Commentary

The Sun Also Sets


Who could blame an investor today for feeling a tad nostalgic for the Panic of 2008? There was a simplicity to the thing. It was such a brutal and impartial rout—slaying just about every asset class—that it made you want to swear off all markets forever. There was comfort to be found in stashing a shoebox full of $50 bills in the freezer. No paperwork. No jabberwocky from your broker. Just the reassuring face of Ulysses S. Grant juxtaposed with your cold, raw fear.

By March 2009, with U.S. stocks at 1996 levels, equities had returned less than Treasuries over the previous 10-, 20-, and 30-year periods—debunking the equity-risk premium so central to Econ 101. Until, of course, the market reversed course and surged 80 percent in 13 months, reminding investors that it was at least theoretically possible to make money in equities. That change of mood edged out fear just in time for the 2010 edition of the credit crisis, an international production that began with Greece's near-collapse and soon spread to Portugal, Ireland, Italy, Spain, and beyond. The Standard & Poor's 500-stock index has now fallen 12 percent in a month, its first official correction since the new bull began last spring.

Corrections are routine and even healthy events; they come along about once every 11 months on average and wring out the excesses and false expectations that rallies inevitably bring. "To the extent that current worries squeeze long positions, extinguish optimism, or even lead policymakers to pursue courses of action that are more supportive—not more punitive—for markets, the selloff may be creating more favorable entry points for investors to buy into a still recovering global economy," writes Stuart Schweitzer, global markets strategist for JPMorgan Private Bank, in a May 24 note to clients. That may all turn out to be true—provided investors don't panic, rush for the exits, and help turn a routine recovery into the second leg of a double-dip recession.

If the lesson of March 2009 is that the sun comes up—the most brutal selloff is just a prelude to the next rally—then the lesson of the recent runup is that the sun can shine too brightly, blinding us to boulders in the road. And then it can set.

With payrolls still slack and credit still tight, the contours of these peculiar economic times are becoming apparent. Last year's snapback is not going to bring a garden-variety, V-shaped recovery. Instead, investors are again having to confront the messy unfolding of a long and overly generous credit cycle, global in nature and marked by a spate of bank and business failures. How the economies of the world digest it is anyone's guess. When the next leg up begins, though, it will mark a critical milestone for a stock market that still needs to rally by almost half to revisit its 2007 high. Getting there despite profound economic challenges is going to take some hard traveling.

"In the U.S., we have no living precedent for this," says Donald Luskin, chief investment officer at strategy firm Trend Macrolytics, whose search for domestic parallels to this credit crisis took him all the way back to 1907. "We have had a living laboratory for it in Japan for the past 15 years. But in the U.S., we're all attuned to the little upticks in metrics that don't necessarily inform much." In other words, we seek auguries where there are none by comparing traditional business cycle statistics such as payrolls and housing starts to once-in-a-lifetime lows from late 2008 and early 2009. Luskin predicts the market will be range-bound for at least five more years as companies and consumers shed debt. "This is not a particularly bearish view," he says. "It's just the expansion-less, low-return world we're now in."

Luskin's unenthusiastic outlook—which contrasts with the prevailing optimism among Wall Street strategists in a May 25 Bloomberg survey—brings to mind the "new normal" paradigm coined last year by Bill Gross and Mohamed El-Erian at Pimco, the bond giant. The idea is that a bitter confluence of deleveraging and reduced consumption and employment will necessarily bring a long period of low growth and low returns. In the absence of a healthy consumer, the neo-normalists point out, there is no other driver to magically propel the economy.

All of which is reasonable—and has largely been ignored amid a recent rush to riskier, less stable sectors at the expense of large-cap companies. This rush was less than rational; if returns are negligible and credit is tight, one would have expected investors to move into big, stable equities that pay dividends. But they didn't, even though the private equity feeding frenzy and promiscuous lending that made small-cap company buyouts all the rage a few years back are long gone. Small companies today are less likely to be self-financed and far more likely to be dependent on volatile-rate bank debt (assuming it is offered to them at all). Even so, the S&P's small-cap index has returned 3.6 percent so far this year—almost 10 points better than the 5.8 percent loss registered by the S&P 100 (the bluest of blue chips, including IBM (IBM) and ExxonMobil (XOM)). Going back to the market's low last spring, the excess return is hardly inconsequential: 90 percent for small stocks, vs. 50 percent for the mega-caps.

The lesson? The financial conflagrations of the past three years did not signal a permanent flight to quality. Appetite for the high-risk/high-reward trade is alive if not well. The resurgence of large-cap equities has, again and again, been exaggerated. According to Leuthold, a Minneapolis fund management firm, small-cap stocks now sell at a "very fat" valuation premium of 20 percent relative to large caps, an all-time record disparity. Nobody seems to care that Johnson & Johnson (JNJ), with a $165 billion market cap and impeccable financials, pays a 3.62 percent dividend—more than 10-year Treasuries. AT&T (T), the country's largest phone company, an inveterate booster of its dividend over 26 years, yields almost twice that, but its shares have badly lagged the broader market this year. All this as banks believe they are doing you a favor by advertising 1 percent for your cash.

To some, any case for U.S. stocks—small, large, whatever—is also exaggerated. Pimco is now lumping the U.S. together with Japan, France, Spain, and Greece in what it calls a sovereign debt risk "ring of fire"—an ignominious league of nations that will increasingly have problems paying their debts. That association would suggest a lot more downside for U.S. shares, whose aggregate 4 percent drop so far in 2010 is but a sliver compared with the S&P Euro Index's 12.5 percent plunge.

Everywhere you look in the U.S. and Europe is another investing dead end. Together, they make the case for aggressive allocation away from developed markets and into emerging markets—yesteryear's financial basket cases turned today's paragons of growth. According to the International Monetary Fund, the developing world has catapulted itself from 18 percent of global GDP in 1994 to 31 percent last year, with its share still gaining at the expense of Japan, Western Europe, and the U.S.

That sort of growth means it is now far too prudish to allocate a mere 10 percent of one's portfolio to developing powers such as Brazil and India. "U.S. investors should move from a U.S.-centric worldview and toward a larger allocation to emerging market economies," says John West of Research Affiliates, an index strategy shop, also of Newport Beach. "They don't face the hurricane-like headwinds of deficit, debt, and demographics that developed markets, including the U.S., do." Since the market's low, the MSCI Emerging Markets index has shot up 77 percent—20 full percentage points better than the S&P 500. Not that no one has noticed: Emerging-market stock funds have consistently taken in multiples of their U.S. counterparts for five years. And while the U.S. and Europe have swooned in the past month, the emerging markets have fallen 15 percent, a resilient showing for a category that has historically been incapable of handling contagion. West thinks that investors in emerging markets amid this global risk realignment will be disproportionately rewarded over the coming decade.

If you don't have the stomach for increasing volatility, you might just take the old advice to sell in May and go away. Or you might park your dollars in gold, which is trading at an all-time high and is certain to go higher, unless it doesn't. Or you might go to cash, which the Federal Reserve is deliberately pegging at all-time low yields, guaranteeing that inflation eats away at what you have.

The sun will rise again, but in the meantime, no one is saying anything about sleeping well tonight.

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Farzad is a Bloomberg Businessweek contributor. Follow him on Twitter @robenfarzad.

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