How to hibernate in a bear market
As long as stagflationary conditions prevail, the stock market is likely to struggle. But it is nevertheless possible to outperform in such an environment.
Notwithstanding economic stagnation, UK CPI surprised to the upside in June, rising by 3.6% y/y. Stagflation, as it were, remains the order of the day.
And not only in the UK. Across the pond, the growth/inflation mix has deteriorated over the past year. US Q1 GDP was outright negative even though inflation remains “sticky” at close to 3%.
The culprit in both cases is government policy. You can’t run large public sector deficits year after year without causing prices to rise. That’s macro 101.
Of course, governments will not admit this.
Inflation is, always and everywhere, a government phenomenon
Children are known to deny responsibility for their occasional misdeeds. On almost no issue is the government more childlike in its denial of responsibility than in how it tries to explain inflation to the public. It more or less claims that inflation is some bogeyman hiding in the closet making an occasional, unpredictable, frightening appearance.
No. To paraphrase Milton Friedman, “Inflation is, always and everywhere, a government phenomenon.”
Nor is the inflation bogeyman going back into the closet anytime soon. Here in the UK, workers in various parts of the public sector have been taking turns to press for higher wages. Teachers, nurses, doctors, train and bus drivers, bin collectors… The list is long indeed.
How likely is it that the government will somehow resist the onging pressure? A government that has already been weakened by a large rebellion over efforts to reduce sickness and disability spending?
How about “zero”?
Higher public-sector wages will place further upward pressure on prices. In what appears more and more like a repeat of the 1970s “wage-price spiral”, UK inflation is likely to remain elevated for some time. Yet as growth remains anaemic, perhaps outright negative, the overall picture remains one of stagflation.
In the US, industrial action has become more common. The weaker dollar of late is likely to contribute to “sticky” inflation going forward. Yet the government, running chronic deficits, bears ultimate responsibility.
Stagflation threatens lofty valuations
Following a sharp correction earlier this year, the stock markets of both countries have recently risen to all-time highs. P/E ratios, while slightly lower than a year ago, remain near the top of historical ranges. This implies that these markets remain vulnerable.
Stagflation normally wreaks havoc on stock markets, the returns on which tend to trail behind the rising cost of living. When stagflation arrives amidst generally overinflated assets, the underperformance is likely to be all the worse.
Cautious investors might consider sitting in cash and bonds, rather than shares, but both are virtually guaranteed to lose value in real, inflation-adjusted terms.
How, then, can defensive investors position themselves to hibernate through a possibly prolonged bear market?
Go where the inflation is
In brief, investors need to go where the inflation is. If widgets are rising in price, and everyone needs a widget, you want to be invested in companies that produce widgets.
Economists call this “pricing power”: when companies can easily pass input price increases along to their customers. This tends to be the case in basic industrial sectors such as energy, mining, materials, chemicals, agriculture and non-discretionary consumer products.
For years, such sectors have been mostly out of favour. They’re relatively old, mature industries. They’re not particularly “green”, although sometimes they try to appear so. They’re not sexy, or cool, or trendy.
But they tend to make money. They tend to be highly cash-generative. And they tend to pay high dividends. They might have low margins, but those margins are stable. Where there’s inflation, it gets passed right on through to customers.
I wouldn’t claim they’re “stagflation-proof”, but they’re certainly more “stagflation-protected” than the high-flying growth sectors, such as technology, which has powered the most recent bull market. And, unlike bond coupons, the revenues they receive, profits they make and dividends they pay out are likely to rise along with inflation over time.
But what about diversification? Should investors go all-in on the stagflation sectors listed above?
Don’t forget gold
No. They should also own some gold. In a stagflationary world, gold preserves purchasing power better than bonds or cash. And it also efficiently diversifies a portfolio of defensive stocks.
How much gold? A simple run of 100 years of data implies a weighting of 10-15% reduces portfolio volatility without sacrificing returns. Looking at the post-Bretton-Woods period only, that rises to 15-20%.
Gold doesn’t pay an income, but then bonds paying interest below the rate of inflation pay, in effect, negative coupons. And, over the longer-term, gold has an excellent track record in keeping pace with inflation. In gold terms, adjusted for taxes, petrol is less expensive today than it was in the 1960s.
A classic example of gold retaining its purchasing power is that one troy ounce allows a gentleman to purchase a Saville Row bespoke suit. I haven’t walked along Saville Row recently, but I suspect $3,400 would at least get me started there.
Investors today need to be realistic and practical. It’s going to be hard to preserve wealth over the coming few years.
They would do well to learn from the bears and other hibernating animals: when there is only little food to eat, it’s best to sleep the winter through, conserve the calories we’ve stored, and await a more fruitful season. It will come. And when it does, those investors who have preserved their capital will likely enjoy the best investment opportunities for many years.