Steve Cordasco and David Evanson
TheStreet.com, Fall, 2012
This is about the time of the year you begin to see predictions from experts as well as, sadly, so-called experts, about whatzzs going to happen next year. “Gold will be up, employment down, consensus earnings will degrade during the second half of the year, and markets will be flat for 2013.”
That may be for some, but thatzzs not me.
Izzm not a predictions guy, at least not at the granular level. This is, to a degree out of respect for the markets in the same way people tend to respect Mother Nature — such a dynamic force really defies prediction. In my experience, predictions of Mother Nature and with the markets tend to lead to misery.
Economics are another story. Here I feel a little more comfortable about what the dismal science is saying regarding the prospects for 2013. The most recent read of the Chicago Fed National Activity Index shows the eighth consecutive reading below zero — not good. The index is a weighted average of 85 indicators of national economic activity drawn from four categories of data: 1) production and income; 2) employment, unemployment and hours; 3) personal consumption and housing; and 4) sales, orders and inventories. Of the 85 variables measured, 54 of them made negative contributions. While one piece of data does not make a prediction, I take the CFNA index seriously because itzzs so broadly based.
For investors, itzzs important to act on facts and not on feelings. Feelings can enter the picture when there is uncertainty regarding an outcome, and unfortunately there are an unending string of uncertainties to distract us: First it was Europe . . . Then it was the importance of initiating a QE III strategy . . . then it was Europe . . . then it was the impending failure of QE III . . . now itzzs the fallout from riding merrily over the “fiscal cliff.”
But the weakening of a broad base of economic indicators over the past eight months are the facts and I believe investors who heed them will be prepared for at least an economic slowdown at best during 2013 or and a recession at worst. Armed with this knowledge, what should investors do?
Pare down stock holdings of companies that have weak balance sheets. Levered balance sheets tend to be weak balance sheets, and a slowdown in business tends to impact levered companies disproportionately. This advice applies to mutual fund and ETF holdings too. Even looking at the balance sheets of the top 10 to 12 holdings alone will give you some indication of how exposed your holding are to a recessionary environment.
Go investment grade or go home. With respect to fixed-income investments — that is, debt investments that generate a regular stream of income — weaker companies stand to be hurt in a sluggish economic environment, resulting in possible bankruptcies or missed payments.
What constitutes a weaker company with respect to its debt obligations? A smaller ratio of free cash flow to debt-payment obligations; revenue streams which are unproven, or more importantly, which are highly correlated to other key economic indicators. Within the Standard & Poorzzs nomenclature, the highest bond rating offered is AAA, meaning “extremely strong capacity to meet financial commitments” — exactly what I believe investors are going to need in 2013.
Cut expenses. If you think about it, cutting expenses is exactly the same as improving investment performance. It may even be one better because you donzzt pay any additional taxes when you lower expenses, but you do when you realize gains or collect more interest. From taking larger deductibles on insurance policies, to appealing property tax rates, there are a myriad of ways to reduce your cash burn.
So, Izzm not much of a predictions guy. But I like to think I know trouble when I see it and, Izzm sad to report, it appears to be just over the next horizon, somewhere out there in 2013.