Economic Cage Match in 2013

Opposing forces will battle for control of the economy in 2013. In one corner we have a housing market that is finally showing evidence of a rebound. In the opposite corner is evidence of a typical cyclical recession. In our view, it is difficult for an economy to experience a recession when the housing sector is operating normally, as it typically contributes between 4 and 5% of GDP. However, housing has not fully recovered and other important business cycle indicators are topping out. The Economic Cycle Research Institute (ECRI) and others have suggested that the US may already be in recession. The people at ECRI, in particular, have a very good track record of recession prediction, so they cannot be dismissed lightly.

Of course, there is also the political situation to consider. Most people are aware that the so-called “Fiscal Cliff” of tax increases and government spending cuts scheduled to take effect in 2013 has the potential to send the economy into recession, if it isn’t already there. Any political compromise between Republicans and Democrats will still likely include both tax increases and spending cuts. Either way, it looks like government policies will be an economic headwind, which will add to the fiscal headwind we’ve been experiencing the last couple of years from declines in total government contributions to GDP (including state and local governments, not just federal).

So which force will prove to be the stronger? Of course we don’t know the answer. The housing rebound is driven by demographics, which can be very powerful, but the recent experience of delayed household formation has shown that it is a force that can be at least temporarily contained by economics. We suspect that fiscal headwinds and a normal downturn in the business cycle may delay a full housing recovery but cannot ultimately prevent it.

Portfolio Positioning

Our investment process is largely unaffected by whether or not a recession is ongoing or imminent. Certainly, once a recession is recognized, stock prices in general will likely fall. However, we focus on valuations, which are based on the entire stream of future earnings that a business will generate. A recession is only a temporary hit to earnings for a durable business. By averaging earnings across the business cycle, one can even account for future recessions when determining what a company is worth.

Unfortunately, the major stock market indices are currently not attractively valued. One has to believe that the current unusual highs in profit margins will persist indefinitely in order to think that stocks are not currently expensive. There are, however, individual companies that are cheap, regardless of when the next recession occurs; one just has to turn over a large number of stones to find them.

As always, we are focused on the margin of safety in each investment. A large margin of safety both limits the downside and provides for a potentially large upside. In the current market environment, we are particularly interested in companies that will perform well regardless of which economic force wins out in 2013. These types of businesses are few and far between and are not often cheap, but we believe we have found a few to comprise a large portion of our portfolio. The rest of the portfolio largely consists of very cheap businesses that have upcoming catalysts that could send their stock prices higher, independent of the economic situation. Last but not least, we have some cash ready for any bargains that are offered up by Mr. Market when he is at his most depressed.

Potential Surprises in 2013

Three brief notes on areas to which investors may not be paying enough attention:

1. France. The French government pays around 2% to borrow for 10 years, which is quite close to the ~1.4% Germany pays. Contrast France with both Italy and Spain, the largest of the troubled PIIGS countries, who pay north of 4% and 5%, respectively. Yet France’s fiscal situation does not look much better than Spain’s, its GDP growth has recently been close to nil, and its political environment has become decidedly (even more!) anti-business. 2013 may see Germany’s “Core” partner in the Eurozone run into trouble, throwing the future of the euro even further into doubt.

2. Corporate Debt Markets. Corporations, particularly the riskier borrowers in the high yield market, are able to borrow money at interest rates that are close to all-time lows. Recently, more “speculative” debt has been issued by companies that want to pay special dividends or buyback their stock instead of investing in new factories or other productive ventures. Many of these deals allow the company to pay interest with more bonds instead of cash (so-called “Payment-In-Kind” bonds), meaning investors won’t even have interest payments to comfort them in the event of default. We don’t necessarily believe there will be a wave of defaults next year, but these speculative issuances are often characteristic of market tops. Corporate bond buyers beware.

3. US Banks. While European Banks are still struggling with the dual issues of undercapitalization and the Eurozone’s fiscal and economic woes, the largest US banks are starting to look like they have largely healed from the excesses of the mortgage bubble and the subsequent financial crisis. Many have become almost overcapitalized by shrinking their loan books and saving their earnings from the mortgage refinancing boom. If the housing recovery picks up steam, look for banks to do particularly well as legacy issues dissipate and back-to-basics mortgage lending once again becomes a cash cow.


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