Scaling the "Wall of Worry": Taking Stock of 2013 to Strengthen Your Portfolio
October marked an infamous anniversary on Wall Street. Twenty-five years ago, the unthinkable happened when the Dow Jones Industrial Average dropped a record 106 points to end the trading week at just under 2500. The following Monday, now known as "Black Monday," the index shed an additional 508 points in one session. While the day's decline was widely blamed on a newfangled process called "portfolio insurance," it didn't help investor psyches that U.S warships started shelling an Iranian oil platform in the Persian Gulf that very same day.
At the time, given the multitude of concerning events, many high-profile economists, strategists, and media outlets immediately began predicting a global recession and bear market. Interestingly, neither happened. The Dow ended 1987 in positive territory, and the economy kept chugging along at a relatively steady pace for years. When the stock market marches upward, despite dire headlines, it's said to be climbing a "Wall of Worry." Veteran investors will tell you these are often the best markets to build portfolio positions in because they typically lack the exuberance that can lead to overvaluation. Yet buying into--and climbing--that wall is never comfortable.
A wild, not-so-wonderful ride
Markets around the globe have been volatile for the past several years, racking up double-digit percentage gains in one quarter, and then losing them all the next. This cycle, amid all the media coverage and array of legitimate long-term concerns (massive government debt, defaults, downgrades, demographics, moderate global GDP, terrorism, the looming fiscal cliff, etc.), understandably leads to frayed nerves and sore stomachs. Further, the public seems to have become disgruntled, disenfranchised, and disgusted by Wall Street. They're also feeling that the little person doesn't have a chance against today's "dark pools" of trades from institutional orders concealed from the public, algorithmic traders, and highly paid Wall Street insiders.
Yet, if you look through the angst and the media noise, you'll see that:
- Corporate America has a collective $1 trillion or so in cash on its balance sheets and record-high profit margins, and is staffed for lean times.
- Valuations on many companies are not excessive by historical standards: price-to-earnings ratios on U.S. equities have declined to around 15x earnings per share versus 18x or so a decade ago.
- Cash returned to shareholders from many of these companies in the form of dividends is substantially above the rate one can earn on bonds (and those distribution rates tend to increase each year).
- The owners of the world's privately held businesses--who swore they were going to get out at age 62, but are now five to 10 years older--are now looking for opportunities to cash out.
- Patent issuance has remained strong in the U.S., boding well for research, innovation, and hot new industries.
- Some of the jobs that went away in the Great Recession are not coming back, as our economy strives to reformat itself. Although this is creating immeasurable anguish for those in outmoded industries, it also creates much potential for those able to retrain and/or shift core skill sets to new opportunities. Think for example, about the potential redirection of activity being prompted by investments in things such as liquefied natural gas; our entire energy dependence or independence landscape could be radically different in a short time.
- Stocks are under-owned. Investors--both individual and institutional--have been taking money out of stock funds for more than five years. According to Morningstar Direct, investors pulled $16.8 billion out of domestic stock funds in September alone--and have withdrawn $127 billion in the past 12 months.
- Bonds are over-owned, and there's a seriously brewing bubble there waiting to pop. According to Morningstar, $30 billion was added to bond funds in September, bringing the 12-month total influx to more than $235 billion. Real yields are negative in several developed countries as investors stretch for yield, and bond fund investors may be taking on more risk than they realize as managers put riskier credits and longer maturities in their portfolios in an attempt to preserve yield.
The coming melt-up?
In much the same way that people stop buying current iPhones in the months before a new release, corporate executives across the country remained on the sidelines for months awaiting the outcome of the election. This wait-and-see approach gained epic momentum in the summer months, we suspect, because of the moderation in growth that showed up in third-quarter earnings reports. State governments, too, sat frozen, at least as it related to implementing key portions of the new health care law, at first awaiting the Supreme Court's ruling last summer and more recently the outcome of the election.
Then Hurricane Sandy, encompassing the Northeast just before the election, further impeded economic activity in the short run. Given the confluence of potentially important events, is it any wonder that many economic statistics showed weakness in the third and fourth quarters?
The market's initial reaction to the election was swift and sour, though we think investors overlooked a key point: at least the election gave us a modicum of directional clarity--whether or not one likes the direction. At least corporations and municipal governments have a clearer idea on what the ground rules will be for the next two to four years. While the "fiscal cliff" was still looming (as of this writing), that too will be more fully defined within a few short weeks or months. I strongly suspect that in 2013--given the cash, the demographics, and the underinvested nature of personal and institutional portfolios--activity will pick up.
Wishful thinking? Perhaps. Hopeful thinking? Most definitely. While I don't discount the weighty issues that both the lame duck and the freshly elected politicians must face, we've climbed Walls of Worry before.
The fundamental pieces stacking up are simply too compelling to ignore.
Carol M. Schleif, CFA, is a managing director in asset management at Abbot Downing, a Wells Fargo business that provides products and services through Wells Fargo Bank, N.A. and its affiliates and subsidiaries. She welcomes questions and comments at email@example.com.
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