pronounced in duration and magnitude than more typical recessions. Economic data is very likely to continue to deteriorate for months to come. For example, we would not be surprised to see the unemployment rate approach 10 percent. The world is essentially experiencing a synchronized margin call. The consumer is deleveraging and increasing his or her savings. However, our thesis concludes that the market has largely discounted a recession of an order of magnitude that would cut S&P earnings roughly in half from the 2006 peak.

Are we recommending a reduction in equity exposure at this time? No. It is impossible to predict a market bottom with precision. Market bottoms are not a day, a date, or a point in time, but a process. However, at this juncture it is our view that equities are too cheap to sell, yet it is too early to buy. The risk-reward characteristics of equities dictate that investors should never commit capital to equities that they cannot hold for at least three to five years. This is never more painfully apparent than at times of financial market stress.

Can equities fall further from here? Yes. Though equities could certainly fall further, at these depressed levels it is also important to keep in mind that this too shall pass, and we should take steps to prudently position portfolios to participate when the market ultimately rebounds. Times of financial stress can present wonderful opportunities for the long-term investor. In the past six months, the fundamentals of many stocks have taken a backseat to the emotions of their owners. For example, the stocks that reside in the portfolios of hedge funds have, in many cases, declined 20 to 25 percent more than others. In other words, they sold what they could, not necessarily what they wanted. In the short-term, there has been little distinction between “good companies” and “bad companies.” However, a deleveraging world where access to credit will be increasingly limited and more costly will set the stage for a “stock pickers market” where there will be substantial differentiation between the “haves” and “have-nots.” To that end, though it is still too early to increase the allocation to equities, we are taking this opportunity to focus our debt and equity holdings on those companies that have solid balance sheets, generate material free cash flow and will therefore be well positioned to take share from their weaker competitors.

As always, please do not hesitate to contact me or your portfolio manager with any questions or comments.

Best regards,
GWH

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.