There are two principal ways to get hit by the markets. One is to hold economically sensitive securities – stocks, credit-sensitive bonds – entering a recession. The other way is to own expensive assets before their fundamentals out and they lose value. Sometimes, as in 2008, both storms arrive. The first case is a recession bear, and the second a price bear.
Defending against recession bears is straightforward. When economic fears drive asset prices, high-quality bonds and cash always win. There's no going wrong with government bonds. With stocks, large companies that have low debt and stable, recession-resistant revenues will withstand the bear better than the rest. Predicting when the economic sell-off will occur is tricky, but knowing how to invest is not.
Is Everything More Expensive than it Looks?
Guarding against price bears is more situation-dependent. What thrives in one downturn may not thrive in another. For example, small-company value stocks lost significant value along with other equities in October 1987 but held up very well during the 2000 to 2002 growth-stock sell-off. Similarly, high-quality bonds might perform well, as investors make "risk-off" trades and flee to safety, or they might get hit because people believe interest rates will rise.
This past weekend, The Wall Street Journal's Jason Zweig forcefully argued that now is a good time to fend off the price bear. In "Everything Is More Expensive Than It Looks," Zweig points out that the only justification for today's US stock-market price ratios – using earnings, book value, sales, you name it – and exceedingly low bond yields is a very small discount rate. Investors expect the return on a future risk-free security to be very low, which makes them willing to pay up for risky assets.
That's all fine and good ... until that discount rate changes. Then the dam bursts. As Zweig puts it, our collective investment success depends upon a "continual bull market." If the discount rate remains low and the economy doesn't collapse, stocks and corporate bonds will likely outgain their safer competitors. Any increase in that rate, however, would put an end to seven years' worth of good fortune.
It's not for me to state when that day will arrive. But, seven years into the current cycle, it's certainly worth considering what might help a portfolio should the prevailing regime change.
Good Value is Always Good Value
One relative haven, Zweig proffers, might be value stocks. October 1987 aside, value stocks generally hold up better than their peers during price bears. As their price multiples are already lower than other stocks', they have less room to fall. More profoundly, because by definition value-priced companies throw off higher current cash flows per amount invested than do other companies, they are less affected by rising discount rates. Growth stocks, to use the parlance of bond investors, have longer durations than do value stocks.
Also, value stocks are now a bargain. Although they comfortably outgained growth stocks over most previous decades, and invariably over all truly long-term horizons (say, 25-plus years), they've lagged in the trailing 10-year period. This is particularly true of larger companies, with the average U.S. large-growth fund beating the average large-value fund by almost 2 percentage points per year through the end of May.
Growth stocks' success can be logically explained. Throughout the time period, many of the biggest growth companies – most notably Apple (AAPL) – have exceeded revenue and earnings expectations; their gains have been no fad. Nonetheless, the fact remains that growth stocks now trade at a larger premium to their value rivals than is customary; that premium will most likely contract should the market decline.
Considering Emerging Market Stocks
Zweig's other suggestion is emerging-markets stocks, which seems a peculiar choice. Normally, one does not fend off a market sell-off by investing in among the most volatile and unpredictable of equities. However, these are not normal times for the emerging markets. Their stocks now carry substantially lower price/earnings ratios than do those of developed markets, the largest such gap in two decades.
Price bears most severely punish expectations, and the expectations of emerging-markets stocks are the lowest that I can recall. True, the 1998 Asian crisis created panic, with many worried that the Pacific emerging markets had dug themselves a hole that would take many years to escape. However, there was always the underlying optimism that once the problem was resolved, emerging markets would reclaim their destiny. That belief has withered.
Obviously, this proposal must be considered in relative terms. Emerging-markets stocks will not rise during a global sell-off. They, as always, are a "risk-on" proposition. But, given the pessimism with which their shares are currently valued, they may be something of a win/win, outperforming other equities if the bull persists, and holding up better than most should the price bear arrive.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
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