By Tom Bradley

What are the stock market declines telling us (other than we’re temporarily poorer)? Are they signaling the end of the world as we know it or, as a veteran value manager suggested to me yesterday, are we entering “opportunity-laden times?”

In my view, it’s both. The state of the world’s finances is such that we have to be prepared for slower economic growth and more frequent disruptions to markets. The outlook has gotten worse. But as Larry “I’ve been through the end of the world a number of times” Lunn, Chairman of Connor, Clark & Lunn, points out in his latest outlook, the gap between earnings yields (the flipside of a stock’s price/earnings ratio) and bond yields is as high as he’s ever seen it (9% - 2% = 7%). Translation: stock prices are factoring in most or all of the bad economic news and valuations are attractive.

In response to recent developments, we’re revising our recommendation to clients. Up until now, we’ve been advising caution, but with further advances in bond prices and a significant retrenchment in stocks, it’s time to make some moves (see the Grip).

The specifics of our view are outlined below. They’re written from the perspective of a balanced client who has been following our asset mix recommendations, but they apply to all investors.

What now?

Bonds are even more overvalued now. The push to safety has driven down yields to unsustainable levels.

Action:

  • Fund manager: CC&L is making adjustments in the Income Fund. In the short to medium term, they’re getting more cautious on interest rates by shortening the duration (sensitivity to interest rate changes) of the bonds. This will help defend the fund from a rise in interest rates.
  • Clients: You should consider moving more out of bonds. This can be done by switching some money out of the Income Fund or selling another fixed income investment.

Equity valuations are getting attractive, even if the economic outlook has worsened. It’s time to do some buying. The market is unpredictable and volatile, but one thing we do know is that if we buy securities at cheap prices when investor sentiment is flashing FEAR, we will make money in the medium term.

Action:

  • Equity fund managers: In light of the market volatility and changes in relative valuation, it’s likely our managers will be making changes. We’ll provide updates in the near future.
  • Clients: We recommend you add to stocks. This would be the first step of a multi-step process (2 or more) because nobody knows when the market is going to bottom. Buying in stages makes economic sense and is more tolerable psychologically (buying now is hard to do). Your purchases can be funded from the bond proceeds and/or by deploying some of the cash on hand. In the case of the Steadyhand equity funds, we don’t have a strong bias to one fund over another, as they’ve all been hit by the market and all own well-capitalized, sustainable businesses.

It’s still a good time to have some cash on the sidelines. The economic fundamentals are poor, political leadership is pathetic, we’re operating without a safety net (i.e. there’s little room for increased government spending or lower interest rates) and we don’t know when the investor sentiment (panic) will improve. There are some positives emerging – share buybacks, lower energy prices, more balanced inventories, improved equity valuations – but we still believe it’s advisable to hold some cash in reserve (5-10% of your portfolio).

As I noted in Part I, long-term investors who are holding cash far in excess of this level should be more proactive in putting it to work. To repeat what I said last week, “You have a long way to go to be fully invested and this is what you’ve been waiting for. GET STARTED!”

To summarize

We recommend you (1) assess your total portfolio from the perspective of your strategic asset mix (SAM), (2) let the Steadyhand fund managers do their thing, (3) hold 5-10% in cash and short-term investments, (4) own a less-than-normal weighting in bonds, (5) be neutral to slightly overweighted in stocks and (6) don’t hesitate to call us (1-888-888-3147) to discuss the specifics of your portfolio.

To illustrate our recommendations, consider a 50/50 client who has modeled her portfolio after our hypothetical Balanced Income Portfolio. Her strategic asset mix (SAM) is 50% stocks, 50% bonds and 0% cash. Her current mix (before the above-mentioned recommendations) would be 5-10% cash, 40-45% bonds and 45-50% stocks. Our recommendation for her now would be to continue to hold 5-10% cash, reduce her bond weighting to 35-40%, and increase her equity weighting to 50-55%.

The steps recommended may be the first of many. We don’t know how the markets will play out from here. (Repeat: We don’t know what the markets are going to do in the short term). We do know, however, that bonds will provide a modest return going forward based on current yields. We also know that stock valuations are attractive again (the S&P 500 is trading at 11-12 times earnings, which is well below the long-term average of 14-16). Further, investor sentiment has swung decisively to the FEAR side of the behavioral spectrum, which means it’s time to pay special heed to Warren Buffett’s words:

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

Safety is now expensive and risk is on sale.