Defensively Building Wealth in the “New Normal” Era

Is your portfolio prepared for the “new normal” economy?

In May Mohammed El-Erian issued a fairly gloomy forecast for the world economy.

The CEO and Co-CIO of PIMCO, a firm which manages $700 billion in assets, said the world economy has entered a “new normal” state.

He predicted:

For the next 3–5 years, we expect a world of muted growth, in the context of a continuing shift away from the [United States, Japan, and Germany] and toward the systemically important emerging economies, led by China.

That’s pretty much in line with what we’ve been expecting. We’re looking at GDP growth of 1% to 2% and single-digit stock market returns in the years ahead. It’s also in line with expectations are a W-shaped recovery or an L-shaped recession.

This is nothing new though. We’ve known the bubble era has been over for a while. That doesn’t mean there’s nothing we can do though. There is plenty. We’ve just got to move with the markets. As we’ve been looking at recently, an investor willing to learn new strategies will always be able to find something that works.

One strategy working now (and should continue to work in the years ahead) is in an asset which has outperformed stocks and bonds during the last period of economic malaise. An asset that has handily beaten stocks so far this year. An asset which we have another chance to buy thanks to the current correction.

But let’s start back at the beginning.

Let History Be Your Guide

In the early 1970’s the U.S. economy was just starting out on a decade of doldrums. The combination of rampant inflation, international conflicts, too many government “fixes,” and a whole host of other problems stifled the economy for a decade.

No one thinks of the years between 1973 and 1982 to be good times. Unemployment steadily grew throughout the decade. There were three official recessions. GDP contracted for 38 out of 120 months. Nearly one-third of the decade was spent in recession.

When the economy was actually growing, it wasn’t growing fast. Real GDP, which takes out the effects of price inflation, grew an average of 1.8% per year during that time.

From an investor’s perspective, there were very few hiding places. Stocks went nowhere. The S&P 500 rose from 103 to 140. This doesn’t seem too bad – until you account for inflation. Once rising prices are factored in, the return is much closer to zero for the decade. Bonds were just as bad. Long-term corporate bonds returned an average of 6% per year. Again, that return turns negative once inflation is factored in.

There was one investment class which performed exceptionally well throughout the decade though – convertible securities – a.k.a. “convertibles.”

Convertibles are an investment which combines the upside potential of stocks with the safety of bonds. They are bonds and preferred stocks which are convertible into common stock at a predetermined price. Hence, they pay regular income like a bond and have the potential return of the stock they could be converted into.

Long-time Prosperity Dispatch readers should be familiar with convertibles. We looked into them last fall as a safe way to wade back into the markets. We also had a chance to for an exclusive one-on-one with the John Calamos, the world’s foremost convertible securities expert.

That was months ago though. Now, with sub-par economic growth practically imminent, we can get prepared. As it turns out, convertibles are practically tailor made for the “new normal” economy.

From a historical perspective, convertible securities perform best during periods of slow economic growth.

Just look at how they did during the last extended period of economic malaise. The table below compares stocks, corporate bonds, and convertibles between 1973 and 1982.

It’s not hard to see convertibles were the one of the best investments of the 70’s. When bonds did well, convertible bonds did just as well. When stocks did well, convertible bonds did just as well. Convertibles really are the best of both worlds. But they get even better.

High Returns Without High Volatility

As Mark Twain noted, history doesn’t repeat itself, but it certainly can rhyme.

Right now, it looks like history is rhyming when it comes to convertibles.

In the first five months of 2009 the S&P 500 went basically nowhere. The index of the largest 500 large-cap stocks took a very windy road to a 1.2% increase.

Convertibles, on the other hand, performed exceptionally well. The Merrill Lynch All U.S. Convertibles Index climbed more than 15% over the same time period.

The chart below shows convertibles not only outperformed stocks, they did with much less volatility.

This is the other value in convertibles. Since they are part bond or preferred stock, they pay regular interest or dividends. As with most other income-focused assets, they’re much less volatile than common stocks.

In the past few months, convertibles have shown their tendency to fall less when markets are falling and rise just as fast when markets are rising. In January and February the S&P 500 fell nearly20%. Convertibles fell about 5% over the same time period. And when stocks did eventually rally, convertibles went up right along with them.

Convertibles really are truly valuable assets as we enter the “new normal.” As with all investments though, the final concern is when to pull the trigger and buy.

When it comes to convertibles, we can consider ourselves lucky we’re still in a period of deleveraging and uncertainty.

Still on Sale

Right now the markets are correcting. Frankly, we expect to see a volatile, yet generally flat market in the months ahead. There are just very few drivers for a sustained rally in the short-term.

It looks like investors are getting used to “new normal” levels of economic growth and valuing stocks accordingly.

That’s why we consider the general market as neither significantly overvalued nor significantly undervalued. Convertibles, however, still remain at historically low levels.

Convertibles have recovered a bit since the credit crisis. So convertibles aren’t the cheapest they’ve been in 30 years. When we exclude the credit crunch though, convertibles are still heavily discounted compared and sitting at multi-decade lows. Convertibles are about 6% below the fair market value according to Calamos’ research.

Two things are important here. Discounts don’t last long in convertibles. Since convertibles offer the upside of stocks and the safety of bonds, they get snapped up quickly when they are this cheap. It’s only a matter of time until the market starts rewarding convertibles for their ability to post solid returns with low volatility. Also, at their currently discounted level, buying convertibles is like getting a 6% head start on the market.

I’ve long considered convertibles to be the closest thing to the perfect investor most folks will ever come across. And now they’re looking better than ever.

Success in the “New Normal” Economy

The value in dynamic investments like convertibles just goes to show there are decent opportunities in the current market.

We may be in the midst of a correction. It may turn out to be the final head fake rally before the next leg of the bear market. We still haven’t reached an ultimate bottom yet. Or it may turn out to be a buying opportunity for the next liquidity-fueled rally.

At this time, no one knows for sure. As investors though, our hands aren’t tied. And investments like convertibles which perform any way the markets go and during sub-par economic growth will be in high demand in the months and years ahead.

The fundamentals of investing successfully haven’t changed. We still have to find low-risk, high-reward investment opportunities. Ones which will perform well in the current and future market environments. It’s all part of the “take what the market gives you” strategy resourceful and successful investors adhere to. And that type of mentality focus will work in any type of economy.

By Andrew Mickey

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