Invest Defensively II (but Think Opportunistically)

Investor’s Corner with Jack Brown

History will confirm that the recession of the past two-plus years was a doozy. The combination of collapsing asset prices, massive “write-downs” and sagging revenues led to a decline in corporate earnings that, on a percentage basis, matched that of the 1929-32 bust. However, a well-balanced portfolio with a cautious eye on attractively-valued opportunities seems to make good sense right now.

Despite a rally from the March 2009 lows, the prior brutish decline in stock prices combined with abysmal 10-year market results have changed the mass psychology of investors. Specifically, as a group investors are – and will be for at least the next 10-years – on ready-alert mode.

The first serious alarm sounded when Greece ran into a funding wall. It is still ringing and is loud. Questions are now being asked: Would the credit woes of Greece or Europe be a problem for our private economy or banking system? Are the sovereign risks abroad pre-cursor to our sovereign risks? Are we Japan “T minus 20”? Has the rally from the bottom overshot realistic valuation levels?

That’s a lot to worry about. The best news is likely that corporate earnings and stock prices are quite closely linked to economic growth. Yes, the pains of underemployment and the risks for the economy remain, but the very worst of a very bad recession was over in early 2009. History will show that the Great Recession indeed had a distinct “V” shape. The risks of a major double-dip or “W” are quite low – according to most reasonable heads, but more simply based on the magnitude of this one (it was so big…).

More specifically, any pullback in economic activity would have much less dramatic impact on corporate earnings and stock prices, in my opinion – namely for the following reasons: 1) earnings declines in 2008-9 were more impacted by unique “write-downs” of assets than declining revenues, 2) the financial services sector is much smaller in terms of market capitalization thus European banking spillovers will pack less of a punch, and 3) re-hiring/expansions haven’t yet broadly occurred so the costs associated with layoffs and downsizing have already been absorbed last year.

The point is this: there is and will always be plenty to worry about and fear is good. It keeps markets from over-heating and provides investors with the opportunity to buy assets at reasonable prices. Accept fear; use it to your advantage. A high quality ongoing business that provides $10 in earnings for every $100 invested in fractional ownership is always a good deal especially considering that businesses (as a group) tend to grow at the nominal rate of GDP. Today the US stock market has only a few opportunities like this, but, fear-willing, more will be on the way. And the trade-offs of opportunities like this compared to late-night infomercials on Gold (or 3.2% yields on Treasuries) usually tilt the odds in favor of the former – in the long run. Look for these because a well-balanced portfolio with a cautious eye on attractively-valued opportunities is the key for wealth preservation and enhancement. Cool heads will prevail.

Jack Brown, CFA

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