Finding Opportunities in a Distressed Market

by Inya Ivkovic, MA

When Alice in Wonderland asked the Cheshire Cat which way she ought to go from here, the Cheshire Cat answered, “That depends a good deal on where you want to go.” These days, many investors are facing the same kind of dilemma. We all know what we want — portfolios with superior returns. Only, to get there, we first need to know exactly where we are in the current business cycle.

There are a few questions that need to be answered first. After a year of being mauled by the bear market, have we found solid footing yet? Have we entered the early stages of a recovery that could lead to a secular bull market for equities? Or, have we been misled by recent rallies, which were largely spawned by massive cash infusions, into thinking that things are improving, when it may all be short-lived and lead to high inflation and further erosion of our economic fiber?

The honest answer to these questions is that no one can say for sure. Still, that doesn’t mean that long-term investors should not think about better repositioning themselves until at least some of the trends clarify themselves. If for no other reason than that, historically, once any bear market finds its true bottom, equity rallies can be quite sudden and quite strong. That said, it may not be a good time to stand on the sidelines.

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To at least estimate the direction of these transitional market trends, it might be prudent to keep a constant watch on key leading indicators, particularly U.S. monetary policy. Remember that, despite much media attention being paid to unemployment claims, the jobless rate is a lagging indicator. In other words, if you notice improvements in that area, it could mean an economic recovery is already on the way and you may have missed the boat.

Now, here is the usual caveat — leading indicators are not always accurate. However, their “hits” are much more frequent than their “misses,” which is why many economists monitor key leading indicators. Among those most intensely watched is the availability of money. If the supply of real money decreases, it stumps business activity and growth. This is the reason the U.S. government took the global lead in increasing the money supply and reduced interest rates to jumpstart lending and the flow of capital. Is this leading indicator showing signs of improvement? “Yes” in the short term, and “Not so sure” in the long term, having in mind only the potentially crippling future inflation rates.

Tied in with money supply is also the yield curve, another leading indicator. So far, the U.S. government has dumped an estimated $3.0 trillion to $4.0 trillion into the country’s economy. That has steepened the Treasuries yield curve, which is typically a sign that the market could be on the verge of recovery. Historically speaking, whenever the yield curve for U.S. treasuries has reached new lows, it was always very close to recessionary onsets. The exact opposite would happen when the yield curve would steepen, typically signaling that the market was emerging on the path of recovery.

Another leading indicator that could signal the beginning of a sustainable market bottom is the narrowing of credit spreads. At this point, bond and credit have only somewhat responded to the massive economic stimulus. Although the spreads have narrowed from mid-November of last year, they are still at historic widths at the moment. Generally, the wider the bond and credit spreads, the steeper the price of taking on risky investments.

I still very much fear a few things, such as the failure to deleverage and the impact of deflation, which could spawn inflation not seen in years later on. But let’s not completely ignore market rallies either, considering how low equity valuations are at the moment and provided that everyone understands that short-term upside momentums are not guaranteed.

At this point, it is all about managing risks and positioning your portfolios to lower their betas. For example, you can lower your
betas by employing long/short strategies, whereby shorts would lower the portfolio’s beta and longs would allow participation in the potentially rising markets. Historically speaking, equity markets tend to “arrive” quietly and unnoticed, but if and when the stars align, equities could advance very quickly.

Don’t forget: equities potentially offer a multitude of opportunities, ranging from defensive to aggressive strategies, from domestic to foreign markets, from long to short portfolios, and any combination thereof. No one can tell you with any amount of certainty if and when the U.S. stock market will recover. However, by reading PROFIT CONFIDENTIAL, at least you’ll be able to keep an eye on leading economic indicators and hopefully find our thought process beneficial in positioning your own portfolios in such a manner as to take advantage of these fast-changing and largely unpredictable market conditions.