The “V” or the “L”

With inflation and interest rates on the rise, I’m becoming increasingly optimistic about the winding down of the current market cycle. Based on my macro views – derived from the bottom-up analysis of my opportunity set – I expect the Federal Reserve to continue raising interest rates (barring a sharp decline in asset prices). As the picture I took last week illustrates, the economy is showing classic signs of late-cycle strains, especially as it relates to wages and labor availability.

How long can rising interest rates and elevated equity valuations live in harmony? It’s a great question, and possibly the most important question for investors attempting to ride the cycle a little longer. Although I don’t have the answer, each basis point increase in risk-free rates applies stress to balance sheets, the economy, and the justification for owning risk assets. However, for now, the Federal Reserve’s gradual approach to raising rates appears to be going relatively smoothly. Similar to past cycles, rising rates may appear inconsequential for months or even years, and then one day investors wake up to discover everything has changed (it is true, they don’t ring a bell!).

As has been the case in previous cycles, once the unexpected occurs and asset prices decline, central banks will likely end their attempt to normalize and reverse course. After the last market cycle ended, the Federal Reserve slashed the fed funds rate from 5.25% in July 2007 to near 0% in December 2008. Other emergency responses, such as quantitative easing, were also implemented.

As the Federal Reserve slashed interest rates and purchased trillions of dollars of assets, financial markets responded in a “V” shape fashion – rebounding sharply and relatively quickly. While the financial pain resulting from the last cycle’s decline was severe, the Federal Reserve’s put option was effective in limiting the bear market’s duration.

Although I’ve been critical of the Federal Reserve from time to time, I’ve also benefited from their policies. Over the past twenty years, the extraordinary booms and busts caused by easy money have also created opportunity. For instance, after being conservatively positioned leading up to the end of the last cycle, the market’s sharp decline in 2008 and 2009 allowed me to rotate out of cash and into attractively priced small cap stocks. Due to the Federal Reserve’s decision to lower rates and purchase assets, many of the stocks I acquired in 2008-2009 rose sharply shortly after purchase. In hindsight, I was very fortunate – the cycle’s trough could have been considerably worse and lasted much longer.

While the last bear market was shortened by extremely accommodative monetary policy, there are no guarantees future bear markets will act similarly. For instance, what if during the next bear market 0% interest rates and central bank asset purchases are less effective or even counterproductive? While such a scenario seems implausible today, considering current trends in inflation and fiscal deficits, a less cooperative bond and currency market may be something investors should consider, if not expect.

Assuming central bank policies lose some or all of their effectiveness during the next bear market, I believe it’s possible the end of the current cycle could look more like an “L”, instead of a “V”. Given current valuations and trends in equity markets, investors do not appear overly concerned about the Federal Reserve’s ability to revive asset prices during the next market decline. And why should they? Over the past twenty years, many investors, including the “buy and holders”, have been conditioned and rewarded for assuming all bear markets and recessions will recover quickly and in a V-shape manner.

While investors have been conditioned to expect the next bear market to be short-lived, I’m positioning and preparing for either the “V” or the “L”. To properly prepare, I believe it’s important to understand the differences between today’s cycle and past cycles and how these differences could influence absolute returns in a variety of bear market scenarios.

In my opinion, and based on my opportunity set, one of the most glaring differences between the current market cycle versus past cycles is corporate balance sheets. During the last bear market (2008-2009), there were significantly more businesses on my possible buy list with strong balance sheets. Many of the stocks I purchased had zero debt and limited liabilities. Today, many of those same businesses have increased their financial risk by taking on debt, often to fund stock buybacks and acquisitions.

The energy industry is an interesting example. Energy was an area I was finding tremendous value during the financial crisis. During the first half of 2008, many energy companies were selling at significant premiums to the replacement cost of their assets. Later in 2008, as oil crashed from $147/barrel to $33/barrel, large premiums quickly turned to deep discounts. As such, I became an enthusiastic buyer. In fact, the energy weight in the absolute return portfolio I was managing increased from practically nothing in early 2008 to approximately 20% in March 2009.

The energy companies I purchased during this period shared an important characteristic – they all had strong balance sheets. Patterson-UTI Energy (PTEN), a market leading onshore drilling and pressure pumping business, is a good example. In 2008, Patterson had a very strong balance sheet with no debt and $81 million in cash. During the crash, I was confident their liquidity and lack of meaningful liabilities would allow the business to survive a prolonged recession and energy bust.

Patterson’s balance sheet looks much different today. Mainly due to acquisitions, Patterson’s net debt has risen considerably since its debt free days of 2008. During the next cycle bust, the decision to buy Patterson will not be as easy, especially for absolute return investors attempting to avoid combining operating risk and financial risk.

In my opinion, the strength of corporate balance sheets will be a very important variable to monitor during the next market and economic decline. Assuming the end of the cycle resembles an “L” rather than a “V”, companies with strong balance sheets will likely have a tremendous competitive advantage over their more leveraged peers. Who wants to do business with a company nearing bankruptcy? And for investors, fifty cent dollars in bear markets are nice, but if your investment doesn’t have the balance sheet to survive a prolonged recession, attractive valuations and healthy margins of safety can quickly become irrelevant.

In order to successfully navigate through the next bear market and recession, investors may find it valuable categorizing potential buy ideas by balance sheet strength. In fact, I’ve recently put together a list of “A” balance sheets, or companies I believe will survive an extended market decline and recession.

Whether or not high-quality businesses go on sale will likely depend on the severity and broadness of the next bear market. Given the current breadth of overvaluation this cycle (including high-quality stocks), I’m optimistic investors seeking liquidity will eventually be forced to sell the good along with the bad. If so, I will be ready.

As I prepare for the end of the current market cycle, I want to be properly positioned for either the “V” or the “L”. While a sharp recovery in asset prices appears to be the most popular and preferred shape of the next bear market, history shows every cycle is different. With trends in inflation and fiscal deficits on the rise, the market’s response to the next round of ultra-easy monetary policy is becoming increasingly unpredictable, in my opinion. In fact, assuming the next bear market will behave like the last could be as costly of an assumption as believing the current bull market will never end.