New Normal

Bill Gross, the world’s most rich and famous bond guru, helped coin a new phrase when he began describing the post-Lehman bankruptcy world as a “new normal” era in finance. But what does that mean?

Does it mean de-leveraging (borrowing less), de-globalization (protectionism), and re-regulation (bigger government), all of which disrupt the normal functioning of business and delay the potential for economic recovery? Does it mean that the dollar loses its cache as the reserve currency, resulting in rapid inflation and the ascent of gold? Will the new normal be characterized by millions of unemployed workers promoting redistributionist political policies? Will this lead to civil unrest and a declining standard of living, as many believe?

Or will it just be…different?

Economic activity appears to be on the mend. Yet it is nowhere near 2007 peak levels. Some industries are reaching new levels of profitability, while others are nowhere even close to restoring the false sense of profitability that was being reported in 2006 and 2007. Money is flowing back into the financial markets, driven back into more risky asset classes by Certificate of Deposits priced at 200-times earnings.

However, both the small business lending market and structured securities markets remained closed. Capital starved small businesses are struggling to remain open. On the other hand, the demise of the Wall Street derivatives casino is probably a healthy outcome. Is the new normal better than the old normal?

Or is it just…different?

No doubt, we have to contend with high worker unemployment, essentially zero return to savers, and cash starved businesses. However, we also have more affordable housing, improved capital allocations, and greater labor force productivity than we had before. Financial industry speculators and materialistic consumers are clearly worse off. But what about the guy who wants to borrow money to buy a big home? What about the conservative car company CEO that didn’t need a government bailout to fix his union problems? What about the Arkansas-based industrial motor company that consolidated plants and reduced its debt burden and is now prepared to manufacture new high efficiency motors more profitably than before?

Are things really that much worse, or just different?

A lot depends on which industry you’re in. The technology industry experienced a deep recession when the technology bubble burst, but only a mild recession in 2009 and earnings this year will likely be well above 2008 prior peak earnings. The tech sector’s corporate customer base is cash rich. BCA Research points out that new orders for technology goods are soaring relative to inventories, tech industrial production is growing faster than capacity, inventories are still under control, and therefore hardware companies are able to raise prices even in the “new normal” environment.

The Baseline chart, below, shows that industry earnings were more than halved from their tech bubble peak. Stock prices fell even more. From the 2002 bottom, however, stock prices have about doubled, while earnings power in the sector is up five hundred percent!

In the healthcare industry, stock prices have truly experienced a “lost decade,” having gone nowhere since 1998. Companies in the sector, however, have not been standing still. In fact, corporate earnings for the companies in this sector have roughly tripled since then.

We know that the concerns about Obamacare have pressured stocks lower across the healthcare industry. BCA Research notes that the sector is trading close to one standard deviation below its long-term trend. After a period of weakness, medical equipment orders have revived. Drug companies have pushed through price increases in anticipation of the new law.

Biotech companies may actually have been one of the biggest winners by retaining a 12-year window of “data exclusivity” for branded biologics. Kevin Cook from the Options News Network explains that generic competitors will not be able to threaten the patent moats of proprietary formulations with “biosimilars” for 12 years.

No doubt, taxpayers have taken on trillions of dollars of liability with the new legislation. Now that the government is more involved than ever in healthcare, in time this country’s status as the place where new drugs and treatments are discovered may be in jeopardy. But are the companies in this “new normal” environment a bad place to invest, given their healthy profits and low valuations?

The May-Investments discipline does not depend on macroeconomic forecasts. Sometimes our view of the big picture causes us to “tweak” the model. At the worst of the sell-off, we actually had to set the model aside for a few months. But the discipline could be maintained with no input as to the macro environment at all.

Particularly now, with the “new normal” giving so many mixed signals, it is actually reassuring to have a model that doesn’t require a thorough understanding of exactly what’s going on from a top down perspective.

We have a “flexible Beta” approach that tends to take on more risk when markets are doing well, and reduces exposure to market fluctuations when the market is soft. However, this is not a “top down” decision that we make to move the beta above or below that of the S&P 500. The flexible beta characteristic is a bottom up result of following our discipline.

We have often said that our strategy tries to get in the way of what’s working, and get out of the way of what isn’t. We combine fundamental research with relative strength to allocate capital to healthy industries with broad investor support. There are some healthy industries, and some of those are attracting investor interest. We want to be invested in those areas.

There are some industries, particularly in the financial services sector and in industries that sell directly to the consumer, that are still doing much worse than they performed in 2007, and seem likely to continue to do so. We don’t want to invest in those areas. Regardless of what the “big picture” looks like for stocks; regardless of whether “the market” can rally much from current levels, at the end of the day we want to invest in healthy industries with companies whose stock prices are low enough to attract the interest of other investors.

For that reason, we’re continuing to search for attractive investments, regardless of what “big picture” concerns we might have. Having a discipline helps us to move forward, even in times of uncertainty.

It appears that in this “new normal,” just like the old normal that came before, uncertainty remains a constant and investors must have a strategy for operating in the face of it.

That’s not new at all. That’s…normal.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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