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The global equity markets are built to appreciate over time and lead to a happy ending. Sure, there are the occasional bumps in the road (volatility), but owning an equity is nothing more than owning a small percentage of a business. Thoughtful CEOs should be able to raise profits over time, and as the owner of those equities, you should benefit as a portion of those profits flow to your personal balance sheet.
Unfortunately, the global equity markets are also fraught with uncertainties, and although crafty CEOs with distinctive business plans and compelling products or services to offer may set the table for success, a number of unpredictable and uncontrollable factors may impede their ability to generate profits over time. Imagine a business world of higher taxes, more government regulation, and consumers with less disposable income to buy a company’s products or services. Even if a company made the best-tasting food or created the most elegant software package, there just might not be enough consumers to buy what that company was offering and its profits would plummet, as would its stock price.
We are now at one of those moments in financial history where the tensions between disciplined and talented CEOs (and no, not all CEOs are disciplined or talented) are being challenged by a number of macroeconomic conditions that are largely out of their hands to control. Exhibit A of macroeconomic stress includes the ever-expanding European debt crisis; the political games surrounding getting a handle on the massive amounts of U.S. debt; uncertainty as to how long China can carry the global growth story while maintaining an acceptable level of inflation in its own economy; and oil prices that cannot go much higher without impairing global economic growth, particularly in the U.S. and Europe. All of the macroeconomic problems are massive, require creative political solutions appealing to different constituencies with different interests (think Republicans vs. Democrats; or wealthy Germans vs. impoverished Greeks), and must artfully convince a skeptical investing public that the solutions have real teeth and are sustainable. That is a very tall order.
Meanwhile, just look at the value opportunities popping up right and left in the global equity markets. Japan may be a basket case, but the Nikkei Index is trading at its book value! Not 2.5 times its book value like the U.S. equity market, but its book value. That’s a far cry from over 3 times its book value 20 years ago. Just imagine if economic reconstruction from the recent earthquake and tsunami reinvigorates economic activity (and profits) in Japan. Equity prices could meaningfully rise.
Did you see the “anonymous” letter posted by a hedge fund manager a few days ago which was sent to the Board of Directors at Microsoft? After five years of holding the stock and watching it go nowhere, he has had enough. He advises the Board to raise $40 billion of debt (why not with interest rates so low!) and to take that $40 billion and immediately buy back shares of Microsoft. Given that Microsoft has a huge amount of cash held overseas as well (which it doesn’t want to send back to the U.S. because it would be subject to taxes), this hedge fund manager also wants Microsoft to borrow against that overseas cash and further buy back its shares. The result? According to this manager (who has 11 million shares of a reason to care), the stock price would appreciate roughly 50% from $26.63 per share to roughly $39.00 per share.
Today’s news that ConocoPhillips is spinning off its refining and marketing operations into a separate company is just another example of the deep values embedded in many stocks at this time. In this case, the announcement has led to an instantaneous jump of nearly 10% in the ConocoPhillips stock price. The management at ConocoPhillips has figured out exactly what its rivals at Marathon Oil concluded and acted upon only a couple weeks earlier: that by dividing the exploration and production business from the refining and marketing business, the sum of the two different operations (which attract different kinds of investors) are worth more than one integrated oil company. Let’s do the math on British Petroleum (“BP”). BP currently trades at 6 times it forward earnings estimates whereas ConocoPhillips trades at over 9 times its forward earnings estimates, and an average of global integrated oil companies trade at over 11.5 times their forward earnings estimates. Dare to dream that BP’s management splits itself into separate companies as was recently suggested by an analyst at Investec Bank PLC.
The list of attractively valued equities is long. U.S. equities are trading at 12.5 times forward earnings, an 18% discount to the 10-year average of 15.3 times forward earnings. This same discount to 10-year averages is true of developed global equity markets as well. By contrast, emerging market equity indices are trading at only a 5% discount to their 10-year averages. Moreover, does buying a 10-year U.S. Treasury bond at 3.00% really excite you? I didn’t think so.
So what gives? The overhang of the four macroeconomic horsemen cited above. Each of these four macroeconomic risks may have a low probability of occurrence (that’s debatable), but an unpleasant outcome stemming from any of these scenarios would lead to a pronounced global economic recession. Imagine the financial panic if the U.S. government (the world’s safest borrower) were to default on its debt, causing global interest rates to rise. Or if the European debt crisis spun out of control leading to a run on money market funds that hold European bank debt and can no longer “hold the buck” in net asset value. If China’s inflation runs rampant, the Chinese government will have to clamp down on its economic growth, which could likewise lead to a global recession. Lastly, significantly higher oil prices would impinge already-strained consumer spending habits and lead to economic decline.
What’s an investor to do? We are living in a world of attractive “micro” investment opportunities that are being challenged if not outright overwhelmed by the risks entailed from severe “macro” economic possibilities. These macro possibilities are deflationary, but the repeated government fiscal and monetary stimulus efforts to address these macroeconomic forces are inflationary in nature. And it’s unclear as to which forces will prevail, deflation or inflation, let alone in what fashion or time frame.
As such, stay diversified. Maintain exposure to assets that can benefit from both deflationary (high credit quality bonds) and inflationary (equities, commodities) pressures. And, as always, closely re-examine your current asset allocation and stay within your “sleep quotient."
