A stock market investor has to ask himself, given what we know now, what is the worst future we can realistically foresee for the stock markets?
An approach that makes sense when trying to work out an investment strategy for the next few years. Putting aside the argument between bulls and bears over the long-term direction of the market, what is the WCS (Worst Case Scenario)?
I don’t think we are going to run into a 1930’s kind of depression. Very many powerful people need to make many serious mistakes for today’s grim financial situation to turn into real disaster on that scale.
But something akin to what happened to the US and Europe in the 1970s or to Japan in the 1990s does look like a realistic worst case. That implies interest rates on cash and bonds could drop far below the normal level of inflation while stocks could fall much further before resurfacing.
Structured products, likely to be promoted hard by wealth managers, also have drawbacks. The idea is that you give up some upside (taking some reduction on the profits you could make in stocks or some other underlying investment) in return for a guarantee that your capital will remain intact or even rise by a fixed amount. Giving up some upside may not be problematic if you do not expect to make money but the guarantee is likely to be expensive.
What does that leave? First, if your asset allocation made sense before, it should still make sense. Unless you hope to retire in the next few years, it makes sense to keep a decent weighting in equities and to keep feeding money in. Timing the market is a mug’s game. But steady investments should pay off over the long term, even under the WCS.
Within the stock market, cash should be king. When confidence is weak, valuations based on cash flows, sales or dividends tend to become more important. So the chance is that investments will flow to companies that reliably throw off large amounts of cash. Rather than just outperforming the market, this might even deliver profits in nominal terms.
Note that the normal advice during downturns - to buy value stocks that look cheap - is not reliable.
Financial stocks look cheap at present but that is for a reason. Under an WCS scenario, they could fall much further.
Foreign exchange markets offer another opportunity. Forex is a zero-sum game: whether in a recession or an economic boom, the amount of winners it produces will always equal the number of losers. Further, there will always be players in the market who are merely making transactions needed to keep doing business: not all players in the market are in it to win. So the chances of being a winner in forex during a downturn look decent, at least compared with other opportunities.
On this logic, money might flow to reliable cash-generating stocks that are generated in dollars, a currency at present wildly undervalued in terms of its purchasing power. In a WCS, recession in the US would hurt other economies and allow the dollar to recover. So big US companies that throw off a lot of cash look interesting.
Others may be following this logic. The US retailer Wal-Mart, even though it could scarcely be more exposed to the country’s consumers, is at its highest level since 2004. Its stock is up 30 per cent since the credit crisis started - possibly because investors want reliable dollar-based cash flows.
A riskier strategy, if you have a long-time horizon, may involve emerging markets. They traditionally under perform developed markets during a downturn, and appear to be doing so again.
Under a WCS, the emerging markets will be harmed by a US downturn, but they are less exposed than they were during the wave of crises in the 1990s. So it |
