Risk & Opportunity

A quarterly political and economic newsletter published by Michael Cuddehe

Q2 '02

Strategies for a Bear Market

The first phase of the bear market is over and pundits are scrambling for indications that the recession is over and recovery is underway. But the pundits, for the most part, are ignoring the obvious - there are still major distortions in most sectors of our economy that have not been corrected. Also, global trade liberalization is under serious pressure from many quarters (although globalization is not) and worse still, geopolitical events are building toward disaster.

Furthermore, the overall economic situation leaves little room for the Fed to maneuver. One can only manipulate a situation for so long before the odds catch up with you. Clearly the economic reaction to the unprecedented easing of rates is much like that of an addict that gets little satisfaction from even a massive dose of the drug. Eventually we will have to take the cure and it's going to be rather painful. For anyone who is given to seeing what is rather than what they want to see, the investment climate remains very dicey.

So the big question is, "How can I best position myself to ride out the coming adjustments and be intact to take advantage of the outstanding opportunities that will be available once the storm is over?" There are several considerations: what to avoid, what to keep an eye on, and what to acquire, keeping in mind that there are ways not only to survive but also to prosper in a bear market.

In general, the stock market is the number one thing to avoid. Stock valuations have a long way to go to get back into realistic territory, and since the market usually overdoes things at the extremes I would expect to see an extended markdown of stock values before the end of this bear market. Final bottom? Probably far lower than would be thought credible at this point so it is best not to put a number on it. Time frame? Probably another three to five years at the minimum and possibly much longer.

The entire investment world is wedded to vastly inflated values and expectations. People will let go of these inflated expectations very slowly. This is what makes the bear extend time wise. It could all be over quickly if everyone would accept the markdown. (This is the argument that corporate economists give to labor.) Capital will eventually take the markdown but not until forced. And of course the markdown period will be accompanied by major stress all across the corporate sector; so many investment grade corporate bonds could morph into junk ala Tyco. Not that there won't be excellent opportunities in narrow bands, time frames and special situations, but overall the corporate sector must be approached gingerly and with great skepticism. For another opinion on this matter read David Kuttner's column "The Market Can't Soar Above the Economy Forever" in the April 15th issue of Businessweek.

The statistics are overwhelmingly in favor of the bear for the foreseeable future. Historic norms for price-earnings ratio's and annual returns on common stocks are 14 and 7% respectively. These are averages. Currently P/E ratio's vary from 22 to 60 depending on whether you divide by expected or current earnings, and average stock returns since '82 (the beginning of the bull) have been approximately 12%. Will we revert to the norm? I can't find any reason why we shouldn't. Even more importantly, we will likely average out to the norm, which means that the odds favor an extended period of underperformance to balance out the recent extended period of irrational exuberance. One more rather telling statistic is that corporate valuations remain at 130-140% of GDP. Historic market lows find corporate valuations at around 30% of GDP. Do you feel the chill?

Fixed income investments hold little appeal on the short end, and taking on an extended maturity is a big gamble, hardly worth the few extra points to be gained. Long maturity bonds of any type are a very high risk investment at this time and best avoided. Even medium maturities are risky. In fixed income, under three years is best for now but of course you aren't getting much.

In the not-so-obvious category there are two major areas of concern, mostly because they are almost universally considered to be virtually risk-free and don't get the kind of scrutiny they deserve -- the muni market, especially the big municipalities, and the Agencies. For an interesting article on the Agencies, see the May 21st N.Y. Times article "Guess Who Doesn't Back Fannie, Freddie and Farmer" by Alison Leigh Cowan.

Real estate generally has been the shining star in the investment universe recently. High quality real estate is probably one of the best places to have your money, but the smart money knows this and these deals are increasingly difficult to find. I have heard some people touting real estate as the technology of the 2000's. I can't buy this outlook. Once the current buying panic is over where will the exit come from? How high can we push prices? People have been buying rates, not price, and even as prices hit new highs, buying power is declining and defaults are spiking in certain sectors. This is not a healthy market. I have heard some say that we may be in for the Europeanization of real estate in the U.S. - low turnover and perpetually high prices. Perhaps, but such an outcome would mean a dramatic shift in lifestyle which is not likely to happen voluntarily. Demographics, rates and panic are pushing prices higher, especially in the Sun Belt, but historically we have never had a recession without a dramatic drop in real estate values. I would bet on history here. As I write this, high end spec projects are already feeling the downdraft and it is my contention that the middle and low end remain vulnerable to renewed recessionary pressure and to a potential blowup in the Agencies.

Things to keep an eye on are basically everything. We are in an unstable economic environment greatly complicated by an unstable geopolitical environment. If the economy goes into another swoon the Fed will be helpless to do anything about it. Another major terror hit could do it, and if Administration Pollyanna's are to be believed such an event is a virtual certainty and could come anytime. A nuclear war between India and Pakistan or a full out war in the Middle East could also do it. Also, from a geopolitical perspective, something to keep in mind for the long term is that the Muslim world has the world's highest percentage of young people - for the most part young people with few or no prospects. There is nothing more dangerous than young men with no prospects. Put those young men in a context of hatred and incitement to violence in the name of God and you have the makings of decades of global terrorism and warfare. The black swans (rare events) are descending upon us, and they are currently feeding upon Muslim extremism. For an in-depth discourse on the issue of black swans read "Fooled by Randomness" by Nicholas Taleb. Also, for an in-depth analysis of the economic foundations and implications of global unrest read "False Dawn" by John Gray.

Despite the many challenges of a general bear market there are a variety of ways to prosper, and it all begins with the right attitude. Realism is the desired approach, with flexibility, and a certain amount of creativity. Investors have become checklist and spreadsheet bound in recent years as quantitative thinking swept over the financial landscape like a tsunami. In the coming period we will no longer to be able to stay within the neat bounds of our spreadsheets and checklists if we hope to maneuver through the coming turbulence. It is going to take some market vision; some outward focused attention, and a certain amount of creativity and common sense in addition to the excellent quantitative tools that have become available over recent years.

What to invest in? This is a highly personal matter depending on each investor's financial situation, background, interests, risk tolerance and other constraints. That said, high quality (preferably) unleveraged real estate and economically useful physical assets, keeping in mind that the market value of these assets could drop substantially. Also, sound basic businesses which can be leveraged up or down according to changing conditions (my favorite), the highest quality muni's (avoid large municipalities), hedge funds - preferably well managed multi-strategy and/or multi-manager funds, select foreign (preferably cash flowing) investments, value funds, venture funds, special situations and future oriented energy and environmental projects, and of course T-bills (not Notes, Bonds or Agencies). Operative principles are active management, diversification, generally short-term or liquid commitments, generally unleveraged but with a willingness to take controlled risk and aggressive advantage of short term opportunities. This approach is admittedly a lot of work, but that is what it is going to take to survive and prosper over the next decade. The days of easy money are over. This is not the time for complacency or cookie-cutter approaches.

Copyright 2002, Cuddehe Capital Management, Inc.

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