Putting your dry powder to work

Investors are grappling with a correction in what are clearly the late innings of a bull market. Especially in the United States, valuations are not extremely stretched at this point, but in a Benjamin Graham world, they do not represent a compelling case either. The dilemma for advisers is how best to position clients’ portfolios in such an environment.

First, over the longer term I see significant upside potential in U.S. equities, particularly in certain sectors that are currently under pressure, such as energy. For example, many well-known integrated oil companies are high-quality institutions that have a long history of increasing dividends. An eventual turnaround in energy prices will give them a lift, both in terms of free cash flow and valuation.

In fixed income, certain closed-end funds represent an area of opportunity because many of them are currently trading at a substantial discount to net asset value. And while the road may be rocky for high yield and bank loans in the near term, once we get past this rough patch, valuations are likely to rise again.

EMERGING MARKETS

Emerging markets are also starting to merit a hard look after suffering substantial losses. Brazil’s real is sitting at an all-time low and its stock market has lost a significant portion of its value in dollar terms. However, Brazil’s situation reminds me of the countries that endured the Asian crisis in 1997 and 1998. Ultimately, people in Asia continued to live, work and spend, and their economies eventually rebounded. I think the same will prove to be true of today’s emerging markets, and there may be a few places in the world where your clients could quadruple or quintuple their money over the next five to 10 years.

The one place that causes me to pause is China. The reality is that China is making a huge structural transition, and it is fairly obvious to me that China’s currency needs to be devalued dramatically. While China remains reluctant to bite the bullet, commodity price pressures are increasing, and ultimately the Chinese government will be forced to capitulate. In the meantime, China should be avoided.

WHEN TO STEP IN

It is always prudent to keep some powder dry in to take advantage of future opportunities, but I believe further weakness in the market now should be considered an opportunity to start accumulating risk assets. Why?

The one message the Federal Reserve sent to us loud and clear when it declined to raise interest rates in September was that it is reluctant to make a policy move that would disrupt capital markets in a material way.

Added to that, the U.S. economy is not falling off a cliff. It may not be growing as fast as we’d like, but the risk of a recession is remote.

While it is virtually impossible to perfectly time the market bottom, “Sell in May, go away, come again at Labor Day” has proven a reliable adage, although empirically the best time to reenter the market coincides with the first game of baseball’s World Series, which this year falls on Oct. 27. As we approach that point, I would expect that the healthy correction in risk assets will have concluded in coincidence with the collusion of seasonal head winds.

POSITIVE TAIL WINDS

After that, positive seasonal tail winds tend to take over, with sizable inflows of capital into the U.S. in pension funds as we approach the end of the year, followed by the all-important 401(k) season in January and February.

Ultimately, the investing public will wake up to the fact that the U.S. economy is doing well and the recent correction in equity prices has been healthy. In the meantime, keep an eye open for neglected opportunities.

By the time the first pitch is thrown in the opening game of the World Series, your clients hopefully will be well positioned to enjoy the game.

Scott Minerd is chairman of investments and global chief investment officer at Guggenheim Investments.

Related Topics: Investment Strategies