Managing Against the “R” Word

For most of us who live and think in terms of markets, the “R” word is shorthand for risk, and about what we fear most: a permanent loss of capital. As market addicts, we have long ago cut the lock-step connection between the late developing economy, current market prices, and more to the point, our views as to future prices. As with many of our beliefs, we are challenged by inconvenient facts. Right now the “R” word that is most on our mind is recession (or worse).

Cyclicality

Anyone experienced in life or history is very conscious that there are ups and downs in the course of human endeavor, chronicled from as early as the story of Joseph in the Bible. We have come to believe that the cycles are caused by the alternating opposites of excess and scarcity, which drive our behavior beyond reasonable limits. In terms of the stock market, the extremes are characterized by widespread speculation and distaste for accepting any chance of momentary loss.

The Three August Weeks

Only a hermit would not be conscious of the market price turmoil of securities and currencies these past three weeks. Declines of more than 20% are not uncommon. Currency moves of 5% have been experienced. These kinds of sharp declines are more normal after extended and widespread bouts of high speculation and extreme publicized behavior. In my opinion, this is not an appropriate description for 2011. Something else is happening.

What is scaring thoughtful people?

The inability of societies on both sides of the Atlantic to politically come to grips with their now recognized, unsustainable budget deficits is an important concern; for we like many of the “entitlements” we receive and don’t want to pay for them today. The fear of losing some of these in various cutbacks concerns the general population. What is more concerning, is the recognition that we will probably be fighting a two-front war with some to materially cut back government spending (which will not be selective in terms of our own proclivities), and which will thus lower demand. The fear is that less spending, combined with some form of higher tax realizations, will crunch ultimate demand for goods and services in our economies. Many are translating lower demand into a general recession. (At the moment, investors and people in general are not focusing on the money previously released by US government spending into the private and personal economy, which is likely to have a multiplier effect.)

Will we have a recession?

I do not know. If we do have one, as consumers we talked ourselves into it by reducing our normal purchases. People do this. They hoard their cash and capital in expectation that their incomes will be hurt in the future. While I have clearly said that I do not know whether we will have a recession, I am managing our clients’ portfolios against suffering a deep recession. Most recessions and bear markets come as a surprise to most people. Discussions of economic problems have been in the news for more than a year, so the possibility of budget and financial problems is not new. (Even if we were to have a recession, most of the time the US stock market bottoms before the recession is officially announced.) The only sector that I see with rampant speculation or unwarranted thinking is on the part of governments around the world.

What are the problems with the governments?

There are two problems governments on both sides of the Atlantic are suffering. The first is that all too often their estimates of the costs for various programs are too low and their expectations on tax realizations are too high. These breed fears on the part of those who have been asked to loan money to the governments. The second and much more basic problem is answering the question, “What is the proper function of government, as distinct from the political need to stay in power?” What is currently being ruminated is the series of issues involved with the second question.

What are the proper functions of governments?

In terms of the valuation of both debt and currency of various countries, the collective views of the marketplace are in the process of being heard. Historically the first function of a government was to arrange the protection of its people. The second was to create a code of behavior that permitted people to interact within their community with relatively little strife. Out of this second function, governments believed they were empowered “to do something” to “help” their people. Increasingly this “help” took the form of intervention into people’s lives to a ridiculous height. In modern days, the level of intervention has reached what some call the “Nanny State.” An extreme example is California’s proposed law that hotel beds must have fitted sheets. There are many other and better examples of government intervention into our lives. The new difference is that increasingly as a society, we are unwilling to fund these interventions.

How does this impact my portfolio of stocks and funds?

There are many ways to filter through the approximate 100,000 funds being offered around the world. (I am using a global figure, as an increasing number of this Blog community resides beyond the US.) One way that may be useful is to look at how much of the earnings power of the companies in stock portfolios are in a relatively high vs. low interventionist country. That approach was one of the reasons that in last week’s blog I stated that we were adding to our Asian exposure. There are four great examples of the many Asian countries who have relatively low debt and deficits compared with their gross national product. China is moving from a command economy where, on the surface, practically every economic act is governed by the party, to an increasingly consumer driven society. China is producing the highest growth rate of any other large country in most economic and financial aggregates. (This is not a recommendation to buy Chinese stocks wherever they are traded. I leave selection of individual securities up to professional analysts and portfolio managers who spend their lives on these matters.) India is another good example of a country haltingly moving from a command economy to a more private sector-driven one. One hears that India is slowly but finally overcoming corrupt practices. India’s growth rate lags China by a bit, but within a relatively few years India will be more heavily populated than China. Both Hong Kong and Singapore are much freer of intervention in economic activities than their two largest competitors, China and India, and their stocks are valued more highly, due in part, to greater disclosure and somewhat less intervention on the part of their market-oriented governments.

What should we do to our portfolios if a recession does hit us?

I have often said that one can recognize gamblers by whether they get out of bed in the morning. Not only am I a gambler (a balancer of returns and risks), I am an optimist, particularly when others are not. (Perhaps, I am saying the same thing twice.) If the markets continue to decline, I would be selling the fixed income holdings and adding judiciously to our diversified equity holdings.

What are you doing?

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