Investing in a secular bear market

Investors have to focus on a paradigm shift that means quality blue chip corporate debt looks better now than most sovereign debt, stocks are bought for growth and income and bonds are used merely for capital preservation, according to Robert Pires of Bermuda Investment Advisory Services.

The second half of 2011 has been subject to very volatile financial markets. The third quarter in particular has been challenging with a negative market performance that was only partly offset by a recovery in October, says Pires.

Contagion fears are spreading through Europe and have real economic effects to the extent that the lesser economies of the PIIGS, Portugal, Italy, Ireland, Greece and Spain, are driving up interest rates and the cost of debt even for those European countries whose fiscal situation may be a lot better.

Meanwhile the US is unable to overcome the budget impasse and only 13 per cent of Americans think that Congress is doing a good job. Social turmoil can be witnessed in much of the world, including the Occupy Wall Street movement, civil unrest in Greece and economic instability in Italy.

In this environment low risk investments like US Treasuries and corporate bonds did OK, says Pires. The FTSE World Stock Index fell -7.6 per cent through September but rallied in October and stood at a drop of -1.3 per cent for the year through 31 October. The S&P 500, which also showed negative performance in the first nine months of the year (-0.9 per cent), had swung to 5.9 per cent return for the year ending at the end of October.

However, emerging markets stocks, where everybody has been looking for great performance because of the tremendous economic growth rates in these economies, have dropped by 10 per cent in the MSCI Emerging Markets Index during the 12 months ending in October, says Pires. “Of course gold seems to take the place of other investments during these troubled times,” he adds.

Despite the losses in equities for much of the year, a comparison of the performance in October and the previous months shows that recently the real performance has been in stocks.

“We want to remind you of that,” says Pires, adding “the desire to liquidate stocks following bad performance is great, but when you think things are at their worst is actually when you need to hold course.”

Paradigm shift

Pires notes that we are experience a paradigm shift. “In the past we used the safety of government debt to preserve the capital in client portfolios. At the same time we sought stocks for growth and bonds for income. Now we are looking at a new paradigm in our view. We are looking at the safety of quality corporate debt.”

Corporate balance sheets are the strongest they have been for decades and this contrasts with the balance of payments for countries like the US. The debt to asset ratio of US companies in the S&P 500 was between 37 and 38.3 per cent for much of the past decade. Since 2008 it has dropped significantly to currently 26.7 per cent.

The opposite, of course, is the case for sovereign debt where most industrialised countries have a rate of debt as a percentage of GDP from between 80 and 90 per cent (France, Germany, UK) and 100 per cent in the US up to 233 per cent in Japan. The PIIGS countries range between 109 and 130 per cent, except for Spain (67 per cent), which has very high unemployment at over 20 per cent.

“The reason is that companies are held accountable, governments don’t seem to think to have that accountability. The electorate in turn is not holding the governments accountable either because they are only in favour of those spending cuts that do not affect them personally,” says Pires.

In his view high grade corporate is now much better than most sovereign debt. “There is still a flight of capital to US Treasuries but we still think that high quality US corporate debt is better for you,” he says.

The issue with bonds is that they offer almost no income. “We used to buy bonds for income for most of my career. You cannot get that much income anymore from bonds. If you hold the stock of some companies you can get as much as three times more income than you would get from bonds from the same company,” Pires says, adding that BIAS continues to buy bonds but only for risk control, ie capital preservation, rather than income.

US corporate debt simply offers a higher return of around 3 per cent than US Treasuries (0.9 per cent).

The return for the year (through 2 November 2011) is indicative of where investors put their trust, he says. Greek and Italian debt showed a decline of -61 per cent and -5.1 per cent. US corporate debt in contrast showed a performance of 14.2 per cent and US Treasuries of 12.3 per cent for five year Treasuries.

“We have restricted ourselves to three years and less because we think that yields are so historically low and we don’t want to get locked too long. But there has been good performance in US bonds this year,” Pires says.

Equities for income

Instead of buying bonds, investors should focus on buying equities that offer attractive dividend yields for income. The dividend yield for companies such as Veresen, AstraZeneca, Kraft, Lilly, Intel or Pinnacle West is between 1.53 per cent and 4.89 per cent higher than the companies’ respective 5 year bond yield.

“There is tremendous pick-up in income from holding those stocks.” Even though withholding tax of between 15 per cent and 30 per cent can apply and this will reduce the return, a significant margin remains over the income that is available from the companies’ bonds.

The Fed Model, which shows the relationship between the yield on stocks and the yield on bonds by subtracting the S&P 500 earnings yield from the 10 year Treasury bond yield, reveals that currently we have the greatest differential between the valuation of stocks and the yield on bonds since 1962.

The strategy is therefore to have a higher proportion of high dividend paying equities, bluechip stocks in the portfolio that generate income.

“Because not only will you have that additional income, you have the potential for the stock to grow, particularly in the current equity markets,” Pires argues. “As a consequence of that the equity portion of our portfolios is more than 50 per cent in stocks paying more than 3 per cent in dividends.”

A crucial question is of course whether dividend paying stocks are better or worse performing than non-dividend paying growth stocks? Pires uses the example of the S&P 500 Dividend Aristocrats index of large cap, blue chip companies within the S&P 500 that have followed a policy of increasing dividend yields every year for at least 25 years. Compared to an equal weighted S&P 500 index the dividend paying stocks performed better during the past decade (134 per cent compared to 102 per cent), as well as during the most recent cyclical bear market (-41 per cent compared to -54 per cent).

However, during a bull cycle growth stocks are performing better, Pires says.

The secular bear market cycle

The difficult performance in the third quarter had prompted BIAS to take a step back and look at the prevailing market conditions and cycles to inform investment strategies and decisions going forward. There are three overlapping layers of market cycles from short term seasonal cycles of less than one year and economic cycles, such as recessions or periods when the economy is growing or in recovery, from three to five years to secular cycles from 15 to 25 years.

Secular cycles include for example the demand for specific commodities. As it takes about 10 to 15 years to get a mine up and running the supply and demand situation changes more slowly on the supply side.

According to Pires and his team we are currently in a 15 to 25 year secular bear market, which started in March 2000. Such secular bear cycles run on average for 191 months and include three to four cyclical bull periods that last from 12 to 60 months.

Despite the overall bear market, returns during these sharp rallies have exceeded 70 per cent in real terms.

Bear market strategies

The difficulty is of course to time the investment in these market conditions, but Pires has four tips in the current bear market:

Hold a large portion of dividend paying stocks – There are dividend paying stocks that offer higher dividend yields than the company’s respective bond yield. Historically dividend paying stocks have performed better than pure growth stocks in market conditions similar to today’s.

Add stocks that are likely to grow regardless of the economic cycle’s phase – One example for a stock like that would be Apple. In terms of a company that is performing it seems to be information resistant.

Buy when you see blood – When things look really bad that is not when you are supposed to sell, that is when you are supposed to buy.

Always remember to take your profits – You may have made a lot of money from Apple, you may be inseparable from your iPad, don’t be greedy, take a profit.

“We buy stocks likely to grow despite a recession, we buy when we see sharp declines in stock prices and we always remember to take profits,” Pires concludes.

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