Investors are tethered to the saga of the European sovereign debt crisis, producing gut-wrenching market gyrations. The threat of Greek (Spain, Italy…) default, European bank recapitalizations, and financial contagion have driven fear and uncertainty to the extreme, and caused investors globally to move en masse away from equities: “highly correlated moves,” in Wall Street parlance. Expecting the worst, investors have particularly penalized cyclical (or high-beta) stocks, driving valuation spreads between those and stable (low beta) stocks to almost unprecedented levels (Figure 1). On this basis alone, one could conclude that it is an awful time to reposition to low-beta stocks, as they are expensive compared to their cyclical counterparts (Figure 2). Even more importantly, we believe there is significant value opportunity in today’s beaten-down sectors. Over time, managements have demonstrated the ability to adapt, and overcome the obstacles in front of them, and to restore profitability in the wake of significant macroeconomic disruptions. Corporations today are well positioned to deal with near-term shocks should they arise, having de-leveraged their balance sheets and realigned cost structures following the 2008/09 recession. So rather than concluding that equities, and cyclical stocks in particular, are in trouble, in many cases we see a different picture: one of resilience, adaptability and solid financial footings. We see opportunity.
Profitability is Strikingly ResilientFrom a global perspective, we find convincing evidence of corporate adaptability to all types of economic environments. Figure 3 presents the return on equity for the MSCI World index over a 37-year period, which includes recessions, high inflation, low inflation, and a myriad of other conditions. Though somewhat variable over the short term, returns on equity have stayed within a reasonably tight band around a long term average of 12%. These data reinforce our on-the-ground observations of company managements taking the necessary actions to meet the challenges of the current economic environment. Most investors were surprised by how quickly corporate profits rebounded after the last recession despite only a muted recovery in GDP. We take encouragement from corporate performance in 2008 as we survey the landscape today.
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