The recent sell-off in equities has been violent, and while it’s natural to be gun shy after such extreme volatility, investors should continue to take the long view. Going forward, the game plan should be to take advantage of dislocations by patiently buying assets that have been disproportionately technically impacted, but not fundamentally impaired.
We can’t predict what will happen the next few days or weeks, but given the strength of the U.S. economy and European recovery, coupled with expected Fed patience and European Central Bank Quantitative Easing, we would be surprised if equities are not meaningfully higher in 6 to 12 months. However, not all assets are created equal, and it’s important to make the distinction between technical and fundamental damage.
1. Avoid anything that has been fundamentally impaired.
a. Emerging markets are suffering from slowing growth, China’s competitive devaluation, deteriorating currencies, elevated geo-political risk, plummeting commodity prices and no clear catalyst even when the knife stops falling.
b. With regard to China, all negatives relating to emerging markets are compounded by the fact nobody has any idea what’s actually going on there. The economy is trending worse and disturbing (and ineffective) government intervention in financial markets could signal that things are far worse than the government is letting on.
c. The commodities supercycle that began in 2000 is now unwinding in spectacular fashion (as they always do). Where should oil/copper/iron ore/etc. trade? Nobody knows, but the steep decline is being driven by imploding fundamentals (too much supply, not enough demand).
d. Many will argue that everything is getting cheap, and it may be, but it can get a lot cheaper before it rebounds, if it rebounds at all.
2. Look to buy assets with short-term technical challenges but strong fundamentals.
a. The Healthcare sector is enjoying strong growth and cheap valuations, with the recent selling driven by technicals and management’s maniacal focus on boosting shareholder returns. In addition, accretive consolidation should continue after recent regulatory changes.
b. U.S. consumer stocks, especially those with a high percentage of domestic sales, are the brightest spot of the brightest economy in the world. The American consumer is deleveraged, rationally cautious and enjoying all-time low debt-service costs, a rebounding housing market, an improving labor market, low but real wage gains (consumer income up 4.5% in last 12 months), and of course, lower energy costs. The majority, if not all, of the selling has been driven by technical liquidation and not fundamental changes.
c. Technology follows much of the same logic as healthcare, but valuations are much tougher to call here. Projecting forward business fundamentals in the technology sector is much more difficult than in healthcare, so our conviction is not as high.
d. European equities have been absolutely bludgeoned (down around twice what U.S. equities are down) despite the European recovery accelerating so far in Q3 with earnings growth at multi-year highs, M&A activity picking up and ECB QE in full swing. This is another one we have lower conviction on than U.S. Healthcare and Consumer companies, but you potentially have more upside if things turn around.
Broad lessons from recent volatility are:
- Don’t sell in a panic, but understand that things can always get worse in short-term before getting better.
- Don’t go “all-in” on equities in case things do get worse and you want more gunpowder.
- Don’t buy things that become fundamentally impaired no matter how cheap they may look on a historical basis.
The good news for hedge fund investors is that most top-tier event-driven and activist managers are already following this game plan. It’s been a tough month, but we believe the U.S. economy and European recovery are too robust for this to turn into a sustained bear market. Furthermore, given the strength of the financial system—banks are completely deleveraged with massive tier one capital levels—there is virtually no chance of a repeat of 2008.