One striking characteristic of the post-financial crisis world is the apparent disappearance of the traditional business cycle. The world's developed economies - heavily indebted, still deleveraging, and in some cases in the midst of painful austerity - are being supported by periodic, unconventional interventions from increasingly leveraged central banks. The result has been an anemic, albeit steady pace of economic activity marked by fits and starts that are increasingly difficult for investors to interpret. It's makes sense then that market cycles have followed suit, with equities showing sudden, at times violent moves that have mixed strong rallies with steep declines over relatively short periods, each driven by marginal changes in the trajectory of economic expectations. Single-stock correlation remains high due to this uncertainty, with more cyclical market sectors the most disadvantaged.
Several factors are at work. Deleveraging associated with the housing bust is a persistent and long-term headwind. Personal savings remain elusive. Rising commodity prices, specifically oil, have affected consumer purchasing power and sentiment. Unemployment remains stubbornly high. And, importantly, the primary source of economic stimulus is coming from central bank programs instead of traditional private business investment.
As if all this weren't enough, there is the backdrop of the intensifying sovereign crises in Europe and slower growth in the all-important emerging economies, especially China. Interestingly, none of these issues is particularly new. They have been part of the landscape for several years now, and distinct patterns have developed around them that have been repeated in each of the last three years, giving investors the sense that cycles of economic activity have compressed dramatically. Previously marked in years, moves up and down in business momentum are now counted in months, if not weeks.
Which leads two questions: Has the business cycle fundamentally changed? Should traditionally cyclical businesses carry lower multiples as a result? It appears to us that in the short term, the market has answered with a resounding 'yes.' Cyclical sectors, such as Industrials, Energy, Technology, and Materials have become increasingly volatile and have borne the brunt of the selling during market downturns.
Within these areas, even high-quality businesses (as measured by balance sheet strength and returns on invested capital) are suffering from the altered preferences of investors for the perceived safety of more stable businesses. Investors continue to abandon equities, gravitating toward fixed income securities even as they recognize the inevitable loss of purchasing power that comes with them. It appears to us that we now have a bubble in fear that is manifesting itself in ways that have our contrarian pulses racing.
We are finding what we think are excellent values in currently unpopular pro-cyclical businesses. Cycles have certainly become shorter over the past three years, but we hold the view that these are anomalous times and that the traditional business cycle will reemerge before long.
The economy does not yet have sufficient self-sustaining business momentum that will allow it to be weaned off the artificial support currently being provided by central banks. The opportunity from our standpoint lies in looking where others are not while holding fast to our time-tested investment approach governed by absolute standards for valuation and return.
In the short term, our interest in cyclical businesses is putting us out of sync with the return patterns of the market. While unpleasant, it is a byproduct of our contrarian nature. In fact, this period is somewhat reminiscent of the late '90s when investors were citing the demise of traditional value investing because of the emergence of the internet and the technology revolution. What was then a bubble in greed has become a bubble in fear.
Investing is a perennially dynamic endeavor requiring both patience and conviction. Those tenets are being sorely tested in the current market. Although business cycles have looked different of late, and the market has been reacting accordingly, our belief is that they will ultimately revert to the mean, benefiting higher-quality companies in cyclical sectors. We take heart from the timeless wisdom of Alphonse Karr, for indeed "the more things change, the more they stay the same."
Important Disclosure Information
Chris Clark is a Portfolio Manager and Principal of Royce & Associates LLC. Mr. Clark's thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements.
Read the original here.